HGR Sample Investment Memo — ZRX

Published in

HGR Digital Asset Group

7 min readAug 16, 2018

Disclaimer

The below write-up is an internal memo on the 0x protocol (or ZRX) written and circulated by HGR Digital Asset Group. It is presented here as a reflection of the fund’s investment deliberation process by which the team evaluates and decides upon whether or not a specific cryptoasset has investment merit. As a caveat, please note that all data presented below may be outdated as per the release of this article.

Recommendation and Investment Thesis

HGR believes the 0x protocol (“ZRX”, or the “Project”) is interesting, given:

Imminent (<18 months) structural and secular shifts towards scalable decentralized exchanges (“DEXs”) amidst multiple pain points with current centralized exchanges (“CEXs”), as described in the Key Hypotheses section below.
ZRX’s likely path to market leadership as a result of its hybrid approach of pairing on-chain execution of trades (ETH as settlement layer) with off-chain order matching via “Relayers” — third-parties who can run a DEX built on top of ZRX (i.e. host their own order books and UI but conduct trades using ZRX smart contracts). More relayer signups translate to greater network effects as the ecosystem benefits from “networked liquidity” — while each relayer hosts its own off-chain orderbook, order matching and settlement can be done across all relayers built on top of the 0x protocol.
Thematic consistence with HGR’s view on near-term value accretion to “middleware” layer and IAAS / crypto-to-crypto projects. ZRX is a protocol which developers can use to face user-facing DEXs, as well as be utilized by dApps requiring back-end token exchange functions such as Augur, Aragon, Maker and Melonport. HGR will look for longer-term, required public infrastructure if we believe the number of token trading pairs will trend towards infinity (digitized assets, non-fungible tokens, etc.).
Current emergence of a real ecosystem that will kick-start usage and potentially trigger immediate catalysts. In line with this: (i) new upcoming relayers should validate the Project as POCs Radar Relay, Paradex, EthFinex, (ii) CEXs may set up ZRX-based DEX arms that will drive ZRX ecosystem volume and validate DEXs as a genuine threat / competitor to CEXs. This may also lead to the emergence of governance utility in the near-future, especially in light of large players (e.g. Coinbase acquisition of relayer Paradex) putting skin in the ZRX game. Other deep-pocketed CEXs (e.g. Binance, Bittrex) may follow Coinbase’s lead in acquiring ZRX relayers, which incentivizes them to participate in and influence protocol policy, increasing governance-based utility demand for the token.
Potential for a near-term ZRX listing on Coinbase / GDAX where, similar to Liteoin’s path to a Coinbase listing, ZRX investors / advisors include 3 former Coinbase employees — Fred Ehrsam, Olaf Carlson-Wee (Polychain), and Linda Xie (Scalar). In March 2018, Coinbase announced its intention to support selected ERC-20 tokens in the coming months, and ZRX is a nice fit with the GDAX Digital Asset Framework, consistent with the themes of open financial markets, economic freedom, and providing decentralization. This criteria match has been noted by Linda Xie, who was an advisor to the creation of the GDAX Digital Asset Framework. Note also that the management team appears to be backable (good (“A-”to “A”) but not “A+” spectacular, CTO doesn’t have formal engineering training), and project is backed by respectable investors (e.g. Polychain, Pantera, BCAP, Multicoin). The team is passionate, meticulous, and disciplined as evidenced by Github development activity and cadence of updates / blog articles — milestones largely hit and management ships product at commendable pace.

Summary Project Description

ZRX is a collection of smart contracts on Ethereum that can be used by anyone to build user facing DEXs or facilitate back-end exchange functions for dApps. It features core business logic smart contracts that accept signed data, processes them, allows settlement on-chain. ZRX also showcases governance contracts which enables voting for upgrades to trading smart contract system.
Ethereum used as settlement layer, with off-chain relays / orderbooks that do high-throughput transactions to achieve scalability.
The ZRX token represents in-network currency to pay for fees to use ZRX smart contracts (i.e. use the underlying protocol), as well as governance rights.

Key Hypotheses (hypotheses that HGR needs to prove true upon further diligence that will provide higher conviction in the asset)

The industry will see an obviation of CEXs in the next 12–24 months as a result of: (i) Third-party custodial risk (insolvencies, fractional reserve systems, unpredictable downtim), (ii) limits on judgment resistance (withdrawal limits, arduous KYC/AML, subject to local regulations). For instance, local trading bans will drive DEX volumes, which can route around censorship and remain globally accessible, (iii) single point of failure (vulnerable to centralized attack vectors given “honeypot” targets), (iv) speed (moving funds to and from hot/cold wallets vs. direct trading on cold wallet), (v) CEX economic rent seeking (trading fees order of magnitude higher than equity exchanges, usually 25 bps).
ZRX’s hybrid / Relayer model is best positioned to be the winning DEX architecture. It is better than 100% on-chain solutions like Etherdelta, where trades are subject to miner front-running (20%+ order failure rate) and UX is poor. There is also a low cost of setting up Relayer based exchange (vs. centralized) results in a broader liquidity pool and overall network effects for everyone using ZRX. Accordingly, Relayers do not need to maintain internal ledger of customer balances, build settlement infrastructure, and no KYC/AML (no asset custody). Relayers can also invest in high-quality UI and charge add’l fees for specialized services but never touch user funds. Finally, a Hybrid model can be implemented in a way that facilitates secure, reliable and fair trading.
ZRX token needs to remain relevant to the network, meaning that i) no one is incentivized to fork ZRX and suggest BTC/ETH as fee currency; and / or ii) governance rights are valued by users of ZRX protocol (DEXs, dAppss, CEXs hedging part of their business via DEX acquisitions) to justify valuations.
The ZRX DEX ecosystem must have an acceptable level of liquidity relative to CEXs. This should be supported by an increasing number of relayer build-outs, including blue-chip backed relayers (e.g. Paradex / Coinbase).

Valuation Commentary

Current Val (April 2018): <$1/ZRX; $450-$550mm (high of $900mm in Jan 2018)
DEX Comps — Market Caps

OmiseGo — $1.8 bn
BitShares — $700mm
Kyber Network — $360mm
AirSwap — $75mm

CEX Comps — Market Caps

Binance Coin — $1.7bn
KuCoin Shares — $330mm
GS-backed Circle acquires Poloniex (CEX) for $400mm

Based on discussions with other actively managed funds, reasonable valuations are believed to lie in the range of $1.2-$2.6

Investment Risks

Execution Risk: (i) Difficult challenges with off-chain order book security — on-chain, you get security for free and (ii)concerns over miner front-running.
Fork risk, obviation/replacement of ZRX token as fee currency: No specifics on token governance model has yet been release.
ZRX may lose market share to competing projects: (i)AirSwap — potentially closest comp, but very weak token use case, lower adoption, (ii)Kyber Network — depends on 3rd parties to set up trading reserves which requires up front capital, weak tokenomics,(iii) EtherDelta — on-chain orderbook, poor UX, (iv) OMG — on-chain orderbook that relies on complex cross-chain interoperability, and (v) Non-custodial centralized exchanges — Shapeshift, Evercoin.

Next Steps

Investment team to conduct deeper desktop research [Completed]
HGR to build Q&D [Completed]
Engineering Team to diligence system architecture and tech stack, understand WP [Completed]
Investment & Engineering teams to hop on call with management [TBD]
Investment team to decide position sizing and trade execution [TBD]
Conduct final approval IC on [ TBD]

May 2018 Update, Q&D Model & Recommendation

1. The price of ZRX has almost doubled in the last month, and the investment is now expensive on a fundamental / utility basis (please see model summary below). While there may still be upside in the form of catalysts (e.g. exchange listings, marketing announcements, new developments), HGR prefers to stand down for now and revisit ZRX when prices retrace to the <$1/ZRX level

HGR has completed a code audit (please see separate tech writeup) with positive findings
Follow-up questions from IC have been addressed (please see separate response sheet)

2. Model Outputs attached below

Model is intended to provide directional conviction (not hard underwriting standards), given uncertainty and irrationality in the crypto markets. Note: This model may be conservative given that it does not adjust for future compatibility beyond ERC-20 volumes.
At a price of $1.30, model suggests MoMs in the range of 3–5x, with mid-teens IRR, which is relatively unattractive compared to other opportunities in HGR’s near-term pipeline.
Investment becomes more attractive closer to $1 entry price, AND if one has conviction that trading volumes will ultimately exceed that of the NASDAQ (imperfect but helpful benchmark). The latter may be reasonable given: (i) Higher velocity / trading turnover of cryptoassets (lower friction, lower transaction fees, 24/7/365 trading) vis a vis traditional fiat securities leading to more trading volume and therefore more trading fees, and (ii) ZRX’s fundamentally larger TAM than the NASDAQ as a function of global reach (not just tech-focused stocks in the United States), and trading of new digital assets that would otherwise not have existed (e.g. ERC 721 non-fungible tokens + crypto-collectibles, ownership in art, video game items, etc.), beyond traditionally defined securities.
ZRX velocity may also be lower than expected, contributing to higher terminal value, if large stakeholders show bona fide interest in governance influence; key buyers of ZRX tokens for the governance use cases include but are not limited to: (i ) Relayers (e.g. EthFinex, Paradex) building on ZRX that want to steer protocol policy, (ii) dApps (e.g. Augur) utilizing ZRX infrastructure, and (iii)Activist funds (such as HGR) that want a seat at the table to push business building initiatives.