Virtual Market Insights
“Protocol Economy Spawning Multiple Virtual Markets”
Disclaimer: The below article does not contain investment advice and should be used for educational purposes only. Moreover, the author may have a financial stake in securities that are mentioned in this article. As a result, the opinions presented in the article below are never intended to provide advice for any investment.
In understanding the commercial potential of decentralization as an investor, it is a serious mistake to gauge returns by focusing solely on the market capitalization of exchange-traded coins (i.e., the aggregate of the number of coins x respective prices). The issue is not the calculation methodology or the fact that it is measuring price rather than value (price is still what you get). Rather, the issue is that market cap is merely a starting point when attempting to value this new asset class enabled by new technology.
To evaluate the value of this new market designed by decentralization technologies, we may start by looking at where engineering, game theory and economics intersect. A good starting point would be the Protocol Economy. Once we have defined what constitutes and governs this particular economy in the first part of this article, we segment and discuss virtual financial markets in the second part. We share two particular insights into this new asset class: a) how new technology is creating a new economy, and b) where to look for investment opportunities.
INSIGHT #1: DECENTRALIZATION TECHNOLOGIES ARE ENABLING THE FORMATION OF THE PROTOCOL ECONOMY
We define the Protocol Economy as an ecosystem that is broadly consisting of three interdependent species all struggling for survival and reproductive success in an ever-evolving environment. Put less philosophically, these three species are made up of 1) Infrastructure, 2) Applications, and 3) Financial Platforms.
We broadly think of Infrastructure as public blockchain platforms that serve as computing platforms and operating systems, such as Ethereum, EOS, Klaytn and Link.
Applications are built on top of Infrastructure and enable people to be active participants in the ecosystem by using digital goods and services.
Financial Platforms are, in its most broad definition, the financial enablers of this ecosystem. They comprise both “CeFi” (centralized finance: centralized exchanges — fiat ramps, custody, etc) and “DeFi” (decentralized finance — DEX protocols, stablecoins, identity, etc). Note that financial platforms can be viewed as either Infrastructure or Application, depending on their respective use case. They also connect the “real world” with the “virtual world” via wallets and fiat on-ramps.
“Similar to the Real Economy where goods and services are produced and transacted, the Protocol Economy is where virtual production and transaction of digital goods and services take place.”
Unlike in the Real Economy, where intermediaries seek rents and monopoly profits, we think that in the Protocol Economy, value flows to users in a more equitable and efficient manner.
The 2017 price mania has prompted use cases to be built and adopted with a hope realizing the extreme valuation of the market. As reality slowly caught up with the price bubble and without any meaningful, widely adopted “killer DApp” on sight, the bubble did indeed burst, as it became apparent that most coins would not deserve their high valuations. Combined with a widespread regulatory crackdown, the market cap metric ultimately collapsed by roughly 85% from its peak. While the loss in market cap is severe, we find it to be both natural and necessary for the evolution of the Protocol Economy.
Against this backdrop, we have been observing continuous development of Applications as well as encouraging progress on the regulatory front. This notion has been confirmed recently by Cambridge Associates, a Boston-based pension and endowment consulting firm that manages approx. $30 billion in assets. In their most recent research publication “Cryptoassets: Venture into the Unknown”, they have noticed increasing investment activity and structural developments in the crypto market. As a result, Cambridge Associates strongly recommends institutions to explore this asset class in greater depth:
“Yet in looking across the investment landscape, we see an industry that is developing, not faltering. Blockchain technology introduces scarcity to the digital world, which can help innovators better monetize their work and foster innovation.”
So where should institutions start their exploration of this new asset class? Mapping out the various assets and market characteristics that offer exposure to this new technology could be of value. Again, we think coin exchange markets represent merely a subset of new virtual markets where various shades of decentralization are exchanged by a global community 24/7. In fact, we are observing how the Protocol Economy is spawning multiple virtual markets.
“The Protocol Economy is spawning multiple virtual markets”
To capture this complex paradigm of value in the Protocol Economy, we require a deep understanding of new and unique market dynamics. Rather than abandoning time-tested fundamental laws that govern markets of traditional asset classes (e.g., equities, credit, commodities, etc), however, we simply need to expand on these concepts with our insights into decentralization-specific value drivers.
INSIGHT #2: LOOK FOR VALUE IN THE ILLIQUID/RESTRICTIVE VIRTUAL MARKETS
We distinguish between “Non-Virtual World” and “Virtual World” Markets as well as “Liquid/Accessible” and “Illiquid/Restrictive” Markets.
Non-Virtual Markets (“NVMs”) are markets where transactions, such as buying and selling of financial instruments of traditional asset classes like stocks or bonds, occur in already well-established markets. This is where a large part of financial economic activity occurs. In contrast, Virtual World Markets (“VMs”) are those markets where decentralization technologies are creating a paradigm shift for transactions and interactions between each other in the form of new digital assets and services.
Additionally, we think that “Liquid/Accessible” Markets, as the name suggests, are markets where the majority of transactions occurs and where access is least restrictive. “Illiquid/Restrictive” markets are markets where communities transact in ways that are relatively restrictive due to either access or size of that market or simply because the utility of transacted goods or services is limited and specific to a small set of insiders.
Note that these markets are not individually isolated, but instead have significant value flow between each other, and the below graph captures the aforementioned financial instruments per segment.
While NVMs are, by and large, governed by the Financial Economy through interest rates, exchange rates, and asset valuations, VMs are governed by the Protocol Economy.
“Virtual World Markets are governed by the Protocol Economy”
“Liquid/Accessible” Virtual Markets — Liquid Digital Assets
Between January 2017 and January 2018, the market capitalization of all then-available coins increased ~45x in value, from ~$18 billion to around $800 billion at its peak. For better or worse, this has brought a lot of attention to the space. This virtual market is characterized by a mostly unregulated, global inclusiveness where almost any participant can gain access via exchanges around the clock. As already mentioned, this is not a local phenomenon but entirely global in reach and perspective. Not surprisingly, the exchanges that make this possible have been targeted by hackers who have stolen close to $1 billion of crypto currencies in 2018 alone, which created an urgent need for custody service, insurance, regulation and additional protections before any serious institutional players can enter the liquid token space. The good news is that we are already seeing steady, albeit small, incremental improvements through more clearly articulated policies and legal frameworks from several regulatory authorities around the world. Additionally, several credible service providers have come forward with bespoke solutions while imbuing a fresh sense of legitimacy to this emerging asset class.
Finding fundamental value at the token level has been an area of focus for many blockchain investors. Token economics and use case are likely the most important value drivers behind these new technologies. We think that tokens that are widely adopted and used specifically for a purpose that exists due to blockchain will carry fundamental value. Also, similar to stock repurchases and dividends, tokens can have similar designs and mechanisms in place to impact their valuation (e.g., token burning). As markets are slowly maturing, we are also observing the dissipation of arbitrage opportunities. This is likely due to the emergence of crypto derivative products as well as institutional market makers.
While token prices still behave relatively irrationally, we believe that, in the short and medium term, price discovery will be governed by sentiment and thus is creating a momentum-driven market. In the paper titled “Risks and Returns of Cryptocurrency” by Yale economics professors Liu and Tsyvinski, we can see significant time-series momentum data at the daily and weekly frequencies for BTC, ETH, and XRP:
“For example, a one-standard-deviation increase in the current day’s Bitcoin return predicts a 0.33 percent increase in the daily return over the next day. Grouping weekly returns by quintiles, we find that the top quintiles outperform the bottom quintiles over the 1–4 week horizons.”
We also observed positively skewed return profiles as well as high kurtoses for the larger coins, making it an overall attractive asset class.
However, looking at the broader coin market, we also observe high, positive correlations between BTC and the rest of the altcoin market, indicating that price discovery is currently taking a back seat.
In order to do well in this market, we want to construct a relatively concentrated portfolio that consists of high-conviction ideas that exhibit low fundamental correlations. What we have observed during 2018 and well into 2019 has made this task particularly challenging: correlations between BTC and other major altcoins have been converging to significantly high levels. In this BTC market, finding opportunities to outperform is difficult for the time being.
Furthermore, BTC also serves as a major gateway into this market as is evident from the graph below. Following the flow of coins highlights the importance of several coins, especially BTC, as the de facto entry point into this virtual market.
In the short to medium run, combining fundamental research with statistical/technical analysis and sentiment data can be a sensible approach when attempting to capture excess returns in the current market. We expect correlations between BTC and other altcoins to eventually diverge, however, creating opportunities for the well-positioned investor.
“Illiquid/Restrictive” Virtual Markets
- “Crypto Venture” — Private Equity / Traditional VC in decentralization-related startups or entities
Another virtual market that has been receiving more attention in the recent past, likely due to the prolonged bear market, is the crypto equity market (traditional VC). We also believe that this market has pockets of value in many places around the world. Research group Diar reported towards the end of 2018 that blockchain and crypto-related startups have raised nearly $3.9 billion through VC investments in the first three quarters of 2018. That represents an increase of 280% when compared to the full year 2017.
Investing into the equity of a decentralization-related startup may let investors capture value if the startup’s effort is required in stabilizing the decentralized protocol or application that is being developed. This usually happens at a very early stage of development. During this period of time, it can be wise to invest in equity rather than in tokens since early-stage ventures may pivot to determine the best fit of their digital good or service. Designing a decentralized product involves a significant responsibility for detail, which creates a need to deal with complications.
While the investment process for equity opportunities should also be driven by the same fundamental thinking of a token investment, evaluating the team behind the project should be a top priority. There are different approaches, but we generally believe that the quality of the idea, timing, and the likelihood of execution success are the main evaluating metrics for gaining conviction in a relatively illiquid, long-term investment. Furthermore, after the investment is made, the relationship between the founders and investors matter greatly. A relationship where both parties are valuable to the project is of utmost importance to the eventual success. We have the tools to both accelerate and build the communities to enable scaling at the portfolio company level. Since investing in equity or tokens are not mutually exclusive, gaining exposure to both makes sense under the right circumstances.
b) Illiquid Digital Assets — new markets offering new opportunities (ICO — STO — NFT)
One of the relatively illiquid/restrictive virtual markets that quickly comes to mind is the ICO (initial coin offering) market. This market has produced many outsized successes and failures alike, and it has come under significant regulatory scrutiny due to its fundraising ease that has attracted numerous scammers and flawed business models.
As a result, this market has become more difficult to access. Additionally, we are observing many serious projects that are oftentimes pursuing different paths than ICO. We think that compliance has been gaining in importance for all ecosystem participants.
A relatively new trend that investors are currently researching is the STO (securitized token offering) phenomenon. Beyond the regulatory and operational challenges, price discovery of security tokens may be significantly enhanced relative to utility coins, simply due to the enhanced ability to put a price tag on them. Valuation methodologies for STOs will be more intuitive and straightforward than trying to assess the network value for an infrastructure protocol. Ultimately, when valuation methodologies are tested and proven over some period of time, we believe that the second-order derivative effects from that will impact the risk-return relationship as well as the market efficiency continuum to more efficient. However, we encourage investors to be patient.
Another truly exciting Illiquid/Restrictive Virtual Market is the NFT (non-fungible token) market. Non-fungible tokens are individually unique and are not directly interchangeable, enabling specific use cases and collectability. This is in stark contrast to fungible coins like BTC. As such, non-fungible tokens offer distinctive characteristics while preserving digital scarcity. Without going too deep into the technological aspects of NFTs, we want to show how they enable new markets to open up. A few markets worth mentioning include Decentraland’s Marketplace, where market participants can buy and sell virtual plots of land in a digitally scarce environment. The idea is to enable users to create content on land that is accessible through VR (virtual reality). It is possible to bid on parcels and even take out virtual mortgage loans. Within the past month >$400 million worth of virtual land was transacted in Decentraland’s marketplace for an average price tag of over $1,000 per parcel. In theory, as certain parcels are worth more than others due to their respective locations within Decentraland, and given the transparency and insight on previous transactions thanks to the blockchain, abstracting the optimal clearing price can be modeled using quantitative techniques. While this could be a fruitless exercise today, once virtual content is actually created, accessed and monetized by a meaningful user base using VR, actual parcel values will be more efficiently determinable.
It becomes more clear that Illiquid/Restrictive Virtual Markets can be created and found in many virtual places. Since NFTs can be utilized directly by a community, they carry fundamental value. Games are an ideal category for NFTs. First of all, gamers do not require as much education on how to use tokens, or game items. Secondly, the utility of the items is much more clear since items are simply used to play the game. Thirdly, gamers, probably more than others, can truly understand the value of these kinds of items. For example, MyCryptoHeroes makes use of digitally scarce items within the game (armor, weapons, and accessories). Within the last month, more than $400 million worth of items have been transacted within the game. Also, CryptoKitties, digital, collectible cats that are built on the Ethereum blockchain, have seen similar transaction volumes within the last month of more than $350 million worth of digital cats (?!). We see new NFT projects come to market at a rapid pace and could continue listing many more. While the value of these items is subject to lengthy debate, we believe that these examples are merely scratching the surface and that we will experience major adoption of games that offer unique benefits made possible through this new technology.
In summary, observing and actively participating in nascent virtual markets since the beginning has enabled us to derive valuable insights and principles. We are convinced that fundamental long-term investors will benefit from understanding virtual market dynamics and analyzing digital assets in the context of where they are used. The Protocol Economy, as the de facto economy of the Virtual World, is where production, distribution, trade and consumption of digital goods and services takes place and, just as in the Real Economy, is shaped by its participants’ behavior. How to capture the growing value within the Protocol Economy is our mission. By constantly revising our heuristics in response to virtual market feedback, we are able to shape our investment thinking and process.
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