An Institutional Take on the 2019/2020 Digital Asset Market
Contrary to what many might think, we believe 2019 was an exceptionally interesting and productive year for the digital asset industry. We expect 2020 to be an even bigger year for the space than 2019. The trajectory of blockchain technology and the talent powering it continue to exhibit exceptional growth. As active participants in this emerging ecosystem, we observed firsthand many major emerging trends and developments in 2019 that we have consolidated into our top 10 takeaways as part of our year in review. We end with a look ahead to 2020 to see how these trends come together into an actionable plan for investors.
Part I. Top 10 Takeaways of 2019
#1: There’s Bitcoin, and Then There’s Everything Else
Although many refer to the digital asset industry as if it were one unified industry, the reality is the industry (at least presently) is segmented into two main categories: Bitcoin and everything else. The parts of the “everything else” category include: Web3 innovation, Decentralized Finance (“DeFi”), Decentralized Autonomous Organizations (“DAOs”), smart contract platforms, security tokens, digital identity, data privacy, gaming, enterprise blockchain or distributed ledger technology (“DLT”), and much more.
We began acknowledging this bifurcation as a result of a few things. First, blockchain technology is complicated; and as a result, many people that don’t work in or interact with the space full time are seldom familiar that there are multiple blockchains, with various differing approaches to distributed consensus, monetary policies, supply distributions, value propositions, and more. Bitcoin is often the only asset they are familiar with, because it was the first blockchain network brought into the mainstream and because it is still the largest digital asset by network value (aka, market capitalization) and likely will be for the foreseeable future.
Second, during periods of uncertainty in the broader digital asset market (as experienced in 2018 and thus far in 2H 2019), many investors unequivocally undergo a flight to safety — a financial market phenomenon occurring when investors sell what they perceive to be higher-risk investments and purchase safer ones. Despite its various risks and higher volatility relative to other traditional assets, bitcoin is by and large the safest digital asset in the blockchain space presently. It is also attractive because of its size (Bitcoin’s network value is $120 billion at present) and its ability to absorb liquidity, as well as because of its historically low correlation to commonly purchased traditional assets like stocks and bonds. There are other narratives circling within digital asset enthusiasts supporting bitcoin’s value proposition: two of the most popular ones are bitcoin’s equivalent to “digital gold” (given its finite supply and true digital scarcity), and its potential to serve as a global macro hedge against a global economic downturn (particularly if one is triggered by a central banking currency crisis). We discuss these narratives in greater detail below. The foregoing observation leads us to our next takeaway: is bitcoin the digital asset market beta of current times?
#2: Bitcoin is Perhaps Market Beta, For Now
We published a report in September delving into this topic (the report can be accessed here). In traditional equity markets, beta is defined as a measure of volatility, or unsystematic risk an individual stock possesses relative to the systematic risk of the market as a whole (the latter of which has a beta coefficient of 1.0). The difficulty in defining “market beta” in a space like digital assets is that there is no consensus for a market proxy like the S&P 500 or Dow Jones. Since the space is still very early in its development, and bitcoin (BTC) has dominant market share (~68% at the time of writing), bitcoin is often viewed as the obvious choice for beta, despite the drawbacks of defining “market beta” as a single asset with idiosyncratic tendencies.
Bitcoin’s narratives tend to change over time — sometimes it’s a store of value asset, sometimes it’s a macro hedge (other times it’s not), sometimes it’s an uncorrelated (or low correlated) asset, and sometimes it’s a risk-on/risk-off asset. We acknowledge that bitcoin is not quite a safe haven yet — relative to traditional assets like gold and U.S. treasuries — and certainly isn’t here in the U.S. where the U.S. dollar maintains the global reserve asset status. But to dismiss bitcoin as a case of greater fool theory is ill-advised. Regardless of the narrative, speculation fuels bitcoin, and bitcoin has risen almost every year since inception. It has continued to garner public interest and capture most of the public digital asset market’s liquidity. As such, bitcoin’s size, combined with its institutionalization (futures, options, custody, and clear regulatory status as a commodity), have enabled it to be an attractive first step for allocators (both large and small) looking to get exposure (both long and short) to the digital asset market. We expect this trend to accelerate, suggesting that bitcoin is perhaps positioned to be digital asset market beta, for now.
It should also be noted that this is certainly not a perfect science given the early nature of this asset class, and there are other suitable options for beta exposure in digital assets as well, such as: passive market indices, direct ownership of the top few large cap digital assets, and thematic beta (e.g., thematic or sector-based index funds).
#3: Despite Slow Conversion, Substantial Progress Was Made on Growing Institutional Investor Interest in 2019
Education, education, education. Blockchain technology and digital assets represent an extraordinarily complex asset class — one that requires a non-trivial time commitment to undergo a proper learning curve. While handfuls of institutions have already started to invest in the space, a very small amount of institutional capital has actually made it in (relative to the broader institutional landscape), gauged by the size of the asset class (~$200 billion according to our estimate — a small figure by institutional standards, considering the global stock market is north of $70 trillion according to Nasdaq) and the public market trading volumes. This has led many to repeatedly ask: “when will the herd actually come?”
The reality is institutional investors are still learning — slowly getting comfortable — and this process will continue to take time. Traditionally, allocators would be looking for quality information for education purposes that can inform investment decisions. This typically takes the form of specialized industry research reports from trusted third parties, and other generic buy side and sell side research. In digital assets, given the space is an open source movement, there is almost too much information. Between Telegram chat rooms and Twitter, Reddit and Medium, Github and Discord, newsletters and podcasts, the breadth and depth of free, high quality content makes it challenging to standardize a formal and traditional research process. This is especially the case when most of the information mediums are not commonly used by traditional institutions and in some cases may even be firewalled, restricting use.
Despite educational progress through 2019, there have been three key questions asked by institutions with respect to digital assets:
· We understand blockchain technology is transformational, but is it too early to be investing in this space?
· When is mainstream adoption going to occur?
· When is bitcoin no longer going to be the entire story?
These types of questions have permitted allocators to develop a notion that they can potentially get involved in investing in digital assets in the future, and still generate positive returns, but in ways that are de-risked relative to today.
There are a few other challenges imposed on larger institutional allocators with respect to investing in digital assets. The first is structural complexity, a topic we discuss more in the next section. The short version is, there is much confusion around whether hedge fund structures or venture fund structures are the better choice for making active digital asset management allocations. The reality is, digital assets don’t fit either bucket well in a standalone sense, suggesting a diversified approach.
Time constraints represent a second challenge imposed on larger institutions; as hinted earlier, the breadth and depth of information available in this space is often met with not enough available time to digest it. Third, there is an agency challenge as it relates to larger institutional allocators; any large organization has multiple layers of decision makers, and those that undergo the due diligence work on behalf of digital assets need to convince many people throughout each layer that digital assets are a worthwhile endeavor. The challenge is each of those people possess different levels of knowledge and different availabilities of time. Nonetheless, true believers inside these large organizations are emerging, and the processes for forming a digital asset strategy are either getting started or already underway. In that sense, that is why we believe substantial progress has been made on the institutional investor front, even if the pace of funding has been relatively slower than many would like.
#4: Long Simplicity, Short Complexity
Another trend we observed emerge this year was a shift away from complexity and toward simplicity. This began with the growth of bitcoin-focused products: according to Grayscale’s latest report, in Q3 2019 the Grayscale Bitcoin Trust experienced the heaviest quarterly inflows ($171.1 million) in the product’s six-year history. Across Grayscale’s platform, dollar-denominated inflows hit the highest level ever in Q3 2019 and reached $254.9 million, up more than 200% quarter-over-quarter from $84.8 million in 2Q 2019. This is despite a -23.3% drawdown in bitcoin’s price over the same period.
Other notable bitcoin-focused products this year include the launch of Bakkt, the launch of Galaxy Digital’s two new bitcoin funds, Fidelity’s bitcoin product rollout, TD Ameritrade’s bitcoin trading service on the Nasdaq via its brokerage platform, 3iQ’s recent favorable ruling for a bitcoin fund, and Stone Ridge Asset Management’s recent SEC approval for its NYDIG Bitcoin Strategy Fund, based on cash settled bitcoin futures.
But this trend was not limited to just bitcoin.
We also observed a growing institutional appetite for simpler fund structures, as evidenced by the hundreds of millions of dollars getting allocated to venture funds actively fundraising in 2H 2019 with first closes targeted in Q1 2020. For the last several years, many Fundamental-focused crypto-native hedge funds operated hybrid structures with the use of side-pockets that enabled a barbell strategy approach to investing in both the public and private digital asset markets. These hedge funds tend to have longer lock-up periods — typically two or three years — and low liquidity. While this may be attractive from an opportunistic perspective, the reality is it is quite complicated from an institutional perspective.
Do these types of funds fall under an institutional allocator’s absolute return liquid strategy (hedge fund) bucket? Or do they perhaps fall under the alternative asset illiquid strategy bucket (the same one that houses venture)? And if the latter, then is venture just a simpler way to allocate? For reporting purposes, the two are mutually exclusive.
There are several complexities associated with these hybrid structures, the most notable being that they can create an asset-liability mismatch if a manager is not careful with the fund’s liquidity. If a fund’s lock-up period expires for an investor, and the investor wants a full redemption but finds the fund is too illiquid, the fund will be unable to meet the investor’s redemption request in full in a timely fashion. This can be detrimental for LPs in need of liquidity. Thus, venture funds with plain vanilla structures — typically 10 years with a couple of extension periods — have appeared attractive to larger allocators given their simpler structural nature. It is not surprising that venture funds have continued to capture most of the institutional fund flows in this asset class to date, in addition to bitcoin and bitcoin-focused products (that tend to be one representation of market beta for the time being). A complicated asset class combined with a simple fund structure has tended to prevail over a complicated asset class combined with a complicated fund structure.
However, as will be discussed later, hybrid hedge funds are able to participate in certain opportunities that standalone venture funds cannot, given their ability to manage more liquid books and strategies. Thus, gaining proper exposure to these strategies requires careful management and thorough due diligence. Finally, in addition to hedge funds with longer lock-up periods (e.g., two to three years), we have also started to observe venture funds with shorter lock-up periods (e.g., five to six years, with a couple of extensions) coming into the market. It remains to be seen how successful these strategies are with respect to fundraising and scaling, but one thing has started become evidently clearer for the foreseeable future: outside of Quantitative-focused active trading (liquid) funds, exposure to crypto-native strategies may require both hedge fund structures and venture fund structures, suggesting a diversified approach.
#5: Active Management’s Been Challenged, But Differentiated Sources of Alpha Are Emerging
For the year-to-date period ended Q3 2019, active managers were collectively up +30% on an absolute return basis according to our tracking of approximately 50 institutional-quality funds, compared to bitcoin being up +122% over the same time period (for those seeking more information, our latest Q3 2019 Crypto Hedge Fund report can be accessed here). Looking only at a limited snapshot of YTD 2019 performance, the charts below present additional findings suggesting that every active manager we have tracked has relatively underperformed passively holding bitcoin in that time period.
Bitcoin’s performance this year, particularly in Q2 2019, has made it clear that its parabolic ascents challenge the ability of active managers to outperform bitcoin during the windows they occur. Thus, the notion of identifying alpha (in the context of beta) can be challenging. Active managers generally need to justify the fees they charge investors by outperforming their benchmark(s), (which are often beta proxies) yet at the same time they need not engage in imprudent risk behavior that can potentially have swift and sizeable negative effects on their portfolios.
However, when segmenting and analyzing these active managers by their distinctive strategies, we identified some interesting observations. For the year-to-date period ended Q3 2019, Fundamental managers (that tend to have relatively high beta exposure) captured approximately 1.7x the upside volatility of Quantitative managers, and approximately 10.7% more upside volatility than Opportunistic managers on average throughout the year. However, on a risk-adjusted basis, Quantitative managers generated nearly double the returns per unit of risk compared to Fundamental managers, and nearly +75% greater returns per unit of risk compared to Opportunistic managers.
Interestingly, active management performance from a longer lens from the beginning of 2018 (representing almost 2-years of observed performance) consistently outperformed passively holding bitcoin (with the exception of Opportunistic managers as of May 2019). This observance is largely due to various risk management techniques used to mitigate the negative performance drawdowns experienced throughout the extended market selloff in 2018.
Additionally, at the end of this report in A 2020 Look Ahead we expand on the differentiated sources of alpha that are emerging on the active management front, both in a traditional sense and in a crypto native sense. Although 2019 has challenged the large-scale success of these alpha strategies, they are nonetheless in the process of proving themselves out through various market cycles, and we expect this to be a growing theme in 2020.
#6: Token Value Accrual: Transitioning from Subjective to Objective
It is no secret that the majority of blockchain application activity to date has occurred on Ethereum, with Decentralized Finance (“DeFi”) becoming a primary area of focus. In this section we explore the relationship between Ethereum, ETH and DeFi. For those not familiar with DeFi, it refers to the ability for anybody to create and access financial services and tools in a permissionless (public) manner anywhere and anytime (including across borders). It enables global access to legacy financial infrastructure, without a middleman, where participants can exchange value in a secure, peer-to-peer, programmable, and uncensorable fashion that was not previously possible before the rise of blockchain technology and smart contracts.
DeFi grew popular within the industry with the early success of the MakerDAO network (for those unfamiliar with MakerDAO, we published a case study on it that can be accessed here). Earlier this year, The Block mapped out Ethereum’s DeFi, providing a terrific visual of the activity occurring within the network. Other sources emerged this year as well to track DeFi’s progress, such as DeFi Pulse, a website measuring the total collateral locked in DeFi applications ($640 million at the time of writing), DeFi Prime, a website tracking various DeFi products, and LoanScan, a website providing credit market information and analytics for debt issued on the Compound, dYdX and MakerDAO protocols, all of which are built on top of the Ethereum blockchain.
Zooming out, at the end of Q3 2019, according to dapp.com, there were 1,721 decentralized applications (“dApps”) built on top of Ethereum, with 604 of them being actively used — more than any other blockchain. Ethereum also had 1.8 million total unique users, with just under 400,000 of them being active — also more than any other blockchain. Yet, despite all this growing network activity, the value of ETH has remained largely flat throughout most of 2019 and is on track to end the year down approximately -10% at the time of writing (by comparison, BTC has nearly doubled in value over the same period). This begs the question: is ETH adequately capturing the economic value of the Ethereum network’s activity, and DeFi in particular?
A new fundamental metric was introduced earlier this year by Chris Burniske — the Network Value to Token Value (“NVTV”) ratio — to ascertain whether the value of all the assets anchored into a platform can be greater than the value of the base platform’s asset. Such a scenario would signify a NVTV ratio less than 1.0, and it remains to be seen if this can occur without weakening the security of a given network.
The ETH NVTV ratio has steadily declined throughout the last few years, as illustrated in a chart on the following page taken from Coin Metrics’ State of the Network: Issue 25 that can be read here.
As of Q4 2019, the ratio approached 1.0 (but still stood slightly above it). Thus, we are seeing that ETH is not (directly) capturing the value of all the assets launched on its platform; instead, value is getting captured in the applications. There are likely to be several reasons for this, but we think one theory summarizes it best: most applications and tokens (e.g., ERC-20, ERC-721, etc.) built and issued atop Ethereum may, in a large sense, be parasitic to Ethereum. ETH token holders, by holding ETH, are paying for the security of all these applications and tokens, via the inflation rate of ETH that is currently given to the miners. Therefore, ETH token holders are being diluted slowly, but the ERC-20, ERC-721 and other application token holders are not. Such token holders that are building and using systems launched on the Ethereum blockchain benefit from the security that comes from the dilution of ETH holders, but do not currently pay for any of it. As these token holders and smart contract developers utilize gas for transaction fees in order to interact with the base Ethereum blockchain, it does drive demand for ETH, but the problem (currently) is it drives demand for just one block, and then those transaction fees go straight to the miners (who are generally the largest sellers in proof-of-work systems).
One could look at this and perhaps attempt to argue the same concept applies to bitcoin, however a key difference is that bitcoin is an asset powered by a deflationary system with fixed supply, making its value proposition quite different from that of ETH. Thus, it stands to reason that unless something changes, as more applications are built atop Ethereum, in a very narrow sense, this may be dampening the value proposition of ETH given a structural disconnect between value created and value captured. Fortunately, however, the Ethereum community is currently undergoing a process of navigating the network toward a proof-of-stake consensus system, and this transition has the potential to change the token economics to the betterment of ETH. Additionally, as will be discussed in greater detail in the next section, ETH is fueling a software-powered collateral economy, possessing certain store of value traits that may continue to enhance its value proposition over time.
Lastly, it should be noted that the purpose of this section was not to highlight a bullish or bearish case for ETH (it should not be read as such), but rather to observe, and attempt to understand, early signs of network stack value capture in the space (e.g., whether value largely accrues to base layers or application layers). It remains extremely early for digital assets and their accompanying networks, and in the grand scheme of things, very little data exists so far to support any hypotheses or draw any conclusions, including the one we proposed herein. Token economic experiments continue to evolve, and new networks continue to launch, each one possessing a different monetary policy, token distribution mechanism, consensus algorithm and overall value proposition than the rest.
#7: Money or Not, Software-Powered Collateral Economies Are Here
Another trend that we observed this year and think is worth highlighting is a larger migration away from “cryptocurrencies” in an ideological currency (e.g., money/payment and a means of exchange) sense, and toward digital assets for financial applications and economic utility. This takes the shape of several forms: a very popular one is the store of value asset, commonly referred to by many in the space as “digital gold”. Bitcoin leads the industry here, but it is not the only one; other digital assets like Ether, Decred, Zcash, Monero and others exhibit certain store of value traits as well.
Another form is the notion of programmable value; smart contracts enable programmable representations of traditional financial contracts and can be quite powerful in their utility. Many things in the world today (e.g., wills, trusts, escrow agreements, securities, etc.) are legal code that owns money and then has some rules around how that money can move around, with humans then executing those rules. Computers deterministically execute code much more efficiently than humans, and as the DeFi movement is showing us, it is not hard to envision where this can go.
As of Q4 2019, we believe DeFi has enabled three relatively successful cases of emerging product-market fit: stablecoins, lending, and synthetic assets. Other experiments continue to take place — prediction markets, insurance, decentralized exchanges to name a few — but these are largely still in the go-to-market phase and have not yet gained as much traction as the others previously mentioned.
However, there’s another form of economic utility that took the stage this year that we think is beginning to extend beyond the others: software-powered collateral economies. People generally want to hold assets with disinflationary or deflationary supplies, because part of the promise of those supply curves is that they should store value well. Smart contracts enable us to program the characteristics of any asset, thus it is not irrational to assume that it’s only a matter of time until real-world (traditional) collateral assets get digitized and put to economic use on blockchain networks.
The benefit of digital collateral is that it can be liquid and economically productive in its nature while at the same time serving its primary purpose (to collateralize another asset), yet without possessing the risks of traditional rehypothecation. Dan Elitzer wrote a superb piece earlier this year calling this “Superfluid Collateral” drawing the conclusion that if assets can be allocated for multiple purposes simultaneously, with the risks appropriately managed, we should see more liquidity, lower cost of borrowing, and more effective allocation of capital in ways the traditional world may not be able to compete with.
#8: Network Lifecycles: An Established Supply Side Meets A Quiet, But Emerging Demand Side
Supply side services in digital asset networks are a commonly discussed crypto-native topic. These are services provided by a third party to a decentralized network in exchange for compensation allocated by that network. Examples of supply side services include mining, staking, validation, bonding, curation, dispute resolution, node operation, network routing, and more done to help shape the direction of networks that supply siders are incentivized to participate in.
The lifecycle of a decentralized blockchain network typically comprises three high-level phases: the fundraising period, the bootstrapping period, and the live period. The fundraising period of a network’s lifecycle is simple; when a founder and development team are first starting out, they need to raise money to fund themselves, and typically issue equity or the future rights to the network token via a SAFT (simple agreement for future tokens) structure, or a combination of the two (permitted the incentives must remain aligned). The bootstrapping period is where supply side services come in; in this phase tech-savvy third parties are incentivized to contribute their time and resources (both hardware and software intensive) to a given network because they are promised a token-denominated reward in return for every block they mine or validate. These actors help the network position for a public launch. Finally, in the live period, the network is formally launched with the token generally being fully distributed and publicly trading on exchanges.
In 2019, we observed the continued proliferation of supply side services across various networks, but very little demand side activity to meet them. This suggests we are still largely in the bootstrapping period of many networks’ lifecycles, otherwise commonly referred to as the go-to-market phase. There is a floating hypothesis that it’s easier to bootstrap the supply side of a network than the demand side; that is, getting supply side participants on board is easier than convincing users to start using the outputs of the supply side and generating revenue from them. Our view is that as developer infrastructure continues to mature and activity begins to move “up the stack” toward the application layer, more obvious manifestations of product-market fit are likely to emerge with cleaner and simpler interfaces that will attract high volumes of users in the process.
However, several concerns have been expressed by industry participants, including that most tokens are currently designed in a way that leads to speculation rather than usage. There has been much ideological debate in the industry pertaining to the difference between speculation and investment, and whether buying and holding a particular digital asset signifies utility or speculation (most commonly in the case of bitcoin). Despite this, there are some emerging cases of networks successfully bootstrapping the demand side. DeFi is perhaps the most commonly known example, and while this has been largely confined to Ethereum to date, it will be expanding to other blockchain networks like Cosmos and Tezos via interoperability initiatives in 2020. Other kinds of demand side traction among smaller networks include Helium, where anyone can set up a hotspot, provide wireless coverage, and earn native token rewards that can be redeemed for a fixed unit of bandwidth on the network, and Basic Attention Token, where publishers receive native tokens from advertisers based on the measured attention of users, and users receive native tokens for their participation that they can in turn donate back to publishers or use on the platform in exchange for premium content from the publishers.
#9: We Are in The Late Innings of The Smart Contract Wars
This section pertains to a tale nearly as old as time for those that have been involved in digital assets since the industry’s early days: the tale of base layer scalability.
For those unfamiliar with the history of the so-called “Smart Contract Wars”, the tale generally goes like this: in 2017, a single Ethereum application — Cryptokitties — became so popular it clogged the network, slowing all transaction processing nearly to a halt. Recall that the Bitcoin network processes 3–5 transactions per second, and the Ethereum network processes about 15 transactions per second, creating the general view that blockchains are simply not scalable at this point in time (especially when compared to traditional networks like Visa or Mastercard that process thousands of transactions per second). A couple problems emerged from the Cryptokitties frenzy, such as high wait times and high fees because anyone desiring to start a new transaction was placed in this long queue of transactions that were all competing to get placed into the next block on the chain. Furthermore, at its peak, Cryptokitties only had about 14,000 users, which is quite small when compared to traditional networks like Visa or Mastercard. Thus, the notion of base layer (e.g., “layer-1”) scalability competition was born.
While Ethereum leads the space on adoption and moves closer to executing on its scalability initiatives, a plethora (e.g., dozens) of smart contract competitors fundraised in the market throughout 2018 and 2019 in an attempt to dethrone Ethereum. A handful have formally launched their chains and operate in mainnet as of the end of 2019 (Blockstack, Cosmos, Kadena and Algorand are some of the popular ones), while many others remain in testnet or have stalled in development. What’s been particularly interesting to observe is the accelerative pace of innovation — not just technologically, but economically (incentive mechanisms) and socially (community building) as well. Many of these competitive smart contract platforms have undergone extensive technical research and have taken differing approaches to achieving these scalability initiatives, and it remains to be seen how well they perform when their mainnets launch.
We expect many more smart contract competitors operating privately as of Q4 2019 (whether in development or testnet) to launch their mainnets in 2020. Thus, we hold the view that, given the incoming magnitude of publicly observable experimentations throughout 2020, we are likely approaching the late innings of Smart Contract Wars. If a smart contract platform does not launch in 2020, it is likely to become disadvantageously positioned relative to the rest of the landscape as it relates to capturing substantial developer mindshare and future users and creating defensible network effects.
#10: Product-Market Fit is Coming, if Not Already Here
One of the biggest complaints pertaining to the digital asset industry is that crypto/blockchain is a solution looking for a problem to solve. This view is generally based upon the various metrics that indicate little user traction to date (relative to common applications built on top of existing internet infrastructure — e.g., the App store) and the fact that crypto is still not mainstream. Even the notion of “product-market fit” (“PMF”) is not well defined in certain crypto circles and often becomes rhetorical in nature. Is a global store of value PMF? Is speculation PMF? Is democratizing access to investments and capital/early stage markets PMF? Is the idea of a token structure as an improvement to the joint stock corporation (and thus a new way of capital formation and incentive structuring/sharing) PMF? Are dApps with users an example of PMF? Is decentralized banking PMF?
Contrary to the above, we don’t think human and financial capital would have continued pouring into the digital asset space in such great magnitude over the last several years if there wasn’t a focus on solving at least one very clear problem. The questionable sustainability of modern monetary theory is one clear problem, and Ray Dalio of Bridgerwater Associates has been quite vocal about it. Big Tech centralization is another. There are also growing global concerns related to data privacy and identity. And let’s not forget cybersecurity. The list goes on.
Yet, it remains early for crypto/blockchain and the potential of the asset class. There are no mainstream solutions yet, and the publicly traded, venture-like nature of the asset class doesn’t help much either for those looking at prices for validation of signs of immediate traction.
We are at the tip of the iceberg as it relates to products and applications blockchain technology enables. Just as it was difficult to conceive of ideas like mobile app businesses or SaaS-based business models in the early days of the internet, similarly it is difficult even for those in the digital asset space full-time to conceive of the possibilities the technology enables. The demand side is not an overnight switch nor is it binary — it’s not likely it will just, all of a sudden, turn on as a result of one or two specific things. It is neither necessary nor desirable that everybody embrace digital assets all at once.
Rather, crypto is more likely to have a trickle and flood effect in various forms and through various interactions by all different kinds of people — but driven by quality products offering solutions and convenience. We are already seeing the trickles (see Takeaway №8), but as of the end of 2019, we are just not there yet. Developers are still finding their footing with blockchain technology, and the right infrastructure is still being built.
Our team has also programmed and deployed different types of smart contracts on Ethereum — and can confirm firsthand that the technology is still clunky despite its tremendous potential. On the whole, we are still largely in the go-to-market phase; mainstream users will come with manifestations of PMF. As more time and attention gets spent on diagnosing problems and working on the applications, protocols and primitives to solve them, the industry will begin to achieve its full potential.
But these things can’t be rushed.
Nonetheless, Facebook’s Libra and Twitter’s Bluesky initiative confirm that as an industry we are heading in the right direction.
Libra was announced earlier this year with the ambitious goal to introduce billions of new users to the world of digital coins — especially those that have little or no access to legacy financial infrastructure. While it is unfortunate that Facebook’s problems with trust and privacy became large obstacles for Libra to overcome, it elucidated just how dangerous Big Tech centralization is becoming. In just a few short weeks, Libra, bitcoin, digital assets and “cryptocurrency” were discussed on every major news outlet and in every major publication, as well as in Congress, in the Federal Reserve, and by the President of the United States on Twitter. This elevated level of mainstream awareness around digital assets has not been generated since the 2017 initial coin offering frenzy.
Additionally, Jack Dorsey’s recent announcement of Twitter funding an open protocol for social media through a project called Bluesky was another major step forward for the industry. Twitter is a Big Tech club member managing greater than 100 million active users each day. The fact that the company’s founder and CEO — who also happens to be a long-term advocate and supporter of bitcoin — is spearheading a worldwide decentralization initiative is simply breathtaking.
We, therefore, end this section with a takeaway from Ori Brafman’s and Rod Beckstrom’s book The Starfish and the Spider that explores the notion of decentralization and leaderless organizations:
Over time, industries swing from being decentralized to being centralized to being decentralized to being centralized again. In the swing toward decentralization, open “starfish” (decentralized) systems are inevitably created when institutions or industries become over-centralized. Therefore, in many respects, the phenomena are not in themselves new, but what is new is our society’s understanding and recognition of them, and how they apply to our current business environment.
Part II. A 2020 Look Ahead
We see 2020 shaping up to be one of the brightest years on record for the digital asset industry. To be clear, this is not a price forecast; if we exclusively measured the health of the industry from a fundamental progress perspective, by various accounts and measures we should have been in a raging bull market for the last two years, and that has not been the case.
Rather, we expect 2020 to be a year of accelerated industry maturation. On the crypto-native side, we expect more layer-1 mainnet launches and continued innovative breakthroughs across the technical spectrum. On the institutional side, we expect the sophistication of the market to increase rapidly, in terms of education, infrastructural advancements and more attractive product offerings. In that vein, we conclude this piece by creating a framework for how investors can think about approaching the digital asset market in 2020.
The below infographic summarizes the previously discussed trends and takeaways in this piece into one consolidated visual. This four-category segmentation provides allocators and potential investors with a clear, actionable framework for digital asset portfolio construction in 2020.
In 2020, we expect to see further growth in simple, passive, low-cost structures to capture beta. With the lowest friction investor adoption focused on the largest liquid asset in the space — bitcoin — the proliferation of single asset vehicles is expected to increase. These private vehicles are a result of delayed approval of an official bitcoin ETF by the SEC and many of these vehicles will look to fill the gap left by that in the meantime.
We believe investors are less inclined to pay high fees for active beta exposure, especially when most of these actively-managed private fund vehicles have failed to keep pace during bitcoin’s parabolic ascent periods. Therefore, whether these beta allocations constitute purchasing bitcoin directly, investing in a private bitcoin-only fund/trust vehicle, investing in a large cap index, or perhaps one day acquiring shares in an ETF (though we think that is unlikely for 2020), we anticipate active managers will begin to specialize in differentiated sources of alpha generation that will complement, rather than compete with, a core passive (and lower cost ) beta position.
The next two sections focus on alpha. We see alpha coming from two distinct sources in this space currently: first, traditional alpha strategies ported over from traditional markets, and second, unique sources of alpha that are crypto-specific in nature and have been enabled by these new markets.
Alpha — Traditional
Just as we saw generalist crypto funds in the pre-2018 era begin to transition to specialized strategy funds (e.g., Fundamental, Quantitative, Opportunistic and Venture), we expect to see these specialized strategies produce differentiated sources of alpha generation — some better than others. Alpha generated by long/short trading, arbitrage (e.g., exchange or basis trading), high frequency trading, pair trading, systematic factor-based trading (e.g., trend, momentum, mean-reversion, etc.) or market timing and technical analysis are traditional market strategies that appear to transfer quite well into digital assets and are typically deployed by managers that come from traditional backgrounds.
Throughout 2019, these strategies have generally been capacity constrained due to the size of the market and opportunity set. Certain trading strategies have encountered scaling challenges and will likely continue to do so if bitcoin continues to dominate the market and if liquidity remains consolidated among few exchanges. However, we expect this to change in 2020 as more liquidity enters the market (see Bakkt, Fidelity, TD Ameritrade, ErisX, etc.). If liquidity continues to expand across the spectrum of digital assets, it will pave the way for diversified trading, help accelerate the development of new derivative markets for those other assets, as well as expand the capacity for all market participants specializing in these traditional alpha strategies. Global competition for liquidity can be expected to drive down the direct fees associated with trading, mitigating the additive costs of active trading as well.
Alpha — Crypto-Native
Alpha generated by crypto-native strategies is extremely unique to this asset class and requires specific crypto expertise that is not easy to acquire. Some examples include: thematic alpha, high conviction asset selection (with a deep fundamental and technical understanding of the network or protocol), software engineering, and generalized mining.
Thematic alpha in crypto stems from the early identification of certain trends, often as a result of being a user of the networks, not just an observer/investor. We have started to see funds focus their entire investment mandate on a specific theme within digital assets, such as DeFi, commodity monies, Web3, infrastructure, or privacy. Think of this thematic specialization as similar to a healthcare or biotech equity-focused hedge fund. The success of the fund will largely be driven by the success of the thematic vertical chosen.
Given the early nature of the space, many thematic areas of interest either have not yet played out in 2019, or have yet to be identified. We believe some of these thematic verticals will become more apparent in 2020.
Switching to asset selection, while concentrated asset selection is very familiar as a strategy in traditional markets, given the breadth and depth of the technical complexity in digital assets, we believe a manager must possess crypto-native expertise to be able to source, diligence, and ultimately get comfortable investing in an idiosyncratic asset with high conviction. On a year-to-date basis, several assets have outperformed bitcoin as of the time of writing (we will not list them here to refrain from implying investment advice). We expect this to continue in 2020 as sophisticated market participants switch back to a “risk on” mentality and rotate out of large cap digital assets and into selective smaller cap ones.
Last, but not least, throughout 2019 we have observed a handful of crypto-native managers specializing in intensive software engineering to actively participate in certain networks (also referred to as “generalized mining”) to generate alpha via the supply side services they are providing to networks. Simply put, these strategies often enable the acquisition of network tokens at below market cost (whether in public or private markets) that can then be sold on the public market at spot price or held for a period of time if there is a directionally bullish view by a fund manager that the token price will appreciate in value.
We expect to see continued growth in generalized mining strategies in 2020, but we believe they will begin to look a bit different from what we saw in 2019. Similar to how maturation has permitted us the ability to granularly segment previously generalist crypto funds into various strategies (Fundamental, Quantitative, Opportunistic) and alpha generation into various types (see above infographic), we too believe generalized mining can be segmented into different categories, with different kinds of firms specializing in different stages.
Smaller hedge funds, by nature of their limited resources, capital, and time, are likely to focus on the early side of network lifecycles (aka the bootstrapping period as discussed previously), with thorough diligence and careful selection of the networks they participate in, as generalized mining will only be as successful as the overall success of a given network (if the network isn’t successful, it doesn’t matter how many tokens you hold). These funds can build intimate relationships with founding teams and assist them in developing the infrastructure necessary to bootstrap a network; in return, they are rewarded tokens and/or permissions to provide work (albeit illiquid, given the network’s early nature). Larger hedge funds aren’t able to justify spending their time and resources on some of these smaller, early networks given their fund size and their need for greater liquidity. Unlike smaller funds, larger funds, with their greater resources, capital volumes, and available time, are more likely to focus on the later stages of network lifecycles (aka, the mainnet/public operation).
A trend we noticed in 2019 that we expect to grow in 2020 is that exchanges are becoming the dominant hubs of liquidity, and as a result they’re going to continue to leverage across all their service lines. These exchanges are becoming favorably positioned to run large scale generalized mining operations and create ancillary income streams as a byproduct of their general business. They also could, in fact, commoditize validation revenue (particularly commissions and transaction fees) by trending it down to zero, and still remain economically profitable by driving revenue from other sources (as of Q4 2019, the Binance exchange did just this).
To protect against these kinds of schemes that can potentially challenge a network’s security model and its ability to decentralize, larger hedge funds have the luxury of competing with these other larger validators, whereas smaller hedge funds do not. Alpha has been generated in situations where an honest actor identifies a malicious actor, and proves to the network (via software engineering) that the actor was malicious, resulting in a forfeiture of the malicious actor’s deposit and a partial or full zero-cost re-distribution of that deposit to the honest actor (who has now grown its token supply in a liquid, public network).
As the length of this section demonstrates, there are growing sources of crypto-native alpha that should be considered distinctly from other strategies.
We end with what is perhaps the simplest risk category of them all, traditional venture. This pertains to illiquid venture capital and private equity investments typically focused on infrastructure-related businesses that are enabling and supporting the development of the digital asset ecosystem. However, such investments are not just limited to infrastructure; throughout 2019 we have seen an abundance of investments made into operating companies focused on gaming, data analytics tools, compliance, investor services, and more.
Some venture funds are focused entirely on equity-only investments, to differentiate themselves from a token-focused strategy. Others believe the digital asset industry requires a mix of both tokens and equity to properly invest across the network lifecycle. It is important to note that these have very different liquidity and duration profiles and the underlying composition of a venture portfolio should be considered carefully.
To address this interesting token vs. equity debate, some founding teams behind digital asset networks have issued both equity and tokens, or equity with token convertibility options, sometimes creating a sense of confusion and/or uncertainty about incentive alignment in the capital structure and the value propositions inherent in those networks. While value accrual undoubtably depends on the distinctive properties of any given network and needs to be examined primarily on a case by case basis, we believe 2020 will bring much more clarity to the market as more token economic experiments go live and more demand gets bootstrapped, resulting in more data and more evidence that will get collected by fundamental analysts and placed into valuation models for studious observation.
While it remains to be seen whether it’s better to invest in tokens or in equity with respect to gaining blockchain exposure, we believe that equity-only investors are missing the transformative investment opportunity this asset class presents.
Finally, the public digital asset market drawdown in 2018 shifted capital formation back to the private digital asset markets out of fear that regulators would begin instigating enforcement actions on potential illegal securities offerings. We have seen various enforcements take place throughout 2019, and expect them to continue in 2020. At the same time, on the whole, the public digital asset market has largely traded sideways throughout the course of 2019, despite bitcoin having nearly doubled in price this year, creating a view that the digital asset investment thesis may take longer to play out than many originally anticipated. While this paints a strong case for further venture capital allocations and private market investments, we believe the public digital asset market will continue to recover in 2020, indicating the need for a diversified approach to the liquid and illiquid markets.
Overall Portfolio Construction
Digital assets are still an emerging asset class with many quickly evolving narratives, trends, and investment strategies. It is important to note, that not all strategies are suitable for all investors. The size of allocations to each category will and should vary depending on the specific allocator’s type, risk tolerance, return expectations, liquidity needs, time horizon and other factors. What is encouraging is that as the asset class continues to grow and mature, the opacity slowly dissipates and clearly defined frameworks for evaluation will continue to emerge. This will hopefully lead to more informed investment decisions across the space. The future is bright for 2020 and beyond.
Vision Hill Group is a full-service investment consulting and digital asset management firm empowering investors and clients to make better, more informed investment decisions in digital assets.
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