Finding Zero: The Short side of Crypto

As many readers will know we are structural bulls on cryptocurrencies and the technology they represent. However, we are hedge fund managers and our primary objective is to provide returns. We are not ideological investors and we have been around long enough to know that bull markets come and go. In this context, we thought this week we would provide an insight into the other side of our portfolio - the short side. And cryptocurrencies, too, can be ripe for harvesting when conditions change. Now is one of those times.

We’ve spent lots of time digging deep into the wide expanse of projects in an ever-developing space, looking for the most interesting opportunities around. This week, though, we put on our bear market hat and head to the other end of the spectrum, in search of opportunities for shorts. The frenzied bull market over the past 6 months has led to a huge tide lifting even the flimsiest of ships and now it’s time to see who is swimming naked.

As we have written in the past, we look at exposures to crypto as listed versions of traditional VC, with a real-time, 24/7 quoted price. On one hand, we would expect the ever-changing situation around these projects to create massive levels of volatility as markets move to reprice the viability of these projects, whether as a function of hype or news – call it “price discovery”. On the other, we would expect that over time, the wheat gets separated from the chaff, with a large number of failed projects heading to zero, while a small number of successes get priced as they should be.

The reality is that there are dramatically more projects with the potential for the mythical zero than the mythical unicorn. But there is a time and a place to begin implementing these types of trades and a rampaging bull market is not that time. Now that the market has reminded everyone it’s not as easy as just “up only”, we can settle down and get to work on finding the best shorts.

Unfortunately, efficient markets don’t apply here either – just as they don’t apply in traditional markets.

The decentralised nature of many crypto projects works both ways: on one hand, the fact that there is mostly only code means that projects can operate with very little overhead. As such, we see successes like Uniswap, Defi’s largest decentralised exchange, where all it takes to run an exchange which moves almost US$1.8bn of trade volumes (across v2 and v3 in total) is a team of 22. Lean and mean, with tiny overheads and revenues that fall straight to the bottom line.

On the other, the fact that it is just code means that there is no “cost of existence” for a crypto protocol. There is no company that needs to do filings that can be shut down and made dormant. The internet remembers, and the code persists. As a result, even “dead” projects continue to remain listed, and all it takes to keep these zombie projects alive is belief, patience and hopefully the next bull cycle.

Whereas a defunct company might have its stock delisted or even its registration struck off, the same does not happen with crypto. The past few months has raised up a good amount of wreckage from the previous cycle in 2017-2018 – consider this our call for caution.

Lindy can lie 

Made popular by Nassim Taleb in his book “Antifragile”, the Lindy effect is a theorised phenomenon that suggests that the longer the period something has survived to exist or be used in the present, the more likely it is to have a longer remaining life expectancy.

To be clear, we’re not saying that Taleb is wrong – he isn’t. But those who attempt to use his arguments to further their ideals may well be fallacious in their thinking.

The correct application of the Lindy effect is to apply it to technologies or ideas – for example, democracy, capitalism or blockchains. The incorrect application of the Lindy effect is to apply it to specific entities, businesses and projects. The fallacy is obvious – the more “big picture” the phenomenon being considered is, the more likely it is that the Lindy effect applies to it.

Whereas attrition would have naturally cleansed the traditional economy of dormant, defunct companies, crypto projects have an infinite lifespan, requiring nothing more than a vestige of their original code to survive. Even where their initial founders have sold out or left their projects for dead, anyone with access to the original blockchain code is able to resurrect it at any time. Such is the power of composability and open-source code – what is dead may never die. Just ask Elon Musk.

As a result, what is seemingly “alive” may not necessarily be usable, or even practical. The most obvious examples are the first-generation token projects which came into existence prior to the 2017-18 crash. Many of them have faded into obscurity, de-listed from exchanges with no more trading liquidity – effectively worth zero. But many others still persist: some of the major forks of Bitcoin, remnants of the early disagreements around block size, block frequency and other parameters of Bitcoin’s operations, like Bitcoin Cash, Bitcoin SV and Litecoin, continue to exist and trade in high volumes; contenders like Ripple struggle to find a purpose for their token; likewise, the first batch of “Ethereum killers” like EOS, or even Ethereum Classic (ETC) whose nodes rejected the fork in the code after the famous “DAO hack”.

And perhaps the most famous of them all, at least at this point in time, is Dogecoin, which was made as a joke by its founders, one of whom famously sold ALL his Dogecoin in 2015 to buy a used 2nd hand Honda after being laid off. By any measure of “fundamentals”, Dogecoin is worth nothing. In fact, the founders themselves say it took 3 hours to build, and that it was “created for sillies” – for all intents and purposes, it was a joke.

Yet Dogecoin currently trades at a total market cap of c. US$44.5bn, making it the 6th largest cryptocurrency by market cap, making it the #176 on the S&P 500 if it were a company, just slightly higher in market cap than investment powerhouse T Rowe Price.

Ripple finds itself in #7 at US$40.5bn of market cap; Bitcoin Cash at #11 at US$11.6bn and Litecoin at #13 with US$11.3bn of market cap. Ethereum Classic is #21 with US$7bn of total market cap and EOS is #28 with US$4.9bn of market cap.

As far as we can see, that’s more than US$120bn of market cap sitting in projects that are used by… whom, exactly?

Believe in bootstraps 

For those who remember guitarist John Mayer back in his glory days, the track “Belief” from his 2006 album “Continuum” has some pretty appropriate lyrics:

“Belief is a beautiful armour, it makes for the heaviest sword; like punching underwater, you never can hit who you’re trying for. Some need the exhibition, and some have to know they tried; it’s the chemical weapon for the war that’s raging on inside.”

To us, that’s US$120bn worth of belief holding up the values of these otherwise dead tokens.

As many founders of crypto projects have learnt, community is critical: if founders are to replace the institutional capital of VCs with what is effectively a public crowdfunding through a token sale, they need to build community and engender belief in their projects. That’s the natural course that most startups take in growing their businesses from scratch.

But whereas an unsuccessful startup would be wound up and liquidated in an orderly way, the same cannot be said for bundles of code. The founders may shut down the office and go their separate ways (as was the case with Dogecoin), but years after that shutdown event, the product may continue to exist and be taken up by someone else to start another hype cycle.

Such is the curse of “what if” immortality: If I sell now, what if it eventually succeeds, then I would’ve sold too low and missed out on all the upside, especially so after having been a long-time holder and/or having endured a prolonged slump. As long as there are enough believers in the promise of “what if”, there will always be buyers – and let’s not even get started on the promoters that add fuel to the hype machine.

The result is a perpetual cycle of hype, bust, hope and repeat: unending promises that this time is different, that this time the cycle is correct, that this time there will be product-market fit. And the same creatures emerge from the woodwork to power the hype machine.

At this point, we would probably have incurred the wrath of ardent supporters of some of these projects – who continue to believe with fervour and conviction in the growth narrative behind the tokens they hold dear. As always, we’d love to have a chat to understand where the use cases are for some of these seemingly defunct tokens and networks – and we’re open to being convinced about being wrong. But our take is that it’s a lot easier to believe when “numba go up”.

Not “up only” 

“Up only” is perhaps the most enjoyable phase of every market cycle, whether in stocks, crypto or any other asset type. Everyone’s happy when the bull market is on. But every practical bull, no matter how structural the bull case is, knows that bear markets inadvertently come along.

We can’t tell whether the current market in crypto is an outright bear market, but what we do know is that it isn’t a full-on bull market. Some call it a crab market – for all the sideways chopping and churning that characterises the status quo.

Whatever one may call it, it’s a market for dispersion. As the various market participants reset to their natural place, the flow dynamics of who is buying and selling which instruments changes too. For now, anyway, the punter money is likely gone, and it is in markets like these where fundamentals come strongly back into play: when the easy money is gone and everyone has to work for their P&L, good quality projects, especially those with solid developer activity, usage and revenue generation, take the opportunity to build while those that are less successful flounder and fade into obscurity.

As investors, the trick isn’t so much to be able to make money when things go “up only” – everyone can do that. More importantly, it’s how to keep hold of those gains when “up only” stops, and even better, grow those gains when things get choppy, profiting from both longs and shorts as the dispersion grows between the successes and the pretenders.

When it comes to shorts, however, what is important to remember is that no one needs to try and catch the top. It is much more favourable in terms of risk/reward to short when the momentum is clearly downwards. As we have learnt from experience: “What do you call a stock that’s down 90%?”

“It’s a stock that fell 80% and then halved.”

One final word on the Lindy effect – we’re optimistic that blockchains as a technology are here to stay. In what form and through which projects, we have our ideas but as ever it’s so early and we really don’t know. The industry develops so rapidly that new ideas emerge all the time, while old ones fade away just as quickly.

But as far as odds are concerned, there will be many more zeroes to come than unicorns. And we think the time has arrived to help some of them on their way, each to their appropriate end points.