The State of Cryptocurrency Investing: End of 2017 Edition

I attended the 2017 Consensus:Invest conference to try and get a feel for the current state of the cryptocurrency market and how it was being perceived by the finance industry.

It gave me a good picture of current state of the market, so I thought I’d publish my notes on a few of the panels here.

TL;DR (Or Major Themes)

There is a generational gap — This is the first conference I’ve ever been to where the average age of the speakers was lower than the average age of the attendees. For some reason, the value of crypto is more intuitive to people who grew up on the internet.

There is still a gap between finance and tech too. Some people seemed very strong technically and understood the platforms themselves and others understood how the finance industry works and how institutional money thinks. There are very few people who speak both the language of technology and the language of finance fluently. Being able to do that seems like a huge opportunity.

There are a few things still holding back institutional money

1. Infrastructure — better exchanges, derivatives, ETFs, and particularly custodianship
2. Reputational Risk — need some people with gravitas in the finance industry to come out pro-Bitcoin so fund managers can buy it without putting their reputation at risk.

Chris Burniske — Ringing the Bell on a New Asset Class

There are 4 elements to asking whether something qualifies as an asset class

1. Investability — is it liquid enough? There are currently $1 billion traded daily in crypto (my note: I’ll use crypto as an abbreviation for cryptocurrency in this post.)

2. Politico-economic Factors -

2.a. Supply Schedules — different assets have different supply schedules. Bitcoin is often compared to gold, but it’s even more deflationary than gold because supply is fixed.

2.b. Bitcoin Transaction Value Per Minute — There were 3 eras of Bitcoin transactions:

• Nerds/miners figuring out how it works
• Illicit uses/drugs (2013–2015)
• More legitimate uses beginning in 2016 with sufficient transaction value per minute to qualify as an asset class

2.c. Trading to Transacting Ratio — Fiat currency is trading more than transacting relative to Bitcoin. This is probably driven by FX markets. As CME futures and other derivatives come online, there will be a lot more trading/speculating on Bitcoin than there is now.

3. Correlation of Returns — bitcoin is highly uncorrelated with existing asset classes. This is largely a function of how young and new it is. It’s likely that Bitcoin and gold both “popped” around Trump and Brexit when equities futures crashed suggests Bitcoin will likely correlate with gold.

4. Risk-Reward Profile -

4.a. Daily volatility — Bitcoin in 2016 was less volatile than oil and twitter. If you are able to stomach that volatility, you can stomach Bitcoin.

4.b. Sharpe Ratio — Bitcoin’s absolute returns are decreasing but so is volatility. Sharpe ratio (a measure of return/volatility) in 2016 was roughly same as 2011 (meaning that over time both the amount of appreciation and volatility are decreasing)

The market cap is only about 5% of the way to the same market cap as the Web bubble when it popped in 2000. Just entering the Frenzy stage according to the Perez model.

First Movers Panel — Brian Kelly, Mike Novogratz, Glenn Hutchins

Think of the different cryptos as different metals. They are like copper and platinum and as their use cases expand or contract then their value increases or decreases.

There will be one winner per use case or ecosystem. E.g. There will be one dominant file sharing protocol, one remittance protocol, etc. (Josh Nussbaum published an excellent ecosystem map.)

We will look back at private blockchains in twenty years the same way we look back at intranets today.

Bitcoin is going to win the store of value use case but won’t be a day-to-day currency because it will be too easy to squeeze and too restricted in terms of money supply.

Global macro fund managers seem to be the first traditional finance people in the space. This is perhaps because it’s more intuitive for them than someone in equities who is looking at discounted cash flows every day.

Bitcoin Bull and Bear Panel

Murray Stahl

Why are you a Bull? Because I think central banks are going to debase currency.

Hayek wrote a paper called Denationalization of Money in the 70s that just wasn’t technologically possible then, but Bitcoin could be that technology.

I don’t think institutional money is going to buy Bitcoin anytime soon because of reputational risk. If you buy 1 satoshi (1 Satoshi = 0.00000001 bitcoin) and it goes to zero then it will hurt your reputation. First, you need people with major gravitas in the traditional finance industry to say that it is worth considering before institutional money will get into it.

Thomas Lee

Why are you a bull? I think it might be the largest technology wave of the next 20 years

There is a big generational divide similar to the internet where the institutional ecosystem was wary but young people really understood it.

The peak will be when pension funds start investing in Bitcoin.

The market structure will be a duopoly. That’s a typical industry structure. It looks like BTC and ETH will be the duopoly right now.

The best way to evaluate Bitcoin is like a social network. You can explain 94% of price movements by looking at unique addresses squared and transaction volume per user, similar to how you would value a social network.

The The Herfindahl-Hirschman index (HHI) is a commonly accepted measure of market concentration that the Department of Justice uses for monopoly. In that measure, 2500 is considered concentrated. Currently BCash is 2600 and Bitcoin is 2100. Bitcoin’s measure was 1050 at the beginning of the year, meaning it’s concentrational measure has doubled since the beginning of 2017. (See also Balaji Srinivasan’s post on quantifying decentralization).

Robbin Wigglesworth (Financial Times)

Why are you a bear? It’s pure intellectual masturbation where smart people think it’s cool and the price goes up and then dumb people pile on.

Bitcoin is like sardines from Margin of Safety by hedge fund manager Seth Klarman. In the story by Klarman, the sardines disappear from their traditional habitat off the Monterey, Calif., shores, the commodity traders bid the price of sardines up, and prices soar. Then, along comes a buyer who decides that he wants to treat himself to an expensive meal and actually opens up a can and starts eating. He immediately gets ill and tells the seller that the sardines were no good. The seller quickly responds, “You don’t understand. These are not eating sardines; they are trading sardines!”

Raoul Pal

Pal bought in $200 and sold at $2000.

Why are you a bear? I think it and the premise has changed a lot since I first invested. When I bought I saw three value propositions:

1. The supply is limited to 21 million — Now, forks are a form of dilution that ruins the sacrosanct 21 million
2. Payment system — Now, India has a payment system that is much better than Bitcoin.
3. Prevent Lehman and 2008 from happening again — The financial system doesn’t need thousands of nodes, you just need a few dozen. If the problem is Lehman, then a private blockchain with a few dozen companies involved will solve that problem.

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Crypto Buy-Side — Patrick O’Shaugnessy, Ari Paul, Ariana Simpson, Linda Xie

The Limited Partners (LPs) for crypto hedge funds were initially venture capitalists, then moved to high networth individuals (often times people who made a lot from BTC and ETH and didn’t want to keep up with all the ICOs), and has recently moved into family offices. Endowments are still 3–6 months away.

There was an interview of David Swenson (manages Yale Endowment) a few weeks ago and no mention of Bitcoin. 2018 may be beginning of endowment money coming into the space. Substantiating the claim that the main thing holding back endowments is reputational risk, Ari Paul, formerly of the University of Chicago endowment, when asked when Chicago would invest said “6 months after Yale.”

Crypto Hedge Funds are restricted in what they can invest in because of a lack of liquidity. There are less than 100 tokens that have sufficient liquidity.

What Markers do you look at when determining whether to invest in a protocol?

• Team is probably the biggest component
• Network usage statistics
• Google search volume

We are at a stage where it’s a poker game. In each ecosystem/coin/market there are a few players who move markets and you need to understand those plage. E.g. Coinbase moves markets with whatever decision they make so you need to understand Coinbase and their motivations.

What is the most compelling existential bear case for the space?

1. Regulation — Cryptocurrency is just banned by the U.S. government (though that could also increase adoption)
2. Technical issue — Some sort of vulnerability in a protocol is discovered or miners are found to be colluding
3. ICOs walking away with the money and not building the tech which brings in regulation and causes people to distrust the whole space and withdraw capital.

The blockchain is a hugely inefficient database because you have to send the data to all these nodes. There are only a few use cases where that is important. Two primary ones are:

1. Censorship resistant — a central entity can not take control of the asset.
2. Judge resistant — Companies like Amazon and Google have assets in every legal jurisdiction so they spread their legal risk around. Bitcoin will provide this but will be better than offshore banking.

What other cryptocurrencies are you interested in?

• Privacy coins — One of the downsides to BTC is that people can see who you are sending money to and that’s not always good. Monero is private by default. Right now about 20% of Zcash transactions are shielded.
• Monero is privacy by default — more used on darknets, wikileaks. Would be viable for supporting a dissident politician in Russia, China, India. It is free speech via donations.
• ZCash is optional transparency which makes it more useful for enterprise use. Have a partnership with JPM. Banks want to be able to offer their high net worth clients some privacy services.

You don’t short stuff on the way up. Trying to time the top is a good way to lose money. You make money shorting something on the way down where confidence has already broken.

It’s possible people are investing at $50 million caps what they would normally be doing as a $3–5 million seed rounds and the whole ICO space is too expensive right now.

Putting 1% of a portfolio into crypto reduces risk because it’s uncorrelated to the rest of the portfolio and it’s so small that risk gets diversified away.

Part of the drive intro crypto is the lack of alpha anywhere else. Public equities are at all time highs.

What are the best news sources for twitter?

• Newsletters
• Token Economy
• Week in Ethereum by Evan Van Ness
• Jimmy Song

New Tools and Products — Alex Sunnarborg, Hu Liang, Daniel Matuszewski, Michael Sonnenshein, Adam White

Adam White (Director of GDax) — Most accounts are still retail, but starting in late 2016, the majority of volume was being done by more institutional type players. GDax’s average daily trading volume has increased 10x this year.

Matuszewski (Circle) — Buy side has exploded. A couple years ago you might get a single $1 million order per month. Now that is the average ticket size.

What Circle does is you tell them you want to buy a million bucks of crypto and they do it over the course of a day on different exchanges so you get the best price.

Who are the institutional investors you’re seeing right now?

• Crypto hedge funds
• Family offices
• Small funds
• Bigger players are in talks but not actually putting $$$ in.

The math bigger investors are doing is that you can put 1% into crypto and it’s like a call option. If it goes to zero then it doesn’t massively affect fund performance, but if it goes up 10x then that will make a big difference on returns.

What are major issues still keeping bigger players out?

• Market size — Blackrock or a player on that scale won’t even look at this market until it’s past a trillion dollars.
• Custodial Risk — how do you store these assets? (My note: This was a recurring theme and major issue)
• There are some solutions for BTC and ETH, but custodianship for most other coins is really hard even for sophisticated players.
• Coinbase has a custody product that they are hoping will solve a lot of custodial issues — looking to expand beyond just BTC, LTC, and ETH to altcoins.
• A global order book

Two of the reasons SEC cited for rejecting ETF was lack of a derivatives market (because you need that to hedge) and how concentrated trading was in China. Both of those are changing now.

Trade Desk: Advancing the Asset

You can use very basic trading strategies and get really great returns in crypto right now.

Arthur Hayes (BitMex) thinks CME futures is going to be a mess because it doesn’t work well with cryptocurrency markets. It is closed on the weekends, only allows so much volatility and is susceptible to DDOS attacks. If you have gap risk where you can only trade during certain hours then people can set you up and take advantage of you.

However, futures are an important step that will let players who want to profit from the volatility do that without dealing with custodianship.

What custodianship there is is very targeted at ETH and BTC. It’s very hard to invest in anything else if you don’t have your own custodian solution.

Current exchanges are custodians and exchanges. E.g. Coinbase lets you buy and sell bitcoin like an exchange but also hold a large number of assets. This makes them honeypots that hackers are targeting.

One of the value proposition for decentralized exchanges is that they never hold the keys so they don’t become honey pots.

Liquidity is the most important thing for an exchange.

2018 predictions:

1. Investment bank adds liquidity
2. Regulators in US do something

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