Can Venture Capital Create an Internet of Finance?
By Simon Paige on ALTCOIN MAGAZINE
If you are a venture capitalist you may want to read this. If you do not share it with someone who is and they may buy you dinner. Outlined here is how a traditional industry could be ripe for transformation by the VC wealth creation model using a new asset class called Self-Managed Investments (SMIs). The result would be the internet of finance.
What was the Tech Boom all About?
But first, step back 20 years when the Internet changed everything. Recall with satisfaction your early investments in Google and Amazon. In those days all the talk was about the efficiencies that come from a distributed network — the Internet itself, and what it meant for the way people could connect and do business with each other. This diagram comes from a website dealing with the evolution of the Web.
The Big Opportunity in Finance
Now back to the present. Look at the left-hand diagram again, the centralized network. Here is today’s big opportunity in finance. Diversification is the number one rule for managing a successful portfolio. Yet today almost all portfolios are centralized networks of assets with a single point of failure. That point of failure is the fiat financial system itself.
A hundred years ago the financial system was made up of independent banks, insurers, brokers, and clearinghouses. If one failed the system as a whole was unaffected. The 2008 Financial Crisis demonstrated how all that had changed. The collapse of Lehman Brothers sent shockwaves through the system because major institutions now depended upon each other for their solvency. Since then these dependencies have only grown. It does not matter if it is Deutsche Bank, New York Stock Exchange, or the Bank of China. They are all facets of a singularity — the dot in the center of the centralized network.
This single point of failure presents a huge risk for investors. In the event of another crisis not only are the (downward) movement of all assets likely to approach a correlation of one, but even access to those assets may be impaired if the counterparties required to liquidate a position are no longer available.
Meeting Investors’ Biggest Need
This situation is likely to give institutional investors the feeling they are skating on thin ice. It is like Sundar Pichai Google’s CEO waking up every morning and wondering if their computers are still running. Of course, the difference is that Google would never tolerate this kind of risk which is why they have millions of servers on farms around the planet. Google, like everyone else, understands the robust design of a distributed network.
So, dear VC, here is the opportunity: return diversification to investors by creating investments that behave like Google servers — stand-alone silos of value independent of each other but all contributing to the performance of the portfolio as a whole.
The way to do this is to have assets that do not depend on the fiat system — the single point of failure. This is now possible with the invention of the distributed ledger (blockchain) and a return to some of the basics of finance, namely that people are the source of all monetary value and that people can maintain a price as a given value (peg). It is no surprise that Satoshi Nakamoto, inventor of the distributed ledger did so in response to the 2008 events. He believed in a better way for finance and like the inventors of the Internet that it was distributed.
I took Satoshi’s vision and distributed ledger and created a digital hedge-fund structure called Self-Managed Investments (SMIs). SMIs can utilize the same investment strategies as a hedge fund, but because they simulate trading rather than actually holding assets, they avoid the systemic and counterparty risks of the fiat system. Through this one act, and their ownership secured on a distributed ledger, they move out of the left-hand centralized diagram to become part of a distributed network of independent assets.
The “Self-Managed” part of SMIs comes from the fact that investors buy tokens and are expected to trade them on digital exchanges pegged to the price of the simulated returns. You can see this in operation at https://bitcoinenhanced.io/, the world’s first SMI.
The opportunity for VCs is that any number of SMIs can be launched and marketed to investors in order to solve a very pressing need by helping to restore diversification to a portfolio. Yet, it is not just diversification that institutional investors are looking for.
After 2008 some funds grasped the need to diversify away from the systemic risk of the fiat system. Funds like the Harvard Endowment Fund started investing in natural resources such as farmland in Brazil, Latin American teak forests, a cotton farm in Australia, eucalyptus plantations in Uruguay, and timberland in Romania. Diversification yes but the problem was poor returns. Last year Harvard’s natural resources lost 12.4%. While once natural resources comprised 9% of the portfolio, the allocation is now down to 4%.
The moral of the story is that institutional investors need not just diversification away from the systemic risk of the fiat system they need good returns as well.
Fortunately, this is something VCs can deliver with SMIs. Because SMIs have no fees like a traditional hedge fund structure, they deliver better returns. For example, $100 invested into a strategy that returns 20% per annum, after 10 years the SMI structure would have returned $619 compared to $379 for a hedge fund with a 2% management and 20% performance fee structure (returns reinvested). This represents a 35% increase in returns over the 10 year period. By year 20 the SMI is returning 180% more than the hedge fund.
Applying the VC Model to SMIs
Traditionally VCs have been tech-focused — still rolling out the benefits of the first shift from centralized to distributed networks begun 20 years ago. Yet the development and risk profile of SMI’s almost exactly matches the development and risk management approach VCs use to build great companies. We should not forget that over the last 20 years this model has been the world’s best performing asset class. Let us look at some of the features of the VC approach and see how they apply to SMIs.
Investing in a start-up is a risky business. 40% are likely to fail. Further, growing a company entails injections of capital into an illiquid asset.
VCs manage this failure rate and illiquidity through diversification. They never invest in just one company. By spreading their risk across multiple start-ups they play the averages expecting the winners to more than compensate for the losers.
SMIs are also initially illiquid. Some will also fail for various reasons such as the non-performance of their investment strategy. The way to manage the illiquidity and risk of failure is to invest in multiple SMI’s and, like a VC start with small rounds, increasing the investment as more tokens are sold and the investment strategy starts to prove itself out.
Growing a business takes time. VCs understand this. As the company grows it probably also needs fresh injections of capital. These are at higher valuations that reflect increasing confidence in the business. The aim of the VC model is to get the company to a liquidity event such as trade sale of IPO where the VC can realize the returns on their investment.
SMI tokens, like the Bitcoin Enhanced XBE token, can initially trade at a discount to the Target Price of the simulated strategy. Like a seed-round, this gives early investors the greatest potential upside with the smallest capital outlay. The aim of the SMI is to grow the number of token holders so that liquidity is created on the exchanges where it is traded. Unlike the VC model, this is not a specific event but grows over time as more investors buy tokens. To aid this process the number of tokens in an SMI is likely to be capped. There are just 4 million XBE tokens. This constraint on capacity helps to create demand and maintain liquidity even when all tokens have been sold and the market is fully functional.
A VC actively engages with the companies it grows, often far beyond simply providing capital. Working with VC staff familiar with the VC road map can help a company navigate its way to its various milestones. Access to a VC’s network provides know-how and potential investors for future funding.
The same is true of an SMI. Apart from the performance of the investment strategy, an SMI is looking to build credibility and confidence as a viable investment vehicle for investors for many years to come. By declaring their holding in an SMI’s and by helping to promote it investors can play an important role in the development process.
Another suggested strategy for early investors is a liquidity commitment. The investor holds back a portion of their allocation to the SMI, publicly committing to invest the remainder from other investors on an exchange. As more investors do the same, confidence in the liquidity pool grows.
VCs Already Know the Market
Apart from the applicability of the VC business model, SMI’s also play to VCs strengths in another way. VC’s already know the market. The majority of VC funds come from institutional investors. These are exactly the people who have the headache SMIs are seeking to solve. A VC can raise a new fund with the explicit intent of helping their investors grow a number of SMIs to mitigate the loss of diversification the fiat system represents.
Is history repeating itself? What did VCs do before the Tech Boom? In ten years’ time will most VC investments be in SMIs? One thing is for sure, the shift from centralization to a distributed network is not over yet and the VC wealth creation model is likely to lead the way.