For the last two years, we’ve been running a buy-and-hold cryptoasset hedge fund.
These assets are a new investment class with many desirable features, including extraordinary upside potential and price movements that are highly non-correlated with other asset classes (such as equities, gold and real estate).
In this post, we present our framework for valuing these assets, which we’ve used to build our portfolio. In its two-year history, our portfolio has had roughly the same volatility as bitcoin, and produced returns far better than bitcoin alone.
It’s worthwhile to spend a bit of time dissecting the term cryptoasset. We define cryptoassets as assets for which questions of ownership are settled via blockchain-based ledgers. We distinguish between Layer-1 and Layer-2 assets. Most blockchains have a single Layer-1 asset (often referred to as it’s native currency). Fees associated with publishing transactions on a blockchain are denominated in its Layer-1 asset and typically this asset’s supply and distribution are mathematically controlled (e.g. via mining). For example in the Bitcoin blockchain the Layer-1 asset is BTC; for Ethereum it’s ETC; for Ripple it’s XRP.
Many blockchains support the creation, transfer and exchange of assets other than their Layer-1 asset; we term these Layer-2 cryptoassets. Examples include TheDAO tokens on the Ethereum blockchain, MaidSafeCoin (via OmniLayer) on the Bitcoin blockchain and Bitstamp-USD on the Ripple blockchain. It’s worth pointing out that many (although not all) Layer-2 assets imply a level of counterparty risk vis-a-vis whatever entity that issues them. E.g. Owning 1 Bitstamp-USD on the Ripple blockchain simply means Bitstamp owes you 1 USD.
It’s worth noting that as an investor, Layer-1 assets are usually preferable to Layer-2. Joel Monegro eloquently captures one of the main reasons why (casting Layer 1 vs 2 in the terminology of protocol vs application) in his Fat Protocols post:
|… the market cap of the protocol always grows faster than the combined value of the applications built on top, since the success of the application layer drives further speculation at the protocol layer. And again, increasing value at the protocol layer attracts and incentivises competition at the application layer.|
It’s worth noting that while we aim to be general, much of our framework only makes sense in the context of Layer-1 assets. Layer-2 assets (especially those representing liabilities of specific issuers) lie outside its scope of this framework.
Questions to ask when Evaluating Cryptoassets
- Market: Is it useful? How big (in USD) is the problem it is trying to solve?
Examples of valuable problems possibly open to blockchain-based solutions include:
- Vanilla Person-to-Person Value Transfer
- Store of Value (Gold 2.0)
- Black/Gray Markets
- Venture Fundraising
- Prediction Markets / Information Markets
- Computational Resource Brokering
- Arbitrary Asset Exchange
- Voting / Decentralized / Venueless Corporate Governance
- Implementation: Does/can it work? Is the underlying technology feasible? What is the current quality of the implementation? What is the quality of the project’s members and its governance? What is their level of commitment and true motivation?
We also look at the technical design decisions, and whether they are appropriate for the use case of the coin. These include:
- Privacy vs Transparency
- Cost (for participants to transact)
- Expressibility (for conditional transactions)
- Scalability / Resource Efficiency
- Settlement speed
One particular design decision of enormous import is the consensus mechanism / governance. The choice of consensus / governance mechanism determines where the chain falls on the spectrum of Trustlessness/Permissionlessness/Immutability vs Centralized Control. Events like the ETH/ETC split demonstrate that the notion of chain consensus must be analyzed at two distinct levels. At the lowest (first-order) level one can analyze the formal rules embodied in a chain’s consensus code. However, one must also contemplate the informal and inherently political process governing how those first-order rules can be changed and what recourse different stakeholders have when confronted with code changes contrary to their interests. The space has attracted experimentation on both levels. In this author’s opinion our collective understanding of both levels is still rather dim. That said, certain things should stand out as red flags, e.g. project’s with (1) no “constitution” (2) incentive-incompatible constitutions or (3) constitutions that have been broken.
- Value accretion: Can it grow in value? If it functions as advertised and is adopted by the target market what is the expected upside potential for early adopters?
It’s worth noting:
- The open source, permissionless and friction-free nature of most blockchains makes it challenging for those using them as application platforms to engineer sustainable mechanisms for rent-seeking (and thus profit) within their applications and/or Layer-2 issues. E.g. If Alice builds an on-chain dice gambling smart contract with a 2% house edge paid to Alice, there’s nothing stopping Bob from creating a copy with a 1% edge.
- Cryptoassets can be useful without being valuable as investments. Some are in fact intentionally structured to discourage speculative holding (e.g. via constant high inflation.)
- Competitive advantage: What advantages does it have vis-a-vis competitors targeting the same market or vis-a-vis outright forks?
Case Study: Monero (Verdict: Buy – Original Analysis from Late 2014)
Market: Anonymous payment.
Implementation: Incomplete and somewhat messy but has the most theoretical promise vis-a-vis available anonymity alternatives. Dev team is comparatively small/slow but on the whole thoughtful and focused.
Value Accretion: The anonymous payments use-case already has a large and growing market. The lack of anonymity provided in practice by Bitcoin is underappreciated. A large segment of this market adopting Monero (as has happened to a certain degree recently) would translate to a large increase in demand. Furthermore, Monero’s inflation schedule in the medium-long term would fall well below demand in such a scenario.
Competitive advantage: Monero started life as a fork of Bytecoin. The Monero team admired Bytecoin’s anonymity tech but found its code a mess and its distribution mechanism patently unfair. Since the split it has managed to command superior developer talent/mindshare.
Zcash’s anonymity tech is theoretically superior but far more complex and will likely take a long time to stabilize.
Case Study: Ethereum (Verdict: Buy)
Market: The goal of Ethereum is to build a general platform for decentralized applications. Is this useful? Platforms per-se aren’t useful, the applications running on them are. In this light some imagination is required since many potential applications would be the first of their kind.
However, even beyond its decentralized application focus, I think a strong argument could be made that Ethereum is better (or will be once/assuming it stabilizes) than Bitcoin when it comes to Bitcoin’s core use-case: p2p value transfer. This is in large measure due to its design having benefited from learning from Bitcoin’s mistakes.
Implementation: Even at the time of its pre-sale, the team working on Ethereum was impressive and since then has managed to attract a development ecosystem rivaling Bitcoin. The management of the project has proven exceptionally competent, focused, pragmatic and open-minded and the result has been the most technically ambitious blockchain project to date.
Value Accretion: The native currency has similar supply characterics as Bitcoin (modulo the possibility that inflation may continue forever at some small level) and other than the genesis block carve-outs for presale buyers and development funding, distribution is via mining (currently). This doesn’t raise any red flags and IMHO an attractive model for speculators.
Competitive advantage: With regard to its core decentralized application use-case Ethereum currently has no real peers functionality-wise other than forks. IMHO developing a distributed application on a fork with a minority of the developer mindshare makes little sense, especially given Ethereum is still an evolving work in progress.
In theory Bitcoin could evolve to compete but this is unlikely anytime soon given its conservative development philosophy.
Case Study: Steemit (Verdict: Avoid)
Market: Steem aims to create a social media platform. This is an admittedly huge market whose revenues traditionally flow from selling user’s data and attention. Existing platforms like reddit rely on complex weighted user voting schemes to curate user-contributed content based on a karma-driven reward system. Steemit has attempted to devised a blockchain-based scheme that rewards valuable contributors with both money and editorial influence as well as allows users to outright buy editorial influence.
Implementation: The core idea is cool but the implementation raises some red flags. To name a few:
- Steem’s design arguably tries to do too many things and is too complex.
- An audit of the implementation does not inspire confidence from a scalability/security standpoint.
- Prominent members of the team have been at the epicenter of other cryptocurrency duds.
- Given the protocols lack of genuinely decentralization, Steemit the company appears to be breaking US laws.
- It’s not clear the incentive structure they’ve designed actually encourages high-quality content.
Value Accretion: There are liquidity constraints intentionally built into Steem (which actually has several different native currencies) that, in our opinion, lead to widespread misunderstanding of its overall true valuation and make it less appropriate for passive long-term speculation. Additionally, the disproportionate amount of it held by the company and its founders make it challenging to model future market supply.
Competitive Advantage: Unclear. You can earn money publishing on Steem. However, it’s not clear it’s the optimal medium for garnering either profit or attention.
While cryptoassets have many attractive qualities, anyone entering this space should be aware of several challenges, such as:
- For every project with merit, dozens exist that are scams. Price manipulation abounds.
- Some of the best opportunities are thinly traded, which limits the market capacity.
- Secure custody of these assets is itself a serious undertaking.
But for those willing to put in the work, cryptoassets offer incredible upside. And their high volatility can actually reduce the overall risk in your portfolio, given the non-correlation of their returns vis-a-viz other asset classes.