Since the creation of Bitcoin in 2009, crypto has evolved into a new asset class designed for the digital age. The industry has matured enough to begin analyzing how crypto assets fit into a traditional portfolio. This series will look at the different investment theses of crypto assets, along with the qualitative and quantitative comparisons of crypto in relation to Modern Portfolio Theory.
- Part 1: Thesis Overview
- Part 2: Returns & Volatility
- Part 3: Correlations with Traditional Asset Classes
- Part 4: Building the Portfolio
Part 1: Thesis Overview
Before comparing crypto to other asset classes, the first question is why it’s an asset class in the first place. What are the value propositions that will potentially drive the returns? When looking at crypto assets it’s important to realize that crypto as a whole contains a plethora of different use cases depending on the blockchains in question. Just as you wouldn’t inquire into the use case of equities, the same holds for crypto.
I will go through the two investment theses for crypto that are most commonly discussed: macro-economic currency hedge and Web 3.0 Infrastructure.
Hedge Against Macro-Economic Turmoil
Perhaps the most formalized investment thesis for crypto is as a macro-economic hedge. This pertains primarily to Bitcoin, but also includes Litecoin, Zcash, Monero, Grin, et al. The idea behind this thesis is that Bitcoin offers an opt-out of a world in which negative yields, quantitative easing, currency devaluations, and trade wars, have become the norm. To put it concisely, Bitcoin acts as a call option on the instability of the global economic monetary system.
This thesis happens to be very similar to that of precious metals, particularly gold (which is why Bitcoin often gets referred to as digital gold). The argument then turns to why Bitcoin is superior to gold for someone trying to make this hedge. In short, Bitcoin beats out gold in nearly every category one would use in determining a strong store of value (portability, divisibility, scarcity, verifiability, etc.).
Two of the bull case outcomes to the macro-hedge thesis are: 1) Bitcoin replaces gold as the standard safe haven asset or 2) Bitcoin becomes the global reserve currency. If Bitcoin can achieve even half of the market cap of gold, it would lead to a price of ~$200K per Bitcoin ($148B vs $7T mkt cap). As for the second outcome, if central banks begin filling their balance sheets with Bitcoin, the future price could potentially be even higher.
While these outcomes admittedly have a low probability of occurring in the near term, the risk-return trade-off should not be ignored. And even if neither outcome is realized, having a censorship-resistant method of transferring value anywhere in the world, even if used only in niche scenarios, will always carry value.
If you would like to dive further into this investment thesis, I recommend:
Vijay Boyapati’s The Bullish Case for Bitcoin
Ark Invest’s Bitcoin: Ringing the Bell for a New Asset Class
Web 3.0 Infrastructure
The second most prominent crypto asset investment thesis is focused on smart contracts, tokens, and Web 3.0 infrastructure. The crypto assets relevant here are Ethereum, EOS, Tezos, and other smart contract platforms. While the previous investment thesis had the benefit of piggy-backing on gold’s value proposition, the potential value of smart contracts in a digital world is far less defined.
A smart contract is a binding digital agreement in the form of code, available to anyone, that is fulfilled on a blockchain when certain conditions are met. Once the smart contract is deployed, it is governed only by the code it contains. By linking these contracts together, you are able to create pseudo-organizations that exist exclusively online, under no jurisdiction. Ethereum is the most well known example of a smart contract platform, in which its native currency, ETH, is used as the fee to run these smart contracts.
To understand the thesis of smart contract, protocol-level blockchains, it helps to look at Internet 1.0. The standard protocols that act as the backbone of the Internet (TCP/IP, HTTP, SMTP, etc.) are an agreed upon set of rules that computers follow to communicate with each other. However, value did not accrue to these protocols themselves but at the layer above. Proof of this is evident if you compare the net worth of Zuckerberg or Bezos, with that of Tim Berners-Lee, who had a lead role in building the Internet.
The difference this time around is that blockchains enable value to accrue at the protocol level due to the transaction costs inherently embedded in the smart contracts running on it. One way to put it is “If Bitcoin is akin to digital gold, then Ethereum is digital oil”.
A number of questions remain to be answered. Will one protocol take the lion’s share of the market or will it be more evenly distributed? Will the value accrue to the base level protocol or the tokens & protocols above them? What is the value in having voting/governance rights for a protocol?
While this thesis is harder to quantify, the potential for these smart contract platforms to dramatically change the way we interact online and with internet-connected devices is apparent.
For more information on this thesis I recommend the following:
Joel Monegro’s Fat Protocol Thesis
Felipe Gaúcho Pereira’s Visions of Ether
Overall, crypto assets have the potential to dramatically shift the current global paradigms. While the chances of some of these bull cases occurring may be slim, the potential returns may be large enough to justify the associated risks. There are also additional use cases beyond the scope of this article, such as: privacy, remittances, tokens, “defi”, prediction markets, stablecoins, and more.
Most experts would agree that crypto assets are here to stay. The question now becomes how to analyze this asset class from a risk-reward perspective. In Part 2, I will begin delving into how crypto fits into the traditional portfolio, starting with returns and volatility.
Disclaimer: The views expressed in this article are solely opinions of the author and do not represent financial or legal advice whether to buy, sell or hold shares of a particular cryptocurrency, cryptographic asset, stock or other investment vehicle. Prior to trading, investing or purchasing any assets, individuals should consult with their own tax, financial or legal advisor. Past performance is no guarantee of future price appreciation.