Primer: Cryptocurrency and Decentralized Finance
THIS IS NOT INVESTMENT ADVICE
In this piece we are focused on a brief overview of the cryptocurrency, (“crypto”) ecosystem overall to provide context to discuss Decentralized Finance, (“DeFi”) a nascent but rapidly growing sub-sector of the blockchain-based decentralized web.
From a high-level perspective, a busy person might read that last sentence and decide that we are looking at a small, somewhat irrelevant development. However, there’s solid reasoning to take the time to understand this: in our view, we are witnessing the early stages of a new ﬁnancial ecosystem being created before our eyes, and we are very very early to it. To use the cliché, this is the internet in 1995. We’re not quite the ﬁrst to get here, but we’re close enough to participate in an unprecedented wave of value creation in the next decade and beyond.
Too long, didn’t read (TL, DR); our investment strategy in crypto:
- Invest an amount of one’s overall investment portfolio that can withstand signiﬁcant volatility and potential losses. This is your total crypto asset allocation, (between 5% and 40% of total investible assets);
- Dollar-cost average between 30% and 70% of this crypto asset allocation into a passive by-and-hold strategy owning the crypto assets that form the core infrastructure of the crypto ecosystem;
- Invest the remaining crypto-asset allocation into an active strategy that invests in and supports pre-launch DeFi projects with a large portion of the strategy in lower risk staking strategies in combination with early-stage equity investments.
The objectives of this piece are the following:
To succinctly address the practical beneﬁts of Decentralized Finance, which is the emerging ecosystem of ﬁnancial applications built on top of the existing crypto/blockchain ecosystem. How is this really an improvement over the existing ﬁat ﬁnancial world? What are the risks and drawbacks? For a more in-depth look at the DeFi ecosystem, we recommend THIS piece by Fabian Schär at the St Louis Fed.
To deﬁne the three core components of the ecosystem — coins, chains, and protocols; and how they interact.
To describe our investment strategy in the space.
Part I: Overview of DeFi
The purpose of this section is to answer the critical question — what is the real value proposition of DeFi? We could spend time discussing the technical implementation of DeFi but it is not necessary for this high-level analysis, except to say that from a technological standpoint the “concept” has certainly been proven:
There are four foundational elements that are inherent to the structure of DeFi that form its value when compared to the existing ﬁnancial infrastructure:
Liquidity — all assets regardless of their market cap or ﬂoat are instantaneously liquid.
Transparency — everything that occurs in crypto* can be precisely monitored by anyone (not to be confused with identity) (*assuming the chain on which it occurs is public, as increasingly most are.)
Incentives Drive Governance — Intelligent incentive design is perhaps the most important improvement from the fiat world. All participants in the crypto ecosystem are directly incentivized to behave in the best interest of the ecosystem. A subset of this behavior is governance, where the owners of an entity control its destiny in direct proportion to their ﬁnancial ownership, (rather than proxy by default, although proxy voting is emerging).
Regulatory Escape — This phrase was chosen carefully, (the parlance in DeFi is “regulatory arbitrage”.) A focus of crypto is whether it can ﬁt within US securities law. Whether or not it should be is another question, given that those laws were written nearly a century ago, (to assume that they should is tantamount to religious belief.) However, the “regulatory escape” that crypto enables is much broader than the borders of one country — it enables a truly ﬂuid global ﬁnancial ecosystem that is above the inﬂuence of elected, (or assumed) political ﬁgures. The Biden administration’s recent appointment of Gary Gensler as SEC Chairman is particularly encouraging on this font.
Any one of these elements would be a signiﬁcant improvement over the existing ﬁat ﬁnancial infrastructure. When you combine all these elements into an infrastructure that is accessible in real-time to anyone with internet access anywhere in the world, it explains why we are observing the acceleration of this unstoppable force that is DeFi, driving signiﬁcant global economic and geopolitical change.
Risks and Drawbacks
The Frontier: We are truly at the frontier of a new form of technology that will surely have far-reaching impacts, particularly for foreign governments and law enforcement, (note that the primary medium for law enforcement by the US government is via the banks and international ﬁnance.) There are necessarily unknown unknowns.
Security: Given the digital, interconnected nature of the crypto world, cybersecurity is a foremost concern and hacks of personal accounts and information are common.
There are best practices that ensure security of assets from cyber-attacks but that is beyond the scope of this piece.
Volatility: Most market observers are familiar with the unprecedented levels of volatility seen with Bitcoin and other crypto-assets. As the holders of these assets become more diversiﬁed and crypto-asset price action becomes less vulnerable to manipulation, volatility is expected to decrease.
Regulation: As is the case with most fast-moving technology, regulation via government is struggling to keep up. As mentioned above, US securities regulation was formed at a time when the crypto ecosystem we see today was unfathomable. There are risks of knee-jerk reactions by regulators and politicians. To date, most developed economy governments seem generally accommodating to crypto technologies, some more than others.
Part II: Ecosystem Overview
Below we list and describe the primary components of the Crypto/DeFi ecosystem, picking several well-known projects that can be categorized within them. For simplicity, we have broken down the components into three categories — Currencies, Chains, and Protocols. Although in some cases tokens from one category can serve the purpose of another, for example, all tokens in themselves can act as a store of value, the categories have been chosen based on the primary objective of that project.
Examples: BTC, DOGE, USDC (and other stable coins), Monero Currencies are designed to be stores of value and or means of value transmission. In this view, BTC is very similar to US dollars, in that you can hold it as liquidity or you can use it to transact for goods, services, or other ﬁnancial assets.
All cryptocurrencies have properties that are embedded in their code base and node network that enable, (or restrict) certain functionality to distinguish them from other currencies and thus make them unique.
Examples are the following:
Bitcoin (BTC) — similar to gold in that it has limited transactability due to relatively high transaction costs and slow block formation times, (it takes about ten minutes for a transaction to clear.) Very simple ledger functionality encourages trust in the code, limits the chances of bugs, and discourages hacking.
Monero (XMR) — similar to BTC, but the transaction source, amounts, and destinations are private to outside observers, meaning that one can transact anonymously on the Monero chain.
Stable coins (USDC, USDT) — stable coins were developed to help solve the issues of price volatility relative to USD — a stable coin is a cryptocurrency that is pegged to the value of the US dollar, (or some other ﬁat asset) via some form of collateral. This is a vital innovation within the crypto ecosystem because it allows a zero-volatility bridge to the ﬁat world — you get the beneﬁts of cryptocurrencies without the drawbacks of the high volatility.
Examples: bitcoin, Ethereum, Polkadot
A “chain” is where the term blockchain comes from. There are many different forms of chains, and they are all independent and have their own independent ecosystem of computers that support them called nodes. There are links between independent chains to enable them to talk to each other and interoperate, but chains remain independent and self-supporting.
Visualize a chain like a series of chain links connected together. Each chain link is a block. Inside of that block, all the transactions or smart contracts, (more on this below) that are executed within a short time, (ten minutes or less) are aggregated together and form the data stored in a block. Each block is connected based on sharing data from all of the prior blocks that came before it, such that the chain is constantly re-validating itself.
There are two very prevalent chains — the bitcoin chain, an example of the store of value chain type, and the Ethereum chain, an example of the virtual machine chain type.
Chain type: Store of Value
Example: bitcoin (fully diluted market cap $900 billion)
*Stratos has held BTC since 2017 at a fully diluted market cap below $20 billion.
The bitcoin chain’s governance token is the Bitcoin cryptocurrency BTC, (side note the chain is bitcoin with a lowercase b, and the token is Bitcoin with an uppercase B.)
The bitcoin chain is simple in comparison to the chains that were introduced later, (bitcoin was introduced in 2009, Ethereum was introduced in 2015.) The bitcoin chain does only one thing — it records transactions. One person trades a Bitcoin to someone else, and the bitcoin chain records that transaction as a public record for anyone to see and verify. That’s it.
Chain type: Virtual Machine
Example: Ethereum (fully diluted market cap $200 billion)
*Stratos has held ETH since 2017 at a fully diluted market cap below $1 billion The Ethereum chain’s token is the cryptocurrency Ether or ETH.
The Ethereum chain is vastly more complex than the bitcoin chain on two dimensions. First, the validation algorithm works differently but that discussion is beyond the scope of this paper. Second, and this is where things get really interesting, instead of each block of Ethereum chain recording transactions like bitcoin, it records entire self-executing algorithms called smart contracts, (hence the term “virtual machine”.) In other words, each block of the Ethereum chain holds within it, thousands of agreements, (smart contracts) between multiple parties that can be inﬁnitely complex — each smart contract can be its own operating “business”, (see below for discussion of protocols.)
A simple example of the type of agreement that can be governed by a smart contract is a derivative or insurance contract. Party A and Party B agree to trade a certain asset for a certain price at a future date. A contract is created, stored in the Ethereum chain, and when that future date comes, the option is self-executed between the parties with no interference from either of the parties or any of the nodes.
There are now many derivatives of the bitcoin chain and Ethereum chain. Each of these derivatives aims to improve upon the prominent chain in some way or another or has modiﬁed the code base of the original chain to provide some benefit for a niche use case. We will discuss the investment implications for this in Part III.
The Next Dimension of Virtual Machines — Polkadot
Polkadot is an emerging blockchain technology that promises to add a new dimension to blockchains. In essence, Polkadot is a blockchain of blockchains, which enables multiple chains to piggyback off each other in a best-of-both-worlds construct.
Ethereum for all its successes is facing some challenges in scaling — the cryptographic process for validating transactions has reached a bottleneck in handling the high volume of transactions being conducted on the Ethereum network. As a result, transaction fees have gone up considerably over the past few years. The bottleneck is created by the intensity of the cryptographic process for validating transactions as the chain continues to grow, among other reasons. Unfortunately, the issues that have led to this scenario will require a signiﬁcant overhaul of the Ethereum network to update, which is expected to take several years.
Enter Polkadot. In short, Polkadot’s chain geometry enables multiple shorter chains to interact with other Polkadot-based chains’ network effects and has a less energy-intensive validation process. Both features are intended to increase transaction throughput 100x from the current Ethereum transaction pace while also reducing transaction fees to a negligible level without sacriﬁcing security. As an added beneﬁt, Polkadot is designed to interact seamlessly with the existing Ethereum network from launch, which means that it is less of a challenger to Ethereum than an enabler and can be thought of as a core component of the crypto world infrastructure as a layer one step below the existing base layer infrastructure.
Polkadot is early in its development and has yet to launch, but the team building it is comprised of several early Ethereum engineers and has already attracted a large number of other highly capable teams to begin building other blockchains based on the new technology. This is a space to watch with signiﬁcant long-term investment potential. We will release further research on Polkadot and the emerging ecosystem surrounding it separately.
Examples: UniSwap, Compound, Goldfinch
To recap, so far, we have discussed currencies and chains. To use a ﬁat world example as an analogy, currencies are — as they are in the real world — means with which to transact and store value. Chains are similar to the payment rails and gateways of the ﬁat world, (like SWIFT, ACH, Visa and Mastercard network, etc.,) in that they act as a means of transmission, (i.e. the transmission layer). It’s worth noting that any chain type can move value from point to point anywhere in the world in minutes, (none of the above ﬁat payments systems can do this,) and that the virtual machine chain type has signiﬁcant additional capabilities beyond just transmission.
Continuing the analogy, there is a need for an application layer that sits on top of the transmission layer to create functionality that is useful for real-world needs. An example of a ﬁat world application layer is merchant processing — you swipe a credit card at a convenience store, and the application connected to the point-of-sale terminal interacts with Visa to debit your credit account with that card’s issuer bank. Another example is Paypal, whereby you log into a web application and use the existing ﬁat transmission layer to transact online.
This is where Decentralized Finance (DeFi) comes into play. DeFi is a blanket term for the application layer now being built on top of existing cryptocurrencies and blockchains. Each project constituting the DeFi application layer is called a “protocol”. Each protocol has its own token, (and sometimes multiple tokens) that is linked to that protocol and can be traded throughout the crypto ecosystem for other tokens or currencies.
However, both aforementioned ﬁat examples are overly simplistic for describing the capabilities of the DeFi protocols that make up the application layer, because the functionality of these ﬁat applications is already embedded within the inherent functionality of both types of chains. More appropriate analogies are: the market-making functionality of the NYSE broker-dealers, or a particular country’s central bank, the overnight foreign exchange money market, or a global bank. We will discuss examples of DeFi protocols that mimic each of these ﬁat application functionalities in the crypto world below. This description will lead to our discussion of the “building block” investment strategy framework that we are pursuing.
Uniswap — Analogy: NYSE broker-dealers
Fully diluted market cap: $21 billion
Uniswap functions like a broker-dealer would, but offers instantaneous liquidity at a given price for any asset 24/7, and always has sufﬁcient liquidity to transact.
Uniswap is a decentralized protocol built on top of the Ethereum blockchain that enables trading of any two crypto-assets instantaneously. The functionality of Uniswap is enabled by a relatively simple algorithm that calculates what the relative prices are for any pair of assets, based on supply and demand for those two assets within the Uniswap protocol. Each currency pair has its own liquidity pool on the Uniswap protocol, so that the assets are always tradeable at the offered price, (like a broker-dealer’s balance sheet.)
Compound — Analogy: Money-market
Fully diluted market cap: $4.5 billion
*Stratos was a seed investor in Compound at a valuation below $100 million.
Compound functions like a money-market would, enabling lending or borrowing of a number of different crypto-assets with instantaneous liquidity. A user can lend or borrow a crypto-asset for a few minutes, or indeﬁnitely, on the Compound protocol.
Compound is a decentralized protocol built on top of the Ethereum blockchain that allows holders of crypto assets to lend those assets to earn yield with no lock-up, or for borrowers to borrow crypto assets and pay interest for doing so. Compound is a fully secured lending protocol, meaning that borrowing assets requires the user to contribute a greater amount of the same asset that they are borrowing. In other words, to borrow 100 Ether (ETH), I would need to contribute 150 Ether.
This may at ﬁrst seem odd, but it has signiﬁcant utility — think of it like leveraging stock on margin. If I wanted levered exposure to ETH, I can borrow it via Compound and
increase my position, (I contribute 150 ETH and borrow 100 ETH for a total position size of 250 ETH for a total cash investment of 150 ETH.) This also eliminates risk for the lender — if I know that the 100 ETH that I am lending is secured by 150 ETH, then ETH can drop by 30% before my capital is at risk, but in that case the Compound algorithm would automatically sell the borrower’s pledged ETH to maintain the margin requirement.
The concept of borrowing against assets you already have in the crypto world is called “overcollateralized lending”. To fully understand the implications of protocols like Compound, it’s important to remember that all crypto-assets are instantaneously liquid, (thanks to protocols like Uniswap as described above.) So, if you want to borrow against your ETH to invest in BTC (or any other crypto-asset), you can contribute your 150 ETH to Compound, borrow 100 ETH against it, and then head over to the ETH-BTC liquidity pool at Uniswap and trade your newly borrowed 100 ETH for whatever that will buy you in BTC at that moment. Now your portfolio still has long exposure to 150 ETH from what you contributed to Compound, as well as BTC exposure worth 100 ETH.
Goldfinch — Analogy: Money-market
Fully diluted market cap: TBD (pre-launch)
*Stratos was a founder, advisor, and seed investor in Goldﬁnch at a pre-seed valuation below $10 million.
Goldﬁnch functions like a global commercial bank, providing loans to borrowers around the world.
Goldﬁnch is a decentralized protocol built on top the Ethereum blockchain that allows holders of crypto-assets to invest in a diversiﬁed pool of loans borrowed by real-world businesses and collateralized by real-world assets. Sophisticated investors can act as underwriters for loans offered to the Goldﬁnch protocol in exchange for higher returns.
The Goldﬁnch protocol project is signiﬁcant in that it is one of the ﬁrst to bridge crypto world liquidity with real-world borrowers. All existing DeFi protocols have enabled some form of application functionality within the Crypto ecosystem, but have not provided that service outside of the conﬁnes of the crypto world. Thus, the Goldﬁnch project, (and others like it) are the ﬁrst step to deploying the foundational beneﬁts of crypto assets for real-world use. Speciﬁcally, the Goldﬁnch protocol will enable a decentralized group of users to collaborate to make underwriting decisions, service loans, and collect collateral when loans default, all on behalf of a pool of liquidity provided by investors around the world who are seeking yield and diversiﬁcation.
Tying it all together
It’s worth describing how a user in the crypto world could use all of the components of the crypto ecosystem described above. The below is a real-world example:
Buy Ether (ETH) with US dollars on Coinbase or another ﬁat to crypto on-ramp. Contribute ETH to Compound to maintain ETH exposure while borrowing against the value of that ETH position for other uses. Take the ETH that was borrowed from Compound, swap for a Stable coin (USDC) on Uniswap. Take this USDC and lend it to Goldfinch to generate current yield on your ETH exposure while maintaining your ETH long position.
Note that these are behaviors that typically only the most sophisticated hedge funds in the ﬁat world could execute, but now anyone with a smartphone can put on trades with a similar level of ﬁnancial sophistication. Today most of the capabilities that DeFi has created are focused on crypto-assets, but this is quickly changing, with Goldﬁnch and similar projects beginning to cross the boundary between crypto and ﬁat assets. When you consider that the DeFi application layer started being built less than 2 years ago, it becomes clear that the scope for continued development in the coming years is vast and will have a significant impact on the future of ﬁnance.
Part III: Investment Strategy
THIS IS NOT INVESTMENT ADVICE
When we provide an overview of the DeFi ecosystem, we are then typically asked — what is your investment strategy?
The development of the crypto world is moving incredibly quickly, which makes the challenge of investing intelligently within a new technological landscape that much more challenging. Accordingly, starting with a clear philosophy, developing an investment framework based on that philosophy, and executing systematically through time is the best way to maximize the odds of positive ﬁnancial results.
Below we describe our general philosophy, the investment framework that results from it, and our strategy for executing it.
Simply put, our philosophy to have exposure to the entire value chain of the crypto world. Although the focus of this piece has been to provide a general overview of crypto infrastructure to contextualize DeFi, owners of that underlying infrastructure will beneﬁt from the growth we anticipate in DeFi, and therefore anyone who is bullish on DeFi should be bullish on other crypto assets as well. (the inverse is also true — if you are bullish on BTC should also be bullish on DeFi generally.)
In addition to investing in the infrastructure of the crypto world, the DeFi protocols represent the applications being built on top of it and constitute a core component of the value chain that we wish to own.
It’s worth noting that this general philosophy is considered from the perspective of making an investment into crypto assets from a portfolio that is denominated in US dollars. However, it’s worth considering this philosophy in the context of a Bitcoin denominated portfolio. Viewing Bitcoin like you would view US dollar cash, with all other crypto assets revolving around it is worthwhile given that most crypto assets trade with highly correlated price behavior to Bitcoin — with Ether trading like a stock with beta of 1.5x to the S&P 500 index (if Bitcoin were the index), and DeFi assets trading with 3x beta to Bitcoin. From this perspective, the focus becomes less on trying to time the Bitcoin market relative to the US dollar, (which is clearly nearly impossible to do) and more on adding value relative to the benchmark crypto asset that is Bitcoin.
At this time there appear to be a few obvious winners that are core components of the crypto infrastructure, whereas the best DeFi protocols are much less obvious.
This leads to a bifurcation in crypto-asset strategy — buy and hold, (buy and “HODL” is perhaps more appropriate here) what appear to be the obvious winners in crypto infrastructure, and implement an “active” strategy within DeFi.
The next question then is, of a given portfolio allocation to crypto-assets, how much of that allocation should one allocate between the buy and HODL crypto infrastructure assets and the DeFi active strategy? In order to answer this question, risk and return objectives need to be considered.
Framework Component 1: Infrastructure Buy-and-Hold strategy
In our view, the two obvious winners in crypto infrastructure are Bitcoin (BTC) in the coin segment, and Ether (ETH) in the chain segment. We explain why below:
Coins — Winner: Bitcoin (BTC)
As described above, the primary value proposition of crypto coins are their role as a store of value and as a means of value transfer. Not online Gold (“shiny rock”) or ﬁat US Dollars, there is always one “reserve” asset that owns the populations mind-share for that purpose. Bitcoin (BTC) is no different — when people hear crypto, they think Bitcoin. Bitcoin’s dominance as the most recognized crypto asset will continue to reinforce its dominance.
Chains — Winner: Ethereum (ETH)
Chains are more complex than coins, (although all chains have coins), and as a result different considerations need to be made in determining the winner. Think about chains like email client protocols — once a sufﬁcient proportion of a population begins using one protocol, that protocol ends up becoming the standard because of interoperability requirements and general familiarity.
The Ethereum chain has become this — today, almost all new DeFi protocols are built on top of the Ethereum chain, and the number of new projects being launched is increasing by the day. Accordingly, at this time it appears to be a foregone conclusion that Ethereum will become the de-facto standard chain, (outside of the bitcoin chain which has limited interoperability with the Ethereum chain.)
Obtaining exposure to the overall growth in utilization of the Ethereum chain is simple — own Ether (ETH), the governance token of Ethereum. The supply-demand dynamics of Ethereum are less straightforward than Bitcoin, which has a ﬁxed ultimate supply, (whereas Ether does not), but Ether also beneﬁts from a similar familiarity-dominance
dynamic as Bitcoin in addition to the positive underlying fundamentals described above.
Framework Component 2: DeFi Active strategy
In our view, the most effective active investment strategy within crypto is to invest in DeFi projects while they are in their development phase before they are launched. This is similar to investing in a pre-IPO venture-backed business, but with a much shorter time horizon until the DeFi protocols’ governance tokens are launched. Thus, the value created by the project becomes liquid, when compared to a traditional venture-backed business. There are two beneﬁts to this strategy. First, the greatest amount of value creation typically occurs before and shortly after a governance token is launched to the greater DeFi community, which also limits the need to make market timing decisions. Second, and building off the point on market timing, it is exceedingly difficult to short-term trade tokens and outperform Bitcoin — even most market-cap-weighted token indexes underperform Bitcoin.
With this in mind, we take a similar approach to the Stratos Technologies ﬁat-tech funds, to provide “cross capital structure” investments to the DeFi projects and get access to the most promising protocols by leveraging our existing involvement with existing high-visibility DeFi projects.
Accordingly, the Stratos Technologies DeFi strategy has two investment components within the same vehicle that reinforce each other — early-stage equity capital for DeFi projects and multipurpose capital to provide liquidity to those projects as they scale and launch.
Early Stage Equity Capital
DeFi projects typically raise capital in a format that is very similar to Seed and Series A equity investments for traditional venture-backed technology companies, with two noteworthy differences — the time to liquidity is generally 1–2 years, (instead of 4–8 years), and the ecosystem of DeFi equity investors, particularly sophisticated ones, is much smaller than that in the traditional venture capital space, (although more are starting to look at DeFi.) However, there are more similarities to traditional venture than differences — investors make equity investments with the expectation that they will eventually have exits and either receive stock of a public company or cash. Advantaged access is everything.
Multipurpose Liquidity Capital
Similar to many of Stratos's existing investments, nearly all DeFi projects need some amount of non-equity initial liquidity capital that can be used to drive the functionality of the protocol while it is in its early stages, in addition to creating a liquid market in its governance tokens once they are launched. Similarly again, most equity investors in the DeFi space don’t reserve capital in their funds to provide this necessary boost and instead rely on their networks of DeFi investors to bring liquidity capital to bear, with often underwhelming results. In our view, this is a bit short-sighted, given that the success of an initial token launch, and thus multiple on capital returned to early equity investors, is highly correlated as the amount of non-equity liquid capital inside of the protocol as of its launch.
Accordingly, acting a highly value-adding equity investor as both an experienced advisor, founding member and early investor in successful DeFi projects and bringing liquidity capital alongside equity capital has provided and will continue to provide advantaged access to the best forthcoming DeFi projects, just as the similar strategy has in the ﬁat venture-backed technology space.
Developing a plan that enables systematic execution of the investment strategy through time is critical to avoid missed opportunities and the psychological pitfalls that are prevalent when signiﬁcant volatility encourages knee-jerk reactions.
With respect to the execution of the buy-and-hold strategy, the best approach to avoid buying an all-time high or missing the low is to dollar cost average in to both core assets over time, ideally on a consistent basis for multiple years or longer.
Regarding the DeFi active strategy, think of allocation to this vehicle like a closed-end private equity fund with a shorter duration than the traditional venture equity strategy, so allocations can be made more intermittently as the manager deploys capital through time-based on opportunities, and the forward returns for those opportunities are less dependent on market timing.
The ﬁnal question then is thinking about crypto portfolio allocation overall, and the allocation between the buy-and-hold strategy and the DeFi active strategy.
To reiterate the too long, didn’t read investment summary is as follows:
- Invest an amount of one’s overall investment portfolio that can withstand signiﬁcant volatility and potential losses. This is your total crypto asset allocation (between 5% and 40% of total investible assets);
- Dollar-cost average between 30% and 70% of this crypto asset allocation into a passive buy-and-hold strategy owning the crypto assets that form the core infrastructure of the crypto ecosystem;
- Invest the remaining crypto-asset allocation into an active strategy that invests in and supports pre-launch DeFi projects.
Allocation between Buy-and-Hold and Active strategies:
With the above in mind, the question of allocation between buy-and-hold strategy and active strategy remains. Given that the two components of the buy-and-hold strategy are Bitcoin and Ether, the question of risk-return between those two assets and an active strategy should govern allocation. Only you as an investor can weigh the risk-return trade-off discussed below, but a well-constructed portfolio should include exposure to Bitcoin, Ether, as well as an active strategy investing in early-stage protocols and other infrastructure.
For example, a portfolio seeking higher returns and higher risk could allocate 70% of total crypto exposure to the active strategy such as that employed by the Stratos DeFi Fund, with 30% of total crypto exposure allocated to the passive buy-and-hold blend of Ether and Bitcoin, (perhaps a 50/50 split between the two.) A lower risk portfolio could be the inverse, with 30% exposure to an active strategy, and 70% exposure to a 50/50 split between Bitcoin and Ether, (or even 70/30 between Bitcoin and Ether for lower risk still.)
In brief, the forward expected return of Bitcoin and Ether is lower than a strategy focusing on investing in early-stage, pre-token launch protocols. To put it in perspective, the minimum expected return over a two-year period for an early stage protocol at current successful protocol valuations is 10x. This is predicated upon simple math — pre-seed valuations are typically around $10 million post, and successful protocols in today’s market are valued between $100 million and $10 billion, so there is signiﬁcant upside to the 10x return target, (for example, our investment in Compound Finance was below $50 million valuation, and the current market capitalization is $2.2 billion, or 50x return.)
Bitcoin and Ether, as the apparent winners in their respective segments, have relatively low risk, (emphasis on “relatively”) when compared to an active DeFi strategy — both Bitcoin and Ether have highly distributed global networks, with hundreds of thousands
if not millions of node computers supporting their network, making a failure of the asset extremely unlikely and decreasing by the day.
However, as a result of this de-risking, forward returns will be lower than they have been in the past. In dollar terms, as of the time of this writing the total Bitcoin market cap is approximately $900 billion, nearly $1 trillion. One of the most popular end-state bull cases for Bitcoin is that it can approach and ultimately surpass gold (“shiny rock”) — worth approximately $10 trillion in value today — as the pre-eminent store of value asset. In this scenario holders of Bitcoin can expect the price of a single BTC to wind up around$500,000 per coin, or a 10x total return, albeit over an uncertain time period but with almost certainly huge volatility along the way, (more on this later.)
For Bitcoin then the risk-return proﬁle, in US dollar terms, is a low and decreasing probability of a zero with long-term upside of 10x, (with no reason Bitcoin value in dollar terms can’t increase from there.)
For Ethereum, the real-world analog that is an obvious comparable for the future market capitalization of Ether in a long-term end state is less obvious. We can start by asking what is the underlying ﬁat global ﬁnancial infrastructure worth? The aggregate market cap of the ﬁnancial sector of the MSCI All-Country World Index (ACWI), at today’s value is approximately $8 trillion of which 65% is comprised of global banks, insurance, ﬁnancial exchanges and data, and asset management and custody banks (data here). This seems like an appropriate proxy for what Ethereum could ultimately displace. However, part of Ethereum’s value proposition includes obviating the necessity for a number of the aforementioned ﬁnancial sub-industries, so this direct market capitalization comparison is not as straightforward as the comparison between Bitcoin and gold (“shiny rock”.) Furthermore, Ether is burned and created in the process of validating transactions, further complicating this analysis. Despite this, for the purposes of this discussion, let’s assume that Ether may ultimately achieve a market capitalization of $8 trillion — at today’s market capitalization of approximately $200 billion, this represents a 40x total return, again over an uncertain time period and with huge volatility.
The risk-return proﬁle of Ether, in US dollar terms, is similar to Bitcoin — low and decreasing probability of zero with a long-term upside of up to 40x.
The cryptocurrency space is evolving rapidly and holds incredible promise. However, investment risks are considerable, and volatility is likely to continue to be extreme for the foreseeable future. Please evaluate investments carefully and allocate capital to the degree that you can accept these risks and inevitable volatility.
We plan to release additional research as we continue to explore the space and ﬁnd attractive opportunities. If you are interested in learning more, please contact me: firstname.lastname@example.org.