Why Crypto Has Likely Bottomed
At Lionschain Capital, we employ qualitative and quantitative analyses to assess both the market and specific projects. We also keep a keen eye on the news flow and look for disconnects between meaningful developments and the market’s reaction.
We have previously outlined why crypto is interesting, and what the potential end games for this market look like. But even if the upside scenarios play out, the path to realizing the potential won’t occur in a straight shot. So how does one know when to start allocating and getting exposure?
Despite the exhaustive selling that pervaded 2018, beneath the surface foundations were laid for the industry to take a leap forward. Our view is that the start of 2019 is not a fluke or a bear market bounce, but is actually the beginning of the next stage of growth. Below we will review some of the key developments that have occurred over the last 12–18 months which strengthened the fundamentals of the crypto market, and which pave the way for the next market expansion (which we believe has very likely already begun).
2017 was the seed round, 2019 is series A
If we take a step back and look at what exactly happened in 2017 when the total crypto market cap exploded from around $20B early in the year to ~$850B at the height of the bubble, we see that the vast majority of projects (>99%) were funded based on the quality of their marketing, the advisors involved, and their perceived potential but not on any meaningful working product.
The primary examples of projects that were actually working in practice were Bitcoin and Ethereum, and when those networks were overloaded with transactions due to the market frenzy, scalability concerns mounted and precipitated the correction.
Fast forward to 2019. In the last year, we have seen whitepapers turned into live running code, being stress tested out on the open market. While some people shoot down the possibility of many meaningful crypto applications, we have identified a number of early products and services which provide real-world value to general audiences.
In some of these cases, the service may provide value to a customer base, but the token which money was raised for does not clearly accrue value through the success of the network. Throughout 2018, the crypto community was heavily focused on exploring token models grounded in sound economics that would be viable for the long term. We believe this area is becoming increasingly clear, which leads us to our next point…
Token use cases and valuation models are being clarified
While the white papers for products like decentralized exchanges and distributed file sharing systems held much promise, there was a fatal flaw with most of the ICOs that raised in 2017. The assumption that native payment tokens in emerging decentralized networks would accrue value commensurate with network growth appears to be an insufficient economic model for most use cases. Unfortunately, this was the default token model design featured in most early whitepapers.
Since anything viable in cryptoland is built on open source code, a project which uses a native token as a required payment mechanism may be subject to be “forked”. This means someone will copy and modify the code such that the native token is not needed to access the network (and instead, a more prevalent currency with better liquidity, ie Bitcoin, would be used for payment in that network). Why is that? Because money gravitates toward network effects, and forcing a user to pay for a service with a “Chucky Cheese Token” is an unnecessary friction point (also known as the velocity problem, first highlighted by Kyle Samani).
If I can get the same service and pay with a form of currency I use for everything else, I will. This is exactly what happened to Bancor, a project that raised $150M. Uniswap came along, forked their code, and created an arguably better product with no native token. Uniswap daily trading volume has caught up quickly to Bancor, both hovering around $1M USD daily.
So if a payment token isn’t the use case for a token, what is the use case?
Chris Burniske put together a great piece which articulates the different value propositions for crypto assets, and our friend Ryan Adams concisely summarized the key points here:
Until recently, the market viewed most crypto assets as currencies which were essentially competing with BTC (and arguably ETH) as payment methods to be used in their own mini-economies. As discussed above, that would be an insufficient model.
However, what we have started to see is that tokens can also act as capital assets, which entitle holders to earn yield by providing “work” to the network they belong. Token holders must “stake” (ie lock up) their tokens, which subjects them to punishment for doing poor work, and rewards when they do good work. In some regard, these can be likened to taxi medallions, and the relative passivity or activity required of the token holder varies depending on the network. These assets can be valued using traditional DCF valuation methods, unlike crypto commodities.
One of the most interesting potential novelties in this market is the ability to create a new type of organization structure, the decentralized autonomous organization, or DAO. A DAO acts as a company by providing services to customers and collecting profits but does not have a clear owner. Rather the ownership and decision making is defined by the token holders.
We will explore DAOs in a future post where we will review various models where crypto capital enables networks which provide better value than non-token networks. The bottom line is we are starting to see projects where the token economics make sense and provide a unique value proposition, which was far from the case in 2017. With clear economic models that work, emerging projects will build sustainable business models and provide lasting value for investors.
Institutional custody and trading solutions are established, and institutional investors have begun to enter
The last 10 years of crypto have been all retail. When pension funds and endowments begin allocating small percentages of their portfolio to this asset class, it will support prices and should also be a catalyst for inter-crypto correlation to decline and create an environment where the top quality assets outperform.
Noteworthy items from the last 6–12 months (non-exhaustive):
- Fidelity, the world’s largest asset manager, launched its own Digital Asset trading and custody platform for institutions
- Intercontinental Exchange, the parent company of the NYSE, has set July as the target date for its crypto futures platform, Bakkt
- JP Morgan is launching their own stablecoin, which we view as an attempt to quickly position themselves as a major on-ramp
- JP Morgan’s move may have been a response to Goldman-Sachs backed Circle launching its own stable coin in late 2018
It’s no coincidence that titans of Wall Street are putting major resources into crypto. While on the one hand, it is a response to customer demand, on the other, we believe that legacy players recognize crypto as an alternative financial system and existential threat and are making strategic investments.
So while traditional financial institutions have begun to build infrastructure, have institutional investors begun to put money to work? Yes.
- The endowments of Yale, Harvard, Stanford, and MIT have all invested in crypto funds or even crypto directly (in the case of Harvard)
- Fidelity survey finds that half of institutional investors consider digital assets worthy of investment
- Coinbase launched its Prime institutional platform in 2018, and is now custodying $1B USD
- Cambridge Associates, a well-regarded investment firm and advisory, issued a recommendation to institutions to allocate to crypto in February 2019
All eyes are on crypto, which we believe provides a lot of fuel for the next bull run (i.e. the one that has just started).
Enterprises are also looking for their entry
Facebook is probably the most noteworthy potential entrant, having been in the news for reversing their ad ban on crypto and for speaking with exchanges about listing their token. We see many angles to the company’s interest in crypto, which probably deserves its own future post.
Amazon was linked to crypto twice last week, with its subsidiary Whole Foods partnering with a payment processor to accept crypto (perhaps a prelude to the mother company doing the same), and for filing a patent on a special application of proof of work technology.
Microsoft announced a decentralized identity management solution. This is one of the key areas of research across the space and we think it’s very interesting to see a legacy tech giant take a stab at it.
What’s notable is that these efforts represent developments toward building on or alongside public network infrastructure (the same holds true for JP Morgan’s activity cited above). Whereas a few years ago, enterprises explored the “blockchain not Bitcoin” theme to see if they could leverage the underlying tech behind cryptocurrency, now they are realizing that the value of this tech primarily resides in the integration with robust public tokenized networks.
Regulation has become clearer, giving space for entrepreneurs to operate
Regions such as Switzerland, Malta, and Singapore, have differentiated themselves as crypto friendly. Most of the rest of the world has taken a positive stance in attempting to reel in scamming, without stifling innovation.
Most noteworthy was the release of the SEC’s Framework for “Investment Contract” Analysis of Digital Assets. Our take was that projects which raised money in good faith during the bubble and are making reasonable efforts to build real decentralized networks will be “grandfathered in” or have to file limited registration to avoid regulatory scrutiny, while going forward, projects looking to raise money will need to go to accredited investors and pursue a security token sale.
There are likely going to be some key legal battles on the horizon, but our general take is that the SEC is making a legitimate effort to understand the nuances of the space in order to allow innovation to flourish while protecting investors, even to the degree of adding decentralization as a major criteria when determining security status. The SEC notably declared BTC and ETH as decentralized enough to not warrant security status, which plays a major role in how we shape our current portfolio.
Scalability solutions
A major factor in the popping of the 2017 bubble was the realization that Bitcoin and Ethereum could not support the level of activity needed to reach mass adoption. At the time, Bitcoin’s Lightning Network and Ethereum 2.0 only existed on paper.
Today, the Lightning Network is up and running, with over 8,000 nodes in custody of over $8M USD worth of Bitcoin. An additional advancement to Bitcoin can be found in Blockstream Liquid Network. Liquid is a second layer solution that provides increased scalability, and improved programmability to Bitcoin.
Ethereum 2.0 is a complete redesign of the Ethereum protocol which is designed to drastically increase the scalability of the network. After roughly a year of development by multiple teams, there are currently two major Ethereum 2.0 testnets up and running that third-party developers can begin working with today. The ETH2.0 roadmap is broken into 3 phases, the first of which is scheduled to go live this year. ETH2.0 will increase scalability by at least 1000x and reduce the operating cost of running the Ethereum network.
While ETH2.0 is in development, a number of scalability solutions have come to market for the current version of Ethereum. Plasma, an Ethereum scaling solution created by the designer of the Lightning Network, is a scaling technique which creates a second layer blockchain, designed to take some of the load off of a main blockchain with a minimal negative impact on security but a massive increase to scalability. Ethereum currently has two successful implementations of Plasma. Loom and OmiseGo have come to market in 2019 and developers are already building scalable applications using these layer 2 solutions.
Interoperability
As more projects come to market it has become clear that not all blockchains are best suited for all use cases. While many blockchains provide “smart contracts”, thus enabling third-party developers to build custom technology solutions on top of a single base layer, an increasing amount of projects in the future will need to own the entire technology stack in order to bring their product to market. This model can be referred to as “Application Specific Blockchains”.
Similar to traditional open sourced software, developers tend to migrate to platforms with high levels of interoperability, creating a kind of “orchard”, where entrepreneurs can pick and combine their favorite “fruits” (pre-built software modules) to create new value offerings.
Ethereum has so-far captured the valuable Open Finance (DeFi) movement through the ease of interoperability between the multiple contracts all using the Ethereum blockchain as their base layer. If a newcomer to the space wants to build something innovative in DeFi, choosing Ethereum as their base layer means they will have access to literally hundreds of Ethereum based DeFi open source applications they can use to lower development costs and speed up time to market.
Projects that eye more ambitious architectures and multilayered use cases may need to migrate away from the “Build on top of Ethereum” model and adopt the “Application Specific Blockchain” model.
Two prominent examples of projects moving away from Ethereum to launch their own chain are Binance, building a decentralized exchange, and Kin, building a social rewards program.
A future of many blockchains is only possible if assets issued and secured on one blockchain are usable on practically any other blockchain. Being able to use assets created on one blockchain via other blockchains makes the whole industry more valuable, and increases the number of use cases a new project can offer to its customers.
Cosmos, Polkadot, and others are coming to market this year with solutions that will help developers build products that communicate between chains. While it is still early in the interoperability space we are seeing a number of players build solutions to help create a future of many interconnected blockchains.
Loom is a company we closely follow, which uses Plasma to enable scalable gaming solutions for blockchain projects. Loom recently announced that in addition to their compatibility with Ethereum, they will be launching support for Tron, EOS, and Cosmos. This update positions loom as a Unity for blockchain game development. Developers can build once on Loom and have access to user’s funds regardless of the base layer on which those funds reside.
Crypto as a hedge
A week and a half ago a very interesting development took place when the big crypto breakout coincided with a major sell-off in global equities. The S&P 500 had its worst weekly close of 2019 and Bitcoin surged to its high for the year, breaking over the key 6500 level from which it tumbled over 30% in late 2018.
Crypto has two conflicting aspects which add to the difficulty in assessing its risk profile. One aspect is that it is early-stage technology, and therefore carries risk inherent to venture-style investments with high failure rates. However, it also represents an attempt at remaking an entire financial system. As a result, it can represent a hedge on traditional global markets in times of uncertainty. The last 10 years have been a historic bull run in equity markets, so we haven’t seen a real test of this hypothesis, but last week may have been a preview of what’s possible.
Conclusion
We have been bullish on the fundamentals of crypto since the second half of 2018, and have positioned our portfolio in that direction since the end of the year. We believe the tide is turning and anticipate the positive newsflow to continue, and more importantly to be reflected in the price. This market reflects George Soros’ theory of reflexivity perhaps more apparent than any other, and we may be seeing that unfold to the upside here in mid-2019.
