…How I Learned to Stop Checking Prices and Love the Struggle***
2018has been a challenging year for everyone in the crypto space, from asset issuers (the people selling coins), to exchanges and platform operators (the people enabling the speculation on the coins), to investors (the people buying the coins).
It’s been an amazing year for lawyers, accountants, PR firms, and other professional services providers who got a windfall of millions, if not billions, of ICO dollars to help folks figure out just what is going on and how to cope.
What a year it’s been.
While the recent price trend (hint: down) feels new, in reality, we’ve been on a steady, sliding downtrend since January 10, when the crypto asset market peaked (in market cap terms); and now the November 2018 Bitcoin Cash fork marked a turning point where some investors decided to finally give up the ghost and, as they say, ‘call it a game.’
Selfishly, the timing couldn’t have been better for a sit down with the CNBC Fast Money crew. The short video below highlights what I’m going to be riffing on in this post.
In this post, we’ll cover:
- Understanding Investor Psychology
- Crypto Markets in Crisis
- The Start of Capitulation
- How to Find Value (Where “Smart Money” is Flowing)
- Where We’re Headed
Buckle up… this should be a fun ride.
Understanding Investor Psychology
In order to understand the present, we must understand the past. And in order to understand how ICOs managed to raise billions of dollars on whitepapers that, in hindsight, are comically bad, let’s understand the psychology of investors (a co-hort which I fall into).
Investors — at their core — are looking to maximize returns while minimizing risk.
In terms of perceived risk — bitcoin just celebrated the 10 year anniversary of the whitepaper. Every day that bitcoin survives and continues to grow in terms of functionality and usage is a day that the asset is de-risked a bit more. Applying that same logic to other, newer assets and governance models is tempting, but foolish.
Recent history has shown us that networks with proven and / or centralized governance models and a long history tend to accrue more value due to investor confidence or perhaps a perception of lower risk.
Moreover, well-known investors (we won’t mention names) have been ‘legitimizing’ both 1) cryptocurrencies like bitcoin and 2) crypto assets by raising funds through ICOs and STOs, reducing the perception of risk.
In terms of (2) reward — ICOs were looking really sexy for a while, from an opportunity cost of capital perspective.
Looking at average returns across asset classes below, as well as some of the pressure on high risk investment strategies like VC (venture capital) or PE (private equity), it’s easy to see why crypto assets felt like a reasonable bet to a subset of investors who had an appetite for risk. An investor may choose to risk a few percentage points of their capital base for a chance to 10x+ their return.
I believe many VC, hedge fund, and family office investors were operating under this mental model when choosing to fund ICOs.
Crypto Markets in Crisis
We can’t talk about crypto without talking about financial performance. Before everyone gets all hot and bothered about price being an imperfect measure for value and growth — let‘s be very honest with ourselves.
Right now, the best proxy the main market has for measuring “value” is price.
Price across all three of the “large cap” cryptos — meaning bitcoin, XRP, and ether, which account for 3/4 of the market — are down 72% this year. Bitcoin, which represents over 50% of the market, is down 58%.
Data sourced on Nov. 15, 2018
Looking next at mid-cap cryptos — while following the overall trend line and down 60% year to date, some are actually holding their value better than ETH and XRP. A few factors to think about here:
- Many investment funds have long term bets on these protocols as “Bitcoin 2.0” or “Ethereum 2.0” (I recently heard Ethereum 3.0 and felt old)
- Many of these are projects have grown up in the shadow of the large caps above; and have less “drama,” more (and better) comms and marketing; a loyal base of stakeholders, some recruited through airdrop or ICO; and a real focus on unique and specific implementations and use cases
- Forgive me crypto gods, for the blasphemy I’m about to speak, but… these projects actually benefit from “centralization” to coordinate activity and messaging. Foundations to give grants, one spiritual leader, consistent branding and messaging, etc.
Data sourced on Nov. 15, 2018
And finally, at the very end of the road, the micro cap cryptos are down anywhere from 75% to 98% year to date, and a lot of mixed feelings despite consistent press coverage and increased trading venues. For these assets, prices spiked the most of any group, but also dropped hard in Q1 and have kept sliding. Teams are in crisis mode — going through leadership changes, downsizing, and facing challenges related to regulation, tax, and product delivery. Several projects have given up the ghost and converted tokens into equity, service guarantees, or securities.
Data sourced on Nov. 15, 2018
Many will argue that price is a bad measure of “growth.” Fine, so let’s take a look at some other metrics. Over 80% of cryptos have:
- Less than $10MM in 30-day trade volume
- Github commits in the double to single digits per quarter
- Only a few hundred active addresses in the last 24 hours
(Stats from OnChainFX — highly recommend)
Activity doesn’t lie. Many assets outside of the top 250 — and many within — are trapped in a vicious death spiral.
The Start of Capitulation
Crypto doesn’t exist in a bubble. Investors who hold crypto also hold other assets, and as much as we’d love to believe “all you need is crypto” — we still live in a world denominated in US dollars.
The global macro environment matters a lot to what happens to the crypto asset class.
The forces that made crypto an attractive concept (centralized mega powerful corporations, political instability, trade wars, shift away from globalization, totalitarian regimes, etc) are the forces that are also creating fear and doubt in other asset classes and markets. In an environment where investors feel fear, their response is to de-leverage, or reduce exposure.
We are starting to see the fraying around the edges of the global investment community. Blackrock, the world’s largest asset manager with $6.4 trillion in AUM, just experienced its first quarter of net outflows in three years.
Stocks are awash in volatility — and investors are getting all of the adrenaline rush they need in traditional markets without reaching for that crypto fix.
However, a lot of investors do have exposure to crypto already, and we’re starting to see those investors hit the brakes on (1) injecting new capital into crypto and more importantly, (2) keeping current capital in crypto.
Inflows into crypto have all but stopped completely. Raising money through an ICO is so passé (and likely to get you enforcement action), and even private placements for ambitious new protocols are struggling to raise capital. Investors are questioning if the medium (selling tokens) is the best tool for the end means (building a useful — and maybe valuable — protocol).
More importantly, investors who already have capital in the crypto market have taken some money off the table. Investors spent most of 2018 waiting for another “bull run” — or an event several standard deviations outside of recent price movement — to pump the price of their portfolio and enable some selling.
Last week, as both issuers and investors starting gearing up for the end of 2018, many on both sides of the table called the game, took the loss, and removed a heavy burden from their conscience.
On the issuer side, many crypto projects that raised money through an ICO face massive challenges to stay relevant and create real purpose. This is what happens when you lack a true finance function, and unfortunately, “crypto finance” is still nebulous and undefined on the whole. Just look at this balance sheet below, which characterizes many crypto firms that raised cash through token offerings.
I can’t really fault projects for pursuing the ICO path. Looking at the cost of capital for equity versus tokens, it’s much more appealing to capitalize a company without taking dilution and without having any sort of legal obligation (see black box above).
Investors (not all, but far too many) signed away billions of dollars of their LP’s money in nebulous and questionable legal agreements and structures that defied the laws of this universe.
In reality, anyone who has been an investor for some time knows that eventually, the ledger must balance. There is real liability you incur when capitalizing a company, and eventually, the other shoe will drop. It probably looks a bit like this:
We’re seeing this play out in real time, as companies need to sell token inventory in their treasury to pay tax bills; need capital to fund legal bills and potential rescissions (refunds); and have to deliver on their community debt to token holders and other ecosystem members who gave them money, time, and energy.
More coming on the cost of capital in another post… corporate finance is one of my favorite topics and crypto finance needs a lot of help…
On the investor side, the people who funded the ambitious, multi-million dollar ICOs did so expecting a return in the form of appreciation in the value of the crypto assets they hold.
I love investors. They’re a critical part of the ecosystem, because new ideas often need capital, and crypto has a wealth of thoughtful investors. But investors are fiduciaries. They don’t sit around their office wanting to fund amazing ideas just because they can. They have to make money to ensure survival. Investors aren’t users. They are speculators.
Selling all of your tokens to financial speculators is a great way to ensure your tokens will have no real utility.
There are funds trying to experiment with hybrid speculator / user models, including CoinFund, who call this activity “network engagement.” I’m not yet convinced these models will work as intended.
As I’ve discussed in my writing on “The Tezos Experiment” — selling governance rights via tokens is a slippery slope. Crypto is still a small game, and the actors are still fairly congenial. As the crypto market grows, a new class of investors will emerge. And these aren’t so friendly. Once the real money shows up and the vultures figure out how to play, we’ll see a more ruthless set of investors swoop in to exploit any potential weakness in these systems to maximize profit.
For all of these investors holding tokens, most have accepted these ICOs they have sitting on their balance sheet will come to market at ‘cost,’ (traded token price = purchase price in ICO) in the best case; and there are still billions of dollars of tokens the market needs to digest. Those projects will delay coming to market as long as they possible can, and funds will try to hold those assets “at cost” or at “paper marks” as long as they can to avoid taking a hit on portfolio value.
I expect we’ll see 2019 shutter some funds, because living on 2 + 20 is challenging as is; and when your AUM finally gets marked down 50% and there is no 20 in sight, the juice just isn’t worth the squeeze.
Here’s my view on the next 12 to 24 months ahead in the crypto crisis:
So what’s an issuer likely to do?
Sell the assets they can and hoard cash like it’s going out of style.
What’s an investor likely to do?
Sell the assets they can, take the hit, and free up mental and emotional energy to focus on generating a return for their investors.
Add these two up, and we get capitulation — the action of surrendering or ceasing to resist an opponent or demand.
Acceptance is the final stage of grief.
I know, I’m so depressing. Sorry. But it isn’t all doom and gloom.
In times of frenzied and rapid growth, with money flying around like champagne on a 90’s rap video set, capital isn’t always allocated in logical ways. We are, after all, only human, and our psychology has set this trap time and time again.
Tech that changes industries and markets doesn’t get built overnight. There are fits, starts, and failures. And value doesn’t always flow to the places we believe it will.
While the above snippet from 2000 might have led one to believe the Web was dead, the long arc of history proved us all wrong. The first generation of companies evolved and many died, and a new industry was born. That industry now dominates global markets as a set of stocks known as the FAANGs (Facebook, Apple, Amazon, Netflix, Google), which have a collective market cap of $3.5 trillion, with some individual companies commanding a $1 trillion market cap in recent months.
Value is being created by crypto assets and blockchain technology. That is an absolute statement.
The real question we’re grappling with is where and how that value will be captured . Investors of all stripes are trying to refine their hypothesis on where they, as investors, will be able to capture value and make money. In 2017 and early 2018, many investors embraced the idea that value capture would happen at the protocol layer, in the assets themselves. The recent erosion of value in the assets themselves is an indication that investors have begun to question this thesis.
Here’s my prediction for where value will be created:
- In the assets, especially networks with proven governance
- In the new companies building infrastructure and services
- In publicly traded companies — both existing and emerging
- In the funds and asset managers providing exposure
For the assets — investors aren’t going to buy crypto assets directly for some time to come. They will get exposure to crypto via existing strategies that they can understand, report on, and easily manage with their existing infrastructure. This includes passive exposure through exchange traded products, passive exposure through long-only “crypto funds”, and actively managed exposure via opportunistic, systematic funds run by known and respected portfolio managers.
For the private companies serving the crypto asset class, the most valuable of these companies are focused on enabling speculative trading of crypto assets. There are a few notable themes here:
- The more valuable companies are being build outside of the US, and have little to no backing from Silicon Valley investors. For instance, BitMEX has few, if any, outside investors and never raised capital from traditional VCs (likely because it couldn’t in its early days).
- New and emerging companies that operate nimbly are able to build value quickly. Binance emerged in 2017 and has become one of the financial powerhouses of the industry, by building quickly, offering simple functionality, and focusing on operating in jurisdictions with friendly regulators and more permissive operating environments.
- These companies are worth more than most crypto assets and protocols, and have raised minimal capital to build these businesses when compared to ICOs. There are only 3 protocols worth more than $6 billion as of Monday, Nov. 19, 2018.
- These companies have cash on hand, and are using it to fund both organic and inorganic growth through new product lines and acquisitions of talent, users, and IP.
For publicly traded companies, I won’t dwell on industry IPOs since many industry pundits have covered the topic extensively. I’ll focus on traditional financial institutions who are looking at crypto as a way to: (1) create new revenue streams; (2) play “innovation” theater; and (3) build enterprise value.
Al of these are less than a year old! Moves * may* be priced in, but more is coming…
Square is probably the most concise example. Square launched crypto trading in the $cash app last fall, and saw its revenue grow and its stock price more than double. While Square has built a tremendous amount of enterprise value in its merchant payments business, its move into consumer crypto was met with excitement from equities investors.
Numerous other firms both within and outside financial services have been rewarded by the market for appearing to be a part of the crypto ecosystem — whether those claims have merit or not. Expect this trend to continue even in a down market for asset prices. Corporates move in annual planning cycles and won’t change gears as quickly as some startups might.
Lastly, the funds and asset managers in the space, while under pressure, have historically done well given their longer time horizon and their ability to survive and weather market cycles. We expect this trend to continue, especially for some of the larger, better capitalized managers with deep experience who are able to manage finances and allocation strategies to capitalize on short-term price movements while keeping a long-term investment outlook.
So while value may be moving out of the assets themselves as the market digests new information and re-formulates its thesis on crypto assets, value is continuing to grow across the cohort of companies serving the crypto ecosystem.
Where We’re Headed — The Long Road to Utility
So here we are… it’s dark and we’re far from home. I’d like to take a moment to share my favorite quote from Dune:
“I must not fear. Fear is the mind-killer. Fear is the little-death that brings total obliteration. I will face my fear. I will permit it to pass over me and through me. And when it has gone past I will turn the inner eye to see its path. Where the fear has gone there will be nothing. Only I will remain.”
It’s easy to look at today’s crypto market — one in crisis — and dismiss it categorically. This, in my view, would be a massive mistake. Bitcoin, and crypto assets and blockchain technology along with it, have reached critical mass.
Bitcoin has gone from being obscure and unknown to mocked, hated, revered, and globally known. Blockchain has been lauded as a panacea to all of the world’s problems and has also been demonized as nothing but a glorified excel spreadsheet.
This polarization of public opinion represents exactly why this idea and this technology will continue to grow and evolve. The crypto community has captured the attention — both positive and negative — of all types of people.
Just look at the people in this industry — thousands who continue to spend their time, energy, and capital on helping the crypto ecosystem grow. By writing, researching, advocating, building, developing, or simply holding.
My colleague Ryan Radloff broke down the math so you don’t have to — there’s already demand for at least half of the remaining non-minted bitcoin supply. I certainly don’t expect this number to decline as more people learn, cash out, and opt-in.
Going back to macro themes — look at the world we live in today. There are broader themes playing out that will have an impact on the utilization and adoption of some form of this idea.
Crypto isn’t just about technology, but it’s also about social, political, and economic change. At its core, we are experimenting with new models of governance. They are flawed and immature, but they are important and valuable.
Protocol projects, companies, and investors will need to dig deep and find true north. They will need to align their activities with long-term value creation. But if the next five years are anything like the last, expect to see value continue to flow from centralized corporate entities to less centralized networks and applications.
The hard work is happening, but it takes time. And growth is rarely neat or linear. While today’s value capture feels like an evolution of capital markets, the crypto revolution will continue to experiment and push boundaries, and ultimately, shift value from centralized systems and structures to less centralized systems.
We can’t pinpoint when exactly this shift will occur, but here at CoinShares, we do believe it’s inevitable.
The future looks promising, but there’s still plenty of work to be done.
Much credit to Jonathan Cheesman , our research team and other members of the CoinShares team for the contributions, edits and comments — getting this right is always a team effort.
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