Introduction
The Blockchain is a revolutionary technology which promises to transform in a fundamental way the underlying infrastructure of many industries. Companies whose business models rely on solving complex logistical problems (e.g. broker/dealers) are at most risk of being displaced by this technology. For instance, the role that banks play as a money transmission system can easily be replaced by a single blockchain-based protocol (e.g. Bitcoin or Dash). Therefore, it is no surprise why giants like Bank of America are in a race to file as many patents related to blockchain as they can as they face a very real threat of obsolescence.
Before moving on to our investment thesis, we’d like to clarify a small, but important point on terminology. Cryptocurrencies is the commonly used term to refer to blockchain based assets. However, we think it is a misleading moniker. Cryptocurrency, technically speaking, is a single use case of blockchain technology. Particularly, one in which the token or coin is designed to be used as a currency. This happens to be the first use case (i.e. Bitcoin) and the reason why the term cryptocurrency is popular. However, this term fails to fully capture the asset class. Currently there are a host of use cases which go well beyond this first use case and range from decentralized crypto asset exchanges to democratic election systems. At DigiCor, we favor the terminology “crypto assets” or “digital assets” since we feel it captures this heterogeneity best.
The case for investing in crypto assets, we think, is a story of sustained growth. We believe that the disruptive process of building the infrastructure of tomorrow using blockchain technology is still in its infancy. The current development efforts are still heavily focused on building the foundations (i.e. protocol layer). In fact, the penetration of blockchain technology, is for all intents and purposes, nil. Although there are many enterprise-level blockchain initiatives with prominent members (e.g. Google and UBS), the technology is still not being fully utilized at scale. In addition, widespread use, even for retail consumers, has not materialized. Therefore, the investment thesis which justifies exposure is one of long-term growth and value transfer from one area of the economy to another.
The Framework
We think that there are three primary drivers of growth in the blockchain industry: 1) value absorption, 2) value creation, and 3) usage.
Value Absorption
Value absorption is the process of transferring the value of a business service (e.g. bank’s role in monetary transactions) to a blockchain based protocol. For instance, Ripple’s goal is to replace and upgrade the currently used SWIFT system of bank to bank messaging (i.e. “the business service”) via a blockchain-based protocol. Ripple’s value proposition is so compelling (i.e. reducing transmission costs by as much as 60% and reducing settlement times to 4 seconds) that it has attracted more than 100 large financial institutions to join the network, among them Mizuho, RBC, and Itaú. Although this is still considered small relative to the 11k+ members of SWIFT, if Ripple accelerates, it could absorb a lot more value from the SWIFT network.
Value absorption, we think, will be the primary driver behind industry returns in the short to medium term, and its performance is governed by network effects. Most of the projects that are in active development are focused on translating business processes onto the blockchain. Additionally, blockchain is ultimately a network of computers all over the world working together for a common goal, e.g. transact across the network. Therefore, the value of the protocol will increase non-linearly with the number of consumers of this network, following a “Metcalfe’s law-like” process.
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Value Creation
Value creation is the process by which new sources of value are found or created. Take for instance, Golem, a network which allows users to earn revenue from renting out their idle computing power. This is an entirely new market, and potentially an extremely large one that hasn’t been tapped before. Another interesting example drawing from the internet revolution is Facebook. This now famous company was able to tap into social value. An achievement that wasn’t possible before the internet.
We think value creation as a return driver will take time to dominate performance. In 2017 alone, over 500 new blockchain projects raised a total amount of $6.5bn via Initial Coin Offerings (ICOs). In the same year, there was a total of 1,248 blockchain related patent filings, more than all the previous years combined. This is but a glimpse of the new use cases coming online in the coming years. After all, it took 7 years from the discovery of the internet, for Google to be born, and then, another 20 years to become the $750bn mammoth that it is today.
Usage
The problem of usage right now is that there is currently none of substance. Adoption hasn’t occurred in mass yet, but market validation is growing. There are 500+ new projects coming online in the next few years. Because these projects are powered by blockchain technology, they are the natural future consumers (i.e. the demand drivers) of protocols like Ethereum. However, given the nascence of the blockchain project, it will take some years for the real demand drivers to form and solidify.
In the medium to long-term, this will be the primary driver of the dynamics behind the growth of blockchain. It takes time for adoption to occur. As it expands and demand firms up, the fundamental drivers of coin value will begin to surface. These will be more correlated to world growth since usage will be driven by real world applications of the technology. It is interesting to note that there are some network effects that impact the growth of usage. Typically, users bring other users to the networks, thereby potentially increasing real demand for the service.
Return Dynamics
Given the above discussion, the growth of blockchain industry must follow the equation:
Given fixed supply*,
* Supply is typically known ex-ante for almost all digital assets, and therefore, it is not a binding assumption.
As the industry matures, each driver will take their turn in driving performance. We are currently in the early stages of the blockchain industry. Therefore, the path of least resistance for the industry to grow, is towards absorbing value from already existing business processes (e.g. banking, cloud computing, etc.). As the industry matures and the understanding of decentralized computing systems improves, demand will firm up and innovation will flourish. As demand matures, it will take over the driver’s seat of performance. Innovation will deteriorate as discovery becomes more difficult. It is worth noting that the absorption driver exhibits strong network effects, and is therefore prone to explosive behavior.
Sizing the Upside
Our estimates suggest that the industry could grow as much as $15tn over the next 25 years. This ballpark estimate translates to around a 15.5%[1] annualized return over the same period. To reach this estimate we used public equities as a proxy to determine the future size of the market. Using this methodology, the value driver contributed by $9tn over 15 years, while innovation could add as much as $8tn over 25 years. It should be noted, that these estimates do not include value generated by private equity, the inclusion of which, would add to the potential total size of the industry.
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The total amount of value that can be potentially absorbed is $9tn over a 10 to 15-year window. The total value of global equities, excluding emerging markets, is $40tn[2] and the impact of blockchain will be felt across all companies. However, not all sectors will be impacted by the same amount nor in the same way. For instance, the IT sector is by far the most at risk for disruption. The reason for this is that many processes rely on cloud or centralized server-based computing. These processes could be displaced by blockchain since a decentralized computing model can potentially be orders of magnitude more efficient. Another area vulnerable to disruption is the financial sector. For instance, banking accounts for 52% of financials, and is one of the most susceptible areas to blockchain’s dislocation. Other industries within the financial sector, such as capital markets (e.g. NYSE), are also at risk. Relative to the total potential market capture of $9tn, the current crypto valuation of $200 bn looks small, suggesting that the value absorption driver has quite a bit of room to grow.
Using public equity markets as a comparison, innovation could unlock as much as $8tn[3] in value over the span of 20–25 years. Since the creation of the internet in 1990 until today, the total return of the S&P500 IT sector has grown by 18.5x. However, these returns only account for the growth of either already established companies that embraced the internet or those startups which reached IPO status. The reason why this point is relevant is that blockchain enables early investing (i.e. at venture level). Therefore, the astronomical venture capital and private equity returns of the internet era should also be included. This addition could raise potential returns to as high as 25 to 30x.
Challenges Ahead
The single biggest risk is that the adoption of blockchain technology fails to reach “critical mass.” There are many challenges that could stymie this adoption, that currently remain unresolved. The policy reactions have ranged from the banning of cryptos in China to the complete adoption in Japan. Additionally, there are other risks that one should also be conscious of. For instance, there are competing technologies such as DLT that could eat away some of the returns estimated above, and “critical mass” of adoption could take years to materialize.
Regulation remains largely uncertain. Entities such as the SEC and the CFTC have been slow to provide clarity in how they are approaching the many thorny regulatory issues surrounding this asset class (e.g. custodianship, money laundering, etc.…). Regulation globally has so far focused on ICOs to protect retail investors from (the sometimes fraudulent) capital raises. This paints a complex backdrop for policy makers to navigate. It is therefore very challenging to know how regulation will evolve, and even more difficult to forecast how it will impact each asset differently (i.e. Bitcoin vs. Ethereum).
The market structure is still fragile. All major crypto exchanges still have outages during “high[4]” volume events. Value is driven by speculation, since structural demand from consumers hasn’t formed yet, causing valuations to move violently with news and sentiment shifts. Additionally, market liquidity is fragmented across various venues making trading at scale a non-trivial matter.
A Diversified Approach is Warranted
Blockchain is a young technology, and without clear demand drivers having formed, it is difficult to know who the winners will be. For instance, Bitcoin is an old technology for blockchain standards, and there are numerous competitors with better tech (e.g. Dash or Bitcoin Cash) trying to dethrone the king of cryptocurrencies. Additionally, there are is a large variety of new projects coming online, some of which could be the next Googles or Facebooks, and may even overtake Bitcoin’s current value.
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For investors, the top 20 cryptos have changed substantially over the past 2 years, therefore a diversified approach is warranted. This large dynamism in the composition of the top crypto assets tells a story of a rapidly evolving industry. As a result, an adaptive and diversified approach is key to harvesting high risk-adjusted returns, since ex-ante it is difficult to know which cryptos will be the winners. It’s worth noting that the top 5 crypto assets have been consistent and composed of Bitcoin, Ethereum, Litecoin, and Ripple over the same period. Additionally, these assets account for the bulk of market capitalization growth of the blockchain industry over the last two years and including them in a crypto portfolio may be warranted.
With this in mind, we have created the DigiCor90 and the DigiCorEW Funds, which track a market cap weighted and equal weighted index respectively. The Funds are designed to provide a liquid and diversified access to the very unique opportunity that digital assets currently present. However, the safekeeping of digital assets can be very challenging at scale. This is DigiCor’s number one concern, as hacking is a very real risk. One of the many steps we take to minimize this risk is to deposit all Fund holdings with a qualified custodian in cold storage vaults. Additionally, all funds are closely monitored by an independent administrator, qualified custodian, the DigiCor team and are subject to yearly independent audits. Our goal is to bring the same sound equity passive investing model to digital assets. In so doing, we follow the SEC’s regulatory requirements for mutual fund management (e.g. follow custodianship rules, etc…).
Conclusion
In a world where sources of differentiated returns are hard to find, and forward-looking performance of the classical asset classes muted, investing in crypto assets is an interesting value proposition. Blockchain technology is revolutionary and is poised to disrupt many of industries across the globe, particularly those that solve complex logistical problems (e.g. broker/dealers). In most cases, blockchain is investable via tokens or coins, which enables venture venture-like returns in a liquid format at a global scale. A feat, which has never been possible before.
The overall investment thesis for blockchain is one of sustained growth and warrants a diversified approach. The value capture has room to run, and even at current valuation levels of around $200bn, it still has substantial space to grow. Additionally, the remaining drivers are still forming and once they take hold, could potentially unlock substantially more value than the absorption driver. However, there are complex risks stemming from investing in crypto assets. For instance, similarly to the early Internet era, it is difficult to know ex-ante which projects will be the winners. Therefore, a diversified approach is warranted to harvest returns from the growth of the industry rather than a single technology. This is why, at DigiCor, we have created the DigiCor90 and the DigiCorEW Funds. These two funds track a market cap weighted and equal weighted index respectively.
[1] According to CoinMarketCap, as of April 5th, 2018, the blockchain industry’s size is $250bn.
[2] As per MSCI’s market cap estimate of MSCI World Index, as of March 2018.
[3] This estimate is equal to the total return of the S&P500 IT sector from 1990 to March 2018 divided by 3. The reasoning behind the 1/3 haircut is that S&P500 IT returns will be influenced by issues such as growth in global demand.
[4] The reason why is in quotes, is that volumes are high relative to the industry, but nowhere close to equities usual volumes.
Important Disclosure
This publication contains information obtained from sources believed to be authentic and highly regarded. Reprinted material is used with permission, and sources are indicated. Reasonable effort has been made to publish reliable data and information, but the author cannot assume responsibility for the validity of all materials or for the consequences of their use. Certain information contained herein may be dated and no longer applicable: information was obtained from sources believed to be reliable at the time of original publication, but not guaranteed.
The views contained herein are the authors but not necessarily those of DigiCor Asset Management. Such opinions are subject to change without notice. This publication has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
References to specific digital assets are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The author or DigiCor Asset Management may or may not own or have owned the digital assets referenced and if such digital assets are owned, no representation is being made that such digital assets will continue to be held.
This material contains hypothetical illustrations and no part of this material is representative of any DigiCor Asset Management product or service. Nothing contained herein is intended to constitute accounting, legal, tax, security or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Readers should be aware that all investment carry risk and may.
Originally published at blog.digicor.io on July 15, 2018.