What Are the Most Interesting Technological Trends and How Do These Translate into Investment Theses?
This week I attended the ICONOMI: Meet the Managers event at the Ritz-Carlton hotel in Vienna on behalf of Columbus Capital to give a talk on some of my thoughts on crypto investing. Below I have tried to lay out the contents of my presentation in blog format to share with those who were not in attendance.
What Are the Most Interesting Technological Trends and How Do These Translate into Investment Theses?
At first glance this is a very wordy and complicated question. However, with some thought the question acts a very meaningful gateway into some of the most important aspects to consider when professionally investing into what is a newly defined asset class, supported by largely experimental technology.
To make this a whole lot more digestible though, I have decided to diagrammatically breakdown the question.
As is depicted, one half of the question requires us to dig deeper into how the underlying technology is evolving? To give examples in a blockchain context: proof of stake vs proof of work consensus, off chain scaling vs on chain scaling, DAG protocols etc. The fundamental value that backs crypto assets is rooted in experimental technology and so one should invest with this in mind. Intelligent investors take a probabilistic approach to assessing different outcomes and when dealing with experimental technology, there is a much wider range of scenarios/paths to be aware of and more importantly a wider range of failure scenarios for any particular asset with relatively high probabilities.
As you can imagine, gaining a deep understanding of the tech can be a difficult pursuit depending on your level of prior technical knowledge. Without a doubt it would be advantageous for the investors to educate themselves as deeply as they can on the technicalities in so far as it assists them in understanding the implications of such developments on value; which brings me to the next component.
How do technological trends translate into investable theses? This half of the question I believe can be better understood when broken down into a qualitative and a quantitative consideration. From a qualitative standpoint, we want to be able to consider if a given technological development or feature creates or destroys value for specific crypto assets or the asset class more generally. Some examples of questions we might want to ask: does proof of stake consensus or proof of work consensus add to the investment case of a particular crypto asset? What does a successful adoption of DAG protocols spell for blockchain-based protocols? Does off-chain scaling or on-chain scaling add more value? However, for us to answer these types of questions we first need to build a quantitative framework to ground our qualitative analysis and also to make our answers investable. We may take a particular view on whether a technological trend is overall positive or negative at the very least and hence be able to make directional bets. However to invest intelligently we must attempt to quantify these potential directional moves in price and assess the probabilities under different scenarios which all requires a quantitative framework to quantify each qualitative view.
How Do We Value Crypto Assets?
This new asset class, which we refer to as crypto assets, offers differentiated investment opportunities for investors. Within the broader crypto-asset class we have identified that there are in fact ways to segment these assets across a few different verticals. These categories however are subject to change as the asset class and our understanding of it evolves. At this point these distinctions are useful from an investment standpoint, as different types of crypto assets possess slightly different drivers of value.
For the purpose of this post I will not go into all the different ways in which you can categorise crypto assets but instead focus on the vertical that is relevant from a valuation standpoint. With regards to my current understanding of crypto asset valuation, there are two separate categories that have been identified with different implications for valuation: medium of exchange tokens/usage tokens and work tokens. This is not an exhaustive list as I believe that the space is evolving in such a way that tokens with other interesting features will come to the fore with different implications for valuation. For one, tokenisation of real assets and traditional securities is something that I believe will become more and more prolific in which case we already have a plethora of valuation tools to look towards which have been established for decades.
Usage Tokens
Usage tokens are tokens that are required as a form of payment to cover transaction fees or any other expenditure that arise through usage of a particular cryptoeconomic network. Such tokens are similar in nature to currencies in the sense that they are used as a monetary base to support a certain level of expenditure. Bitcoin, ZCash and Dash are examples of usage tokens that could potentially be used as monetary bases to support large swaths of economic activity that are currently transacted using traditional fiat currencies. Such economic activity includes both digitally native as well as real world commerce. We also have usage tokens, which can be used to support digitally native commerce within a network, which serves as a micro economy of some sorts, such as Request Network. Finally we also have usage tokens that power smart contract platforms such as Ethereum and EOS.
Valuation of usage tokens should be valued using the equation of exchange, MV=PQ, which originates from monetary economics. When applied to crypto assets we are able to draw some interesting generic conclusions. It should be noted however that this valuation method is applied more of as a guiding framework and it is likely that the model will likely have to be tweaked or even perhaps discarded as our understanding of crypto assets grows.
When applied to crypto assets the equation of exchange is:
MV = PQ
Where,
M = Network Value
V = Velocity of Token
PQ = Total value of good and services purchased with crypto asset
M = PQ/V
Token Price = M/Number of Tokens
An important conclusion that can be drawn from applying the equation of exchange to the valuation of usage tokens is the potential impact that token velocity can have on the token price in isolation and also the relationship between PQ and V which may determine how changes in PQ (which is tantamount to adoption of the network) may affect token price. The equation implies at the very least that a high velocity for a particular token could be detrimental for token value and so usage tokens which also act as stores of value are likely to hold more value than usage tokens that don’t, as they are likely to have a lower velocity.
Work Tokens
Work tokens are tokens that are required to perform some sort of cash flow generating activity as a part of a network. Therefore unlike usage tokens, work tokens are cash flow generating assets and hence should be valued as such. However unlike an equity or dent instrument the cash flows are not dependent on the cash flow generation of a particular company but instead dependent on the holder of a particular asset correctly performing some sort of commoditised function. An example of a work token is the REP token on the Augur prediction market network. Holders of the REP token serve as oracles for the network and in return are able to earn fees. Investing in a work token is like being an investor into income producing real estate. There is the possibility of earning income, which is subject to you renting out your property. When investing in real estate a prime location is important and when investing in a work token a widely adopted network is important. Token value grows in line with adoption of the network, as there is the opportunity to capture a growing stream of cash flows through holding a unit of the token and performing the necessary work. Valuation of work tokens is simply done using the discounted cash flow model.
Now that we have a quantitative framework in place to value some crypto assets I will now take you through some illustrative examples of technological trends that I find interesting. This list of technological trends is of course not exhaustive but it is my hope that through your own research you will begin to identify what developments are taking place and then make that knowledge investable by using the framework I have laid out.
Trend 1: Decentralised Exchange
In general, decentralised exchange refers to the class of protocols and applications that allow for crypto assets to be exchanged with minimal input from third parties.
So what is the driving this trend? What problems are we trying to solve here? Why is the concept of decentralised exchange interesting?
There are two things driving the innovation surrounding the adoption of decentralised exchange functionality:
- Decentralised exchange provides an immediate solution to the risks and problems faced by investors/traders that currently rely on centralised exchanges. This is a problem which requires a near term solution as speculation on crypto assets is currently the largest use case to have emerged. It is also requires a sustainable solution to foster healthy, well functioning crypto markets.
- Mainstream adoption of dApps will require users to move between app tokens in a way that provides for a frictionless user experience. Centralised exchanges currently represent a layer of friction for users that would significantly impede mainstream adoption.
An interesting implication of decentralised exchange which we can derive using our quantitative framework is that medium of exchange tokens that are not used as a store of value but just used to transact within some specific micro-economy may not be able to sustainably hold non-speculative value. With the onset of decentralised exchanges, it’s is likely that the velocity of tokens will greatly increase as it will be technologically possible to be switch between different tokens at great speed and without much friction. If users can seamlessly acquire the necessary usage token at the point of usage, what is their incentive to hold the token for long periods of time and suppress token velocity? This question seems to be the pivotal question for many usage tokens in determining a source of sustainable value, which is comparable to token valuations currently. Serving as a store of value is one way of dampening token velocity, but this feature is less about design and more about perception. The most likely assets to become stores of value are cryptocurrencies like Bitcoin and Monero or perhaps even smart contract platform such as Ethereum. The token velocity problem, compounded by decentralised exchange could be a much bigger problem for dApp tokens however.
Trend 2: Blockchain Interoperability
Blockchain interoperability refers to the ability for different blockchain protocols to communicate with one another by passing value and data between each other.
So what is the driving this trend? What problems are we trying to solve here? Why is the concept of blockchain interoperability interesting?
Within the public blockchain space we have seen various different blockchain protocols emerge with different functionalities and use cases across multiple verticals, which include level of security, privacy, efficiency, flexibility etc. Value and data finds itself fragmented across these protocols with no easy way to move between them.
Blockchain interoperability can be used to achieve:
- Asset encumbrance
- Decentralised exchange, atomic swaps
- Portable assets
- General cross-chain smart contracts
An interesting implication of blockchain interoperability protocols that we can derive using our quantitative framework is their effect on the sustainability of adoption. Sustainable long term value for cryptoeconomic protocols is rooted in a sustainably growing adoption of the protocol which could be jeopardised by weaker network effects as a result of blockchain interoperability. If value can move seamlessly between smart contract platforms then users will have no preference between using dApps being built on Ethereum and dApps built on Neo.
Conclusion
For many who are not familiar with the space, they are eager to see fully fledged real world applications that solve existing problems and would like to see mass user adoption as soon as possible as an indication of investment potential.
At this stage we are still dealing with experimental technology and so a sturdy foundational toolkit must be built first before we see major adoption. Hence, in the short to medium term there is a clear case for adoption growth of protocols that act as an infrastructure layer for the crypto ecosystem to be built upon.
