The (re)birth of digital assets.
Everyone remembers 2017: the year of Bitcoin’s meteoric rise and fall, THE bubble of our times. Everyone also probably remembers those things called ICOs, “Initial Coin Offerings” that left investors mostly wiped out after making grandiose promises of world-changing projects.
The conclusion for many was that it was all a scam, an easy-money-scheme by the snake-oil salesmen of the digital age, leading to the entire space being written off by most investors. But the problem with making broad-brush statements like “it’s all made up” is that we become blind to the true nature of what is truly happening.
This could perhaps be the biggest point of distinction between investors and inventors: investors are on the hunt for the best balance of risk and reward; inventors on the other hand are preoccupied with building things that work, even if it takes time. While the implosion of the crypto bubble left many investors burnt, discouraged and disgruntled, the inventors have taken the learnings of 2017 (and in some cases the generous investments of the former) and built.
And from the ashes, something absolutely fantastic is emerging and taking form.
This time isn’t different.
Big excitement, huge (and largely irrational) capital inflows, and everyone from taxi drivers to bartenders believing that they’d found the next big thing, followed by a massive crash that leaves these early “investors” wiped out – that’s a story we’ve heard before, and that’s the warning tale that many armchair investors tell.
Mocking those who say “this time is different” seems to make sense. Bubbles end in tears, don’t they? After all, look at the Dot Com boom. How many companies were wiped out? How much investor wealth was obliterated thanks to the irrational exuberance of those times?
We agree. This time isn’t different. Where we disagree is that the story of the Dot Com bubble has ended. After all, the great Amazon.com (does anyone even call it a .com anymore?) at one time saw its stock -90%, languishing in the same bucket as its less fortunate investments Pets.com and Living.com.
On the contrary, we would argue that the Dot Com bubble is actually well and alive, even today. The only difference is that in the 20 years between the initial meltdown and where we are today, the proverbial wheat got separated from the chaff.
So yes, this time isn’t different. The mistake is assuming that the story is over. With hindsight, everything is easier. The question we need to ask is: given the benefit of hindsight, and given the chance to find the equivalent of Amazon right now and reap the benefits over the next decades, would we take it?
Sifting through the ashes.
The aftermath of 2017 wasn’t pretty.
For most observers sitting outside the digital assets space, attention is often drawn to Bitcoin, the grandfather of digital assets at the tender age of 11. Bitcoin’s coming of age is an interesting tale: from a game for geeks, to currency for crooks, drug dealers and smugglers; then as currency for rogue governments, gradually evolving into the famous “Blockchain and not bitcoin” argument (and that every sensible company can have their own blockchain anyway). Fast forward to today and the narrative is something unimaginable even 2-3 years ago: that Bitcoin is the new-age supporting act for Gold, an “immutable, digital store of value”, and an increasing favourite of macro investors, heeding the famous call to #GetOffZero.
But dig deeper and you land up in the world of Decentralised Finance, better known as DeFi. The DeFi space has been fascinating us for a long time: we first penned our thoughts on DeFi last year after attending a DeFi conference in London at Imperial College, and as our understanding of the sector grew, DeFi made its way into our list of emerging opportunities.
As it was at our first DeFi conference, so it is now: the degree of collaboration across different projects, each helping to amplify and augment the capabilities of another, was astounding. Even more intriguing was the average age of the developers, entrepreneurs and researchers behind these projects (early twenties would probably be a fair estimate!).
Compound interest.
Fast forward a year or so and the performance of these formerly “small” projects has been nothing short of spectacular. Until last month, there had been some impressive gains in many DeFi tokens, but the space erupted into action in earnest with the release of Compound’s token offering. For those unfamiliar with Compound, think “collateralised lending of digital assets”, and then extend it to “factoring”.
The incentive structure around Compound’s token was the first to unleash the power of token economics in the DeFi space at a reasonable scale (Compound has about US$1.85bn of value locked in its smart contracts, earning a yield of up to 9.5% for the DAI stablecoin), and since then a number of other projects have further innovated around this as total value locked in DeFi as a whole rocketed to almost US$4bn (from about US$1bn in February 2020).
Source: DeFiPulse.com
The speed of development and innovation in the space is breathtaking, and the incremental developments seen in the likes of Aave, Synthetix, Kyber as well as a fascinating new project called yEarn have led to their token values all multiplying numerous times in recent months (yEarn is incidentally only 2 weeks old!).
These systems do not function in isolation. For these platforms to operate, they rely on pricing oracles like Chainlink and Band, which connect them to real-time data in a decentralised manner. Chainlink, in particular, made it to the top 10 largest token market capitalisation charts over the past month, although it has taken a bit of a breather since.
The most amazing part of this is that these movements in token values aren’t driven by the irrational exuberance of 2017: in the eyes of the general investing public, crypto is dead, a fool’s errand for idealistic programmers. And until new inflows enter the digital asset space again in earnest (think internet post 2001), the only money that’s moving around is money that decided to stay – committed money, determined to push these projects to completion. Any new inflows; that’s just upside.
Investing for (and in) a new age.
Quite literally, these investments are putting us on the path to a new age of financial decentralisation – a profound challenge to the incumbents that potentially turns their biggest asset (their legacy and scale) into their biggest liability.
Yet the means by which one goes about navigating the digital asset space is also starkly different from traditional finance. Where stocks and bonds were peddled by the ladies and gentlemen of the Square Mile and Wall Street, with information propagated via exclusive and esoteric channels like Bloomberg terminals and exchange filings with all manner of strange language and codes (know your 10-Qs from your 6-Ks and your S-1s?), the new world of investing finds its home on Twitter.
Just as sports betting guru turned day trader Dave Portnoy leads his followers on a Day Trading charge, aided and abetted by cheap/free market access on Robinhood and almost every other brokerage house on the planet, influencers drive the narrative of DeFi on cryptotwtitter, coining for themselves an equally illustrious vocabulary: “shill”, “fill your bags”, “bagholder”, “FUD”, “dump”, along with the old school “hodl” and “rekt”, are the words and phrases that form the common parlance in this age of digital asset investing.
No suits and jackets, no ties and brooches, no well-heeled (of any height) analysts; just influencers doubling up as analysts and emerging fund managers who artfully tweet about anything and everything. Including the memes that give these communities their identity: the Chainlink Marines, the Synthetix Spartans, the Ripple Army – the list goes on of strong communities who truly and fervently believe in the projects they back and evangelise the corresponding gospel.
Ironically, despite DeFi looking like an esoteric enclave of complexity and risk, the reality is that everything that you ever want or need to know about digital assets is right there in front of you. All one needs to do is read, watch and learn, all with a pinch of salt. Top it up with a bit of experimentation: a trading account on Binance; a wallet on Metamask; a few decentralised transactions on Uniswap, Curve or Balancer; stake some USD stablecoins on a staking platform and farm (not on a field!) for some yield – and the learning experience will come quicker than trying to decipher ex-ante the myriad of whitepapers in circulation.
Waterfalls and overflows
The key takeaway from all the excitement in DeFi is that every single one of these platforms is built on Ethereum (to be precise, the ecosystem is Ethereum, and the native token powering it is Ether). Ether makes every transaction on the Ethereum blockchain happen: from approving a connection between your wallet and a web interface to actually making a trade, deposit or withdrawal. Yet up until last week, despite all of the value that has been constructed on Ethereum, no one seemed to notice. The past week has seen the price of Ether pick up blistering speed as the implications of all of the effort put in over the past few years became apparent.
Of course, there are arguments about Ethereum’s shortcomings – speed, capacity, cost – and speculation about whether its successor (still a work in progress) Ethereum 2.0 will be a success, but as ever, what matters right now is narrative, with a brand new narrative being written for the entire space as we speak.
Central to that narrative is the idea that all of these tokens are essentially VC-type instruments, with an added zing: they are as undeveloped as a VC investment, but as liquid and publicly accessible as a listing on the NYSE, with shedloads of operating leverage, growth potential and of course risk associated with them. At this stage, it’s all about milestones rather than earnings, although many DeFi token designs are increasingly having their value linked to some form of cash flow. And indeed, cash is king. In an age where the search for yield is happening with ever-growing fervour, the high returns for yield farming are appealing to many, despite the clear risks along the way - think risk drift, but arguably worth the while for a sizeable uptick in yield.
DeFi platforms offering up assets for lending in exchange for generous yields impossible for traditional financial institutions to offer are amongst the ones seeing the biggest inflows, driving their token values up. Has this gone too far? Only if one thinks that US$4bn total value locked out of a total of US$18.3tn of M2 money supply (just for USD), some 0.02%, counts as “saturation”.
State of flow.
Perhaps most instructive of all our observations (so far) of the digital asset space is how this most recent run in digital assets has transpired, particularly in the way it has been influenced by the flow of money. As we have seen in the listed equities space, it is the flow of money – driven by passive flows – that moves markets. These flows lead to price action that is increasingly contrary to what many active investors believe should be happening.
Unlike equities, that had to go through the cycle of maturity, with ETFs appearing at the tail end of its history (so far), digital assets were born into a world where passive is the norm. Despite its nascent state, flows in digital assets already comprise a fairly sized passive component. At least, that’s what we think may be the case, given how hard it is to measure this with any certainty.
Consider this (largely well-thought-out) hypothesis: it was widely believed that the next digital asset rally would be led by Bitcoin, with Ethereum close behind. The theory went on to posit that after these two behemoths moved, the so-called “altcoins” would run as risk appetite ramped up and investors moved up the risk spectrum in search of higher returns. On the flipside, everyone also opined (perhaps rightly) that first generation projects like Litecoin, EOS, XRP, XLM and other Ethereum/Bitcoin “killers” would disappear into oblivion, just as it was previously opined that Bitcoin and Ethereum would be “killed” by these same “killers”.
Reality couldn’t be further from this: Litecoin, EOS and Ripple, for example, still sit happily in the top 10 market capitalisation charts in the digital asset world, and Bitcoin and Ether have been the laggards, rather than the leaders in this rally.
In contrast, what actually happened was that the rally started in the DeFi subsegment of the market, which attracted attention to Ether. Ether, in turn, got going, and only then did Bitcoin and many of the other top 10 names start to catch a bid. Conflating the empirical observations is also the fact that Gold itself “mooned” (another one for the vocabulary list) at the same time, so Bitcoin could well have been driven up by (surprise!) mainstream macro flow.
But what about the others in the top 10 (LTC, EOS, XLM et al) which have arguably poor fundamentals but which are rallying together with Bitcoin and Ether? Strong performance and weak fundamentals. Sounds almost too familiar? Well let's reflect on the plethora of fundamentally challenged stocks rallying due to passive driven flows.
Furthermore, as we’ve seen in the past week, when the large caps rallied hard, the formerly top-performing DeFi assets fell sharply (initially and then resumed their uptrend). This too seems vaguely reminiscent of the growth-to-value rotations that are common in the listed equities world as allocators shift their exposures around based on top-down investment decisions, although perhaps the label should be “super growth” vs “stratospheric growth” since even the relatively “value” oriented instruments like BTC and ETH are themselves in their nascency.
Same-same, but different
Ultimately, the point we want to make is two-fold.The first is that the digital asset opportunity is poorly understood by mainstream investors, especially those scarred by their memories of 2017 and who see risk everywhere. As we have written before, there is definitely risk, and it is huge. Yet, because these instruments are listed and trade 24/7, one has an unprecedented ability to control risk and enjoy asymmetric, VC-grade risk/reward balances.
Volatility is massive given the possible range of outcomes on all of these projects and the perceived evolution of these outcomes, yet with proper position sizing, maximum loss parameters and correct entry/exit processes, we are very optimistic about the future of the space. And where others may shy away from learning about the unknown, we embrace the challenge of learning with great delight. As the great Aldous Huxley wrote, “Facts do not cease to exist because they are ignored.”
The second point is that while the content of what we need to learn in the pursuit of knowledge threatens to be starkly different from what we’re used to, it is also not that different. Fundamentals still matter, and so does the state of the market. The Big Play, Small Play and Charts remain fully relevant regardless of the type of asset we contemplate.
We can’t claim to have any clarity on which projects will become the Amazon equivalents in 2030 or 2040. We’d certainly hope that we will find them (ex-post!) on our watchlist, but until then, we read, listen, watch and learn, and in that knowledge, embrace and look forward to what will be, rather than scramble for familiarity and obsess over what is – or has been.
And we encourage everyone else to do the same.