A common analogy for investors new to the world of cryptocurrencies (crypto) is the scene in "Alice’s Adventures in Wonderland" where Alice follows the rabbit down a rabbit hole and into the upside-down world of Wonderland. The analogy works so well because when an investor learns of the technological concepts behind crypto, it can feel like they stumbled into an upside-down world of make-believe. If you’re interested in learning about digital assets, where we believe the industry is headed and the truly upside-down world of decentralized finance (DeFi) in plain language, this is for you. And, if after all that you end up exiting the rabbit hole, that is ok! Even Alice eventually woke up from her Wonderland dream.
Why Crypto, Why Now
Cryptocurrencies are a relatively recent phenomenon, and as with other technological breakthroughs, was born out of a technological revolution much longer in the making. So how did we get here? The story of crypto and blockchain technology goes hand-in-hand with the evolution of the internet itself.
Remember the early days of the internet when all we did was check email and visit AOL chat rooms? The technology that enabled those functions was called Web1. Obviously we’ve come a long way since then, but the more interesting subtext to this timeline is that somewhere along the way, the internet took a detour to become dominated by a few advertisement-driven behemoths (e.g., Alphabet and Facebook) in the period commonly called Web2.
Needless to say, applications from ridesharing to social media on a global scale would not have been possible without Web2. However, the centralized control exercised by these behemoths has become problematic for a growing number of users due to rising privacy concerns. In our view, the momentum is starting to shift back to the original decentralized, user-controlled experience of Web1. Thus, we believe we are at the early stages of the next iteration of the internet, taking concepts such as the Internet of Things (IoT), artificial intelligence and decentralization and calling it Web3 (Figure 1).
Figure 1: The Evolution of the Internet
|1990s — Web1: The Birth of the Internet
|2000s – Current — Web2: The Rise of Oligopolies
|Future? — Web3: Decentralization
Crypto Merits & Risks
We currently view crypto as speculative investments and not suitable for all investors; however, adoption rates continue to build, so we think it’s worthwhile to examine the world of crypto through an investor’s lens. We highlight what we believe are the key merits and risks of investing in crypto (Figure 2).
Figure 2: Merits and Risks
|Growth Potential: Decentralized blockchain technology is a breakthrough disruptor for numerous industries and offers significant growth potential for years to come.||Regulation: If the Securities and Exchange Commission (SEC) or other global regulatory body classifies a digital asset as a security (rather than a commodity), there will be numerous challenges to growth and adoption.
|Rapid Adoption: The bitcoin blockchain in particular has a very strong network effect. Even when the price declines significantly, the user base remains stable.||Volatility: Given the nature of a nascent technology priced in real-time, digital asset volatility is well above traditional securities like equities.
|Transparency: Valuation metrics, while unorthodox, are rather easy to obtain since all blockchain data is freely available to investors||Going Concern: Given the early stage of DeFi, projects could lose significant market share as new and improved projects are developed.
|Access: A unique feature of DeFi investing is direct access to venture capital-like projects without accredited investor requirements.
||Security: Investors face the risk of a breach from hackers on intermediary platforms (e.g., custodians or exchanges). This is in contrast with the blockchain networks themselves, such as the bitcoin network or the Ethereum network, which have not been hacked to date due to their decentralized nature.|
Classification of Crypto Assets
An asset class is defined as a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations. Asset classes comprise instruments which often behave similarly to one another in the marketplace. Historically, the main asset classes broadly have been equities and fixed income, spanning both public and private markets, as well as traditional cash equivalent and money market instruments.
Crypto assets fit none of these descriptions, so from a multi-asset class allocation framework, where do we go from here? Fortunately, investors have already received guidance, as U.S. regulators have classified both bitcoin and ether as commodities. According to the CFA Institute, a commodity is a physical good attributable to a natural resource that is tradable and supplied without substantial differentiation by the general public. We believe the latter part of the definition clearly describes the essence of crypto assets, and thus the commodity label is appropriate.
Using our multi-asset class framework, the primary asset classification for cryptos starts with the realm of alternative investments. The sub-asset class of real assets includes areas such as timber/land, inflation-linked securities and commodities. Therefore, from an asset allocation perspective, crypto would be a subset within the commodity exposure (Figure 3).
Figure 3: Alternative Investment Asset Classes
|Private Equity||Leveraged Buyout|
|Oil & Gas|
|Event Driven||Activist, Merger Arbitrage|
|Relative Value||Equity Market Neutral, Arbitrage, Relative Value Credit|
|Directional||Macro, Global Tactical Asset Allocation, Commodity Trading Advisor|
Learn the Crypto Lingo.
DeFi: Decentralized Finance; any blockchain technology that does not rely on a centralized point of control and is instead executed through pre-programmed software.
dApp: Decentralized Application; a computer application that runs on a distributed computing system.
Fork: An iteration of an existing crypto (e.g., bitcoin) that is created when a group of users wants to make a significant modification to the software to the point where they leave the original crypto network and form a new one.
FUD: Fear, Uncertainty and Doubt; for example, when a person has views against digital assets in general or against a specific crypto, they usually include some degree of FUD in their argument.
HODL: Hold on for Dear Life; the mindset of longer-term crypto investors due to periods of significant price volatility and high downside risks.
ICO: Initial Coin Offering; akin to an initial public offering (IPO) of stock.
Mining: Solving cryptographic equations using high-powered computers to generate new coins on a specific network.
NFT: Non-fungible Token; a wholly unique digital file that is stored on a blockchain.
Nuked: Slang for when a crypto price declines swiftly, abruptly stopping upward price momentum.
Rekt: Slang for “wrecked,” as in a permanent loss of capital.
Whale: An investor that owns a relatively significant amount of a specific crypto asset.
When Lambo: A light-hearted question crypto investors ask, referring to when their coins will be worth enough to afford a Lamborghini.