The question of “how to evaluate crypto-networks” has been approached from a few distinct schools of thought, what I'll term the NY/SV bifurcation:
- Some traditional financial analysts (“NY”) have approached the problem like an equities valuation, leveraging monetary economic theory to model velocity of tokens in a crypto-network (attempting to derive a valuation for a future equilibrium point). While this approach is incomplete, it's sparked much discussion around designing useful tokens that can see value accretion (something ~99% of teams have not considered deeply).
- On the other hand, Silicon Valley has approached this with inspiration from traditional platform models, with much of the venture capital cognoscenti coalescing around the “fat protocols” thesis (and newer iterations like the “utility hypothesis”). These models are likely incomplete as well, with their heavy focus on evaluating networks as software, leveraging fundamental indicators learned from decades of software evaluation (developer network effects, DAUs, early product experiences, etc.). This thesis has led to a frenzy to fund prospective “first layer protocols” — Ethereum competitors — that have collectively raised billions in the last year.
A third, growing narrative (what I and others are terming the fat monies thesis) has been centered around positioning of Bitcoin (and other crypto-assets) as pure financial commodities. Positioned as a macro trade (possible crisis alpha in the event of a currency crisis), I believe this narrative resonates best with macro traders and institutions as the market is too speculative to evaluate in a bottom-up way and likely relatively overvalued given the lack of utility in most protocols. While the properties of an eventual SoV winner are hotly debated, this thinking frames my favorite fundamental indicator: where are new capital inflows coming from and what narrative (read: meme) are they latching on to?
As crypto-assets are purely reflexive, nearly all (real) market movements are driven by memes, whether it's “uncensorable sound money” (Bitcoin), “private money” (e.g. Zcash, Monero, others), “developer mind-share/an explosion of dApps” (Ethereum), or even more silly memes (e.g. the “Chinese XYZ”, “security tokens”).
Over the next 2-3y, I believe we'll see steady inflows into crypto-currencies that exhibit properties of good monetary policy as institutional investors allocate capital to narratives they can understand. I anticipate much of this inflow going to Bitcoin and other projects which exploit potential trade-offs in the digital money design space (Zcash, Monero, Decred, etc.), with a smaller, more prudent portion serving a hedge against the utility thesis (Ethereum, EOS, Tezos, Dfinity, RChain, Cardano, NEO, RChain, Kadena, Zilliqa, etc.). As dApps gain adoption or utility networks don't prove their thesis (i.e. base layer protocols not being value accretive), this will shift fund flows accordingly.
In many ways, I frame crypto markets as an emerging market like any other, and have learned a lot through research of other, older emerging market cycles. One of my favorite comparisons is to make while explaining digital assets is to see the development of the Asian equities market from the mid-90s through the last decade. Some immediate notes similarities that come to mind:
- Early in the cycle, many progressive funds will allocate to managers to “get smart” on the space (see: Passport Capital, Union Square Ventures, a16z, Sequoia, and others allocating to crypto-funds). This comes out of a recognition that the new asset class is different than the one that they're used to but could potentially become much more relevant to their strategy. In the Asian EM cycle, this came in the form of larger global macro hedge funds allocating tiny sleeves of their portfolio to fund managers “on the ground” who better understood capital deployment given the high barriers to entry. Investing in (and trading) crypto requires deep knowledge of deal structuring, technicals (distsys, cryptography, etc.), and a market microstructure that's not present in traditional venture capital. Investing in Asia early on had similar opacity and information asymmetry to crypto markets today.
- The inaccessibility of crypto to traditional venture capital and asset management firms means financial instruments that offer exposure see large inflows as a way to get beta exposure to the asset class independent of any fundamental conviction. In “blockchain”, this means investment in publicly traded blockchain equities (e.g. $RIOT, Canadian blockchain equities), pink sheets products (e.g. GBTC or the Swedish Bitcoin ETN), and a limited set of assets available on Coinbase (garnering them a potential premium). In the Asian EM cycle, we saw this with fund flows into limited China A-shares, India promissory notes, and a variety of indices. Allocation to these assets is driven primarily by a desire to make a macro bet on a rising tide. The inevitable release (over the next 12mo) of high-quality, institutional-grade custody solutions and services will meaningfully increase the amount of products investors can allocate to.
- As initial hype subsides, a second generation of capital allocators will emerge who are more experienced, taking away capital from the gun-slinging fund managers who rode the first wave. It's highly unlikely that the very best fund managers in a new asset class were also the first to spot it. We're starting to see this now, with Matt Huang and Fred Ehrsam's new fund, a16z's newly announced crypto-fund, and several more unannounced funds raising money in today's crypto bear market. As more experienced investors enter the space, expectations from LPs will go up, leading to a further “institutionalization” of the Crypto Wild West.
- As many of the doubts around regulation and custody are clarified, ETF products will slowly come out, leading to further capital inflows into products offering broad-based market exposure. As the Asian markets grew, allocators were eventually expected to have an answer to the question “What's your Asia strategy?” As crypto markets become institutionalized, these new inflows will likely “pump” many of the "blue-chips" (the largest tokens by market cap) that were able to leverage early capital markets structure - the EOS / XLM / LTCs of the world.
Analyzing fund flows is a bottom-up approach to analyzing crypto markets, framing a number of interesting questions: Which memes are gaining steam tomorrow? How will that change next month or year (or 5)? What are prospective catalysts that could change the dominant narratives of today? How does this differ globally? Over the next few months, I'll be releasing much more detailed research examining these questions; follow along the ride @arjunblj.