January 5, 2020

A Calculated Bitcoin Investment Bias: Part 1 of 2

Is there a case for investing in cryptoassets? If so, what type of cryptoassets should an investor allocate to? In this two-part series, we first focus on utility cryptoassets powering so-called smart contract platforms.

We are living in interesting times (every generation must have felt this way). Ours is the time of the apparent “Everything Bubble”. Today’s world is awash with liquidity, myriads of projects get funded and markets are chasing all-time highs. At the same time, investors are craving for yields, firms are binging on stock buybacks and commercial banks are in constant need of bank reserves supplied by central banks.

All of this is happening in what can be called the traditional world of finance. This amazingly complex world of financial promises has grown ever larger, capitalizing on one of the greatest of human achievements: mutual and reciprocal trust relations. These emerge out of the intellectual and cognitive ability to abstract and bargain with the unknown to potentially enhance the capabilities and possibilities not just of one’s own self, but that of society’s as well. The ability to trust and form mutual and reciprocal trust relations is the foundation of what is commonly associated with the progress of humanity through division of labor, specialization and social scalability.

Trust is a very delicate issue. The initial establishment of trust is up against the unknown. In an initial state, things are rather skewed and odds are most definitely against the development of trust. Why should trust relations emerge? As humans, we are disturbed by the unknown. The unknown mirrors uncertainty, which goes hand in hand with insecurity. But because humans are able to bargain with the unknown, they can make a leap of faith, testing the unknown and see whether uncertainty and insecurity persist. As we know from experience, once a threshold is surpassed, uncertainty and with it insecurity can actually diminish, bringing trust relations to life. These again can be corroborated by reality and the world around us, making the bedrock underlying reciprocal trust relations ever stronger.

The establishment and maintenance of reciprocal trust is ultimately the result of the interplay between a human’s ability to bargain with the unknown and her/him experiencing the real world. Experience is (hopefully) providing her/him with arguments in favor of upholding reciprocal trust relations. Depending on what reality unravels, trust relations either strengthen or weaken. If reality keeps on providing reasons discouraging the upholding of trust - either because promises are broken or are being hollowed out - bargaining power vis-a-vis the unknown diminishes making trust relations ever more brittle.

The Great Hollowing-Out

As a matter of fact, this seems to be the increasingly dominant view of the state of the financial world today. With what is referred to as the Great Recession of 2008, myriads of financial promises have been disregarded or broken outright (and they still keep getting violated to this day as a consequence of the crisis). Be it firms not honoring their financial liabilities, be it central banks trespassing their mandates or be it governments neglecting their own constitutions and laws.

All of this has been done, to prevent the financial order from crashing epicly and irreparably, so the argument goes. By preventing a complete collapse of today’s astronomically high pyramid of financial promises, a greater number of even more foundational financial promises have been made, i.e. issued. While this has certainly helped in the short run, over the long term the hollowing-out of the foundational financial promises underpinning today’s traditional world of finance has only been accelerated.

Once trust is broken it takes forever to rebuild. Fortunately, trust is sticky and because of its stickiness, it can take a lot longer to become void than expectations would have one believe. Trust is not quantitative, it is qualitative. It cannot be measured, only be estimated, which is why we can never accurately assess the fragility in question. Thus avoiding the traditional world of established finance is no real option. As an investor opportunity costs of not being invested in traditional finance would be way out of proportion. And because today’s traditional world of finance is an infinitely complex and interconnected web of trust relations, whenever a couple of strings tear in one corner, others are being reinforced elsewhere. It is perfectly fine - we at Schlossberg&Co would even consider it essential - to look for remaining investment opportunities in the traditional world of finance. Always against the backdrop of an ongoing hollowing-out of foundational financial promises, which makes every promise higher up the stack riskier after all.

With this proceeding hollowing-out of trust relations in traditional finance, it is obvious that alternatives are being explored. It was in the midst of the financial crisis when a new meta idea named Bitcoin appeared. In fact, Bitcoin initiated a new era: The primacy of the digital is upon us and the emergence of Bitcoin was its missing piece.

Bitcoin is the most prevalent metastasis of a meta idea the world currently knows

It is hardly possible to truly grasp the dimensions and proportions that this epochal upheaval will bring. By all means though, the world as we know it will look and work differently after Satoshi - Bitcoin’s anonymous creator. The process has already started. We are moving into a new age - the age of internet-powered public blockchain protocols.

The New World of Cryptoassets

As a prudent investor one is encouraged to look into these competing public blockchain protocols. This entirely new world is only a little more than ten years old. It is still in its infancy and there are known as well as unknown unknowns to what foundational pillars - more commonly known as base layers - this new world will mature into. Nonetheless, the world is developing at a staggering pace, which is why it makes sense for an investor to have some stake in it.

The question is: What sort of investments should this stake consist of? Whoever delves into this new world of so-called cryptoassets quickly discovers: There is a vast array of protocols, projects, and endeavors. Being an investor, one does not simply want to have a stake in something, but it is crucial that this something generates real value for the investor.

Currently, the new world of public blockchain protocols offers four broad categories, each of which is said to be about one key attribute. All of these four categories could potentially make up this something:

  • Smart contract platform with utility asset (granting access to blockchain network)
  • Distributed applications (dapps) on top of smart contract platform
  • Digital cryptosecurities (tokenized bonds, shares, commodities, real estate or more)
  • Money (store of value or payment functionality)

As of now, digital cryptosecurities have not been established yet. Regulatory as well as infrastructural groundwork is being built as we write. While there is great potential in cryptosecurities, we will discuss them in a future research report in great detail. At this point in time, the focus is on utility protocols, oftentimes described as smart contract platforms. In part two of this series, we will also shed some light on blockchain protocols striving to have some sort of monetary asset embedded.

Recent years have had financial analysts try to come up with proper cryptoasset valuation methods. So far many frameworks have been proposed, but no one has become the gold standard of cryptoasset valuation. And this is no anomaly since throughout history valuation methodologies have lagged behind the emergence of the new assets they represent. In the early 1600s, the Dutch East India Company was the first company to sell stocks on a public exchange, but it took another three centuries at least until a comprehensive framework for assessing the fundamental value of equity was developed

Because there is no definitive methodology of valuation as of yet, assessing what cryptoasset to invest in is a qualitative, fundamental and ontological approach. While there are also some low-hanging fruit to catch in the short- to mid-term, our investment strategy is built on a long time horizon. As such this analysis is of a fundamental type and is focused on the long run. At Schlossberg&Co we are of the belief that the long term is easier to predict than the short term.

Utility Assets and Value Accrual

Probably the major divide among cryptoassets today revolves around the distinction, which is framed along the lines of a Turing-complete blockchain versus a non-Turing-complete one. Broadly speaking, Bitcoin falls within the latter category, while Ethereum is still the epitome of the former. Another way of framing the division boils down to the fact that non-Turing-complete blockchains are said to be striving towards becoming money, while Turning-complete ones are aiming to function as general-purpose smart contract platforms (for more on this dichotomy consider this).

In recent years, smart contract platforms - Ethereum has the lead but others are following suit - have stirred up quite some interest among cryptoasset enthusiasts. Because smart contract platforms exhibit general-purpose functionality that can potentially power intuitive real-world use cases, they are deemed more useful than a “simple” public blockchain like Bitcoin.

In the eyes of many crypto believers, it is this greater usability and functionality that will drive the further adoption of these sorts of cryptoassets, giving them a bigger user base, high network value and a great amount of transaction throughput. In the end, a handful or maybe even one public smart contract platform will emerge on top. So clearly, this must be the cryptoasset to hold for an investor, right? 

Quite to the contrary as it might turn out. The mix of a big and vibrant user base, high network value and great transactional throughput might be a rather bad combination when it comes to the value of a token. It may be counter-intuitive at first, but a high transaction throughput is not sufficient to guarantee a lasting high token value. 

When it comes down to assessing the (hypothetical) equilibrium value of a public blockchain’s token, token velocity is one of the key metrics. It measures the number of times a token changes hands within a public blockchain network in a given amount of time - usually calculated in terms of one entire year. The higher the velocity of a token, the greater the downward pressure on its value. The market capitalization (or said differently the network value) of a given smart contract platform can be high overall. But once velocity is also high, the (hypothetical) equilibrium token value of this smart contract platform will be suppressed by the high velocity. Since it is a smart contract platform’s stated goal to be used in various useful use cases (decentralized applications), assuming a high token velocity in a state of presumed equilibrium is a rather probable assumption.

On top of expected high token velocity, the market capitalization of a single smart contract platform might also be at constant risk of being split up in a hypothetical equilibrium state. Power laws will most likely drive certain platforms to emerge as dominant figures within the space. But the more potential use cases a platform aims for, the more potential tradeoffs there are because different use cases usually require different optimization routes. This obviously creates more attack vectors. And a defining feature about the world of public blockchains is that it is public, transparent and open source. So code for a specific use case or platform feature can be copied at will to potentially bootstrap a newer and better version - as long as the defining feature is really only about technology (and not about money for example, as it seems to be the case with Bitcoin. More on this in part two). If forking indeed keeps on happening, and the competitive low cost environment of public blockchains suggests just that, ongoing fragmentation of a dominant smart contract platform’s network value would be a recurring phenomenon.

The technology stack of what can be called interchain (combination of internet + blockchain) will be made up of many different thin protocols (governance protocol, storage protocol, processing protocol and more) instead of one big dominating utility asset protocol. 

With these rather bleak prospects for value accrual, some people might feel inclined to rush to the conclusion: Cryptoassets might not be such a good alternative to the traditional world of finance after all. This conclusion does not hold water though: Public blockchains have the potential to disrupt a number of industries substantially and create vast economic surplus in the process. Interestingly enough, the majority of the economic surplus will go to users. Competitive forking and protocol fragmentation will be to the great advantage of users. Public blockchain protocols have initiated the great transfer of value from equity over to utility. End-consumers will be winning out at the expense of investors. 

Consequently there are some ideas of how value can be retained for token holders. Clever tokenomics are considered to be a way to have some value accrue to investors. Whether or not well-thought out tokenomics models will be successful cannot be conclusively assessed here. One thing is for sure though: Artificial velocity suppression mechanisms are not panacea. Staking, mint-and-burn and other implementation can only be useful - if at all - to the extent that they genuinely improve governance and user experience as opposed to acting as artificial price props.

Intermediate conclusion

Investing in a smart contract platform of any sort (like Ethereum) can be a positive-sum game after all and an investor might reap an upside. Because of a smart contract platform's design and use case though, token velocity might be rather high and turn out to be a decisive factor in suppressing the value of the platform's native token. In part two of this series we will touch on why utility assets might be treated as working capital - another reason that would dampen a utility asset's token value. Having covered this, we will then focus on the other category of cryptoassets: Coins striving to be money. Are they any good investments at all?

Stay tuned to find out!

Research Contact
Schlossberg&Co
research@schlossbergco.com
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