Don’t ignore the competition

Cryptocurrency investors usually only look at the investable landscape.  They ignore those projects that are hard (or impossible) to invest in.  This is a big mistake when considering an investment in a competitive industry.

++ When I talk to cryptocurrency investors, they often defend an investment by saying, “great team, great technology, real use case.”  I then ask, “who are their competitors and why do you think that this team will be the winner?”  Usually…silence.  Sometimes, the person will respond by naming other competitors with an exchange listed cryptocurrency or an upcoming ICO.  Never do they respond with competitors that have no cryptocurrency.

++ Consider Ripple (XRP).  XRP has numerous competitors with no tradeable cryptocurrency like R3 and Digital Assets Group.  To decide if XRP is a good buy, you have to look at the competitive landscape and decide why you think XRP is likely to beat out the competition.

++ Civic (CVC) is another example.  Great project, great team, but they have at least a dozen serious competitors, some of which may have greater traction.  CVC may be a great bet on the blockchain identity use case, but we can only conclude that after comparing Civic to its long list of competitors.

++ It’s important to remember that most cryptocurrency is open source, and so the value is based primarily on network effects.  When looking at new projects that don’t yet have meaningful network effects, we’re mostly betting on the team’s ability to quickly establish a first mover advantage in a particular use case.  Making that call requires evaluating the level of traction the competition has achieved.

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Table Selection

++ Back in my college days, I played poker. A lot of poker, at high stakes. I played online, in Atlantic City, in underground Philadelphia poker clubs, and against other UPenn undergrads. I was a very good player, but I had a few college friends who were objectively better. They were better at every aspect of the game…except one: table selection. And because of that one weakness, a couple of them were constantly broke.

++ These young poker players would make tens of thousands of dollars playing against “fish”, but would then take their winnings and sit down with the very best players in the world. They would challenge the best professionals, like Phil Ivey, to high stakes heads up games. Inevitably, they’d eventually lose to the superior players and often they’d lose everything. Then they’d borrow a few thousand dollars from friends and rebuild, only to lose it all again against the top pros.

++ I too occasionally tested myself against the best in the world, but I knew I was paying for a lesson, and would only sacrifice a small percentage of my winnings. I spent most of my time playing against weaker players. I realized early on that table selection was a part of poker too, and there was no shame in using that as a critical part of playing profitable poker.

++ “Table selection” refers to choosing a poker table at which to play. And it, more than anything else, determines whether you’re likely to end up a winner or a loser. Unless you’re the very best or very worst in the world, your expected value depends on your opponents. If you’re the 10th best player in the world but only play against the top 9 professionals, you’ll go broke. If you’re a mediocre player but exclusively play against even worse players, you’ll be profitable.

++ This concept applies throughout life. Venture capitalists know it’s a bad idea to invest in companies trying to beat Amazon at its own game. And as a trader, there are some tables I want to sit at, and others that I want to avoid.

++ Trading in many traditional markets is like sitting down at a table of the top professionals. It’s possible to win as a long/short equity trader, but you’ve got to be among the very best in the world. In contrast, cryptocurrency trading is currently like sitting at a table of weak players; there may be the occasional professional, but we’re not competing with the professional. Rather, we’re playing against the price insensitive retail investor – the person who panic sells BTC at $1800 that has never heard of BIP 91, or the person who buys ETH on margin at $400 without a glance at the network capacity or scaling roadmap. We’re not trying to impress with complex trade ideas. We’re not trying to show off by out-thinking other professionals. We’re here to win.

++ In practice, this means that we’re flexible. Back in April I was sitting at the ICO table. I invested in the Cosmos Network’s Atom token at an attractive valuation. Over the following month, the ICO table got much more competitive. Initial valuations skyrocketed as investor capital flooded into the space. And a great many of the professionals entering cryptocurrency are currently focused on ICOs. So…for now at least, I’m not. This isn’t to say that there aren’t attractive ICO opportunities – there are. But I see softer tables at the moment.

++ Table selection requires that we banish our egos. Avoid the temptation to compete against the best (even if you think you are the best.) Choose your opponents carefully.

Posted in Cryptocurrency | 8 Comments

Cryptocurrency’s “Nifty Fifty”

++ Usually in bull markets, the “high beta”, riskier securities outperform. This is what we saw over the last 7 months. Bitcoin rallied impressively, but was dramatically outperformed by the more volatile and more speculative Ethereum, which was itself outperformed by some of the even more speculative and smaller cryptocurrencies. The tail end of such rallies are often “junk rallies”, with the strongest gains accruing to the fundamentally least attractive securities.

++ But this pattern doesn’t always hold true, and I think we’re about to see the exception. I think we’re likely to see a strong cryptocurrency rally that’s led by a handful of high market cap cryptocurrencies. For a historical analogue, consider the “Nifty Fifty” in the 1960s and 1970s. Institutional investors became enamored with about 50 growth stocks that came to be viewed as “single decision” stocks. People felt they could buy those equities with confidence they were both safe and high performing assets. That belief becomes self-reinforcing for a time – as money flows in and people buy every dip, the securities do indeed look both very stable and very lucrative.

++ Which securities are the cryptocurrency “Nifty Fifty?” Consider where institutional and retail money can flow most easily. Look at the cryptocurrencies offered by Coinbase, Gemini, and the investment trusts offered by Grayscale, and the equivalent companies in Asia. Look at the most liquid, most stable, and oldest cryptocurrencies, the ones that would be most appetizing to, say, a Family Office that wants to broadly invest in cryptocurrency in as passive a form as possible. What cryptocurrencies can most easily be thought of as “established”?

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The Wall Street Moment

++Over the last two years, the big investor in cryptocurrency was “Silicon Valley.” The high profile investors were mostly tech entrepreneurs and their family offices and venture capital firms.

++I just finished a NYC roadshow with mostly that same type of investor (despite being on the opposite coast), but also had some surprising meetings with “Wall Street.” Today I spent an hour at a bulge bracket Wall Street bank and met with their prime brokerage and capital introduction divisions. They’re interested. They get that this is going to be big. Each of the half dozen senior bankers around the table kept saying, “I need to learn more.” Their research divisions are starting to publish detailed sell-side research on cryptocurrency and blockchain tech (including a very impressive 80 page report on blockchain disruption.) They’re holding internal informational seminars for their partners. They’re starting to think about offering prime brokerage, custodial services, capital introduction…the laundry list of services that Wall Street provides for every major asset class. They have a long road to building those platforms, but I suspect that within 9 months, they’ll start providing some of the services necessary to make institutional investors comfortable with cryptocurrency.

++I also met with a couple reporters at two leading financial publications on background – and they’re in a similar place. They’ve been reporting on cryptocurrency, but usually as a one-off story. They report on sharp rallies and collapses in the price of bitcoin or ether and occasionally mention the small fund managers in the space, but usually it was presented as a quirky observation of something crazy happening. The reporters have a growing appreciation that this is here to stay but aren’t sure how to approach covering cryptocurrency. Do they treat a crypto fund manager like any other hedge fund manager? Do they report on individual cryptocurrencies like equities or commodities or as new technologies? They know they need to learn more.

++Six months ago, I realized we were about to have “the wall street moment.” The pattern of adoption of cryptocurrency has (and I think will be) something like this:

Cypherpunks -> Engineers -> Silicon Valley -> Wall Street -> Institutional Investors -> Main Street

Posted in Cryptocurrency | 4 Comments

The Coinbase Effect

++Coinbase added Litecoin for direct purchase today, and litecoin (LTC) is up about 30% as a result. The rumor of this addition may have also contributed to LTC’s 100%+ rally over the last 2 months.

++The only other currency Coinbase added (beyond its initial offering of Bitcoin) was Ethereum back on July 21st 2016, just a day after Ethereum’s hard fork. Ethereum’s addition to Coinbase produced an immediate 14% rally, although it’s hard to tease out the real effect given the volatility surrounding the hard fork. Ethereum’s accessibility on Coinbase (and then Gemini) likely contributed to its massive rally over the following 9 months.

++Are these rallies rational? Yes. There is a very heavy accessibility premium in cryptocurrency valuations. As a cryptocurrency becomes easier to purchase and easier to store, it’s valuation should rise…and it clearly does.

++What does this mean for investors? We enjoy a tailwind if we’re willing to invest in cryptocurrencies that are harder to access. If and when those cryptocurrencies then become more accessible either by being added to Coinbase, offered in trust form, or purchasable via ETF, we can expect the valuations to generally rise substantially.

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How To Think About Investing In Cryptocurrency Part 2 of 4: What *needs* to exist.

++Part 2 of the 4-part series “How to Think About Investing In Cryptocurrency” starts exploring the economic forces that will drive market segmentation to help us identify the future industry leaders.  It’s best to start by asking, what needs to exist?  What services does the world need that can best be provided by a public blockchain?

++First, let me try to convince you that cryptoccurency isn’t “winner take all”, although some specific niches within the crypto world probably are.  Imagine if Uber tried to offer term life insurance?  Imagine if Lloyd’s of London tried to sell virtual reality headsets?  Imagine if McDonald’s tried to offer a 12-course $400 dinner with wine pairing?  Imagine if Nordstrom tried to compete with Walmart with rock bottom pricing?

++Some business models are natural fits for particular products.  People want to buy their insurance from stable, long-lived, boring companies.  And the companies best suited to compete on cutting edge technology offerings are generally smaller, leaner, and have an ethos of “move fast and break things.”  IBM is a good example of a huge stable company that appears superficially to be a tech business, but really is a consulting firm that just happens to consult on tech.  Similarly, Apple used to be a nimble tech innovator, but is now a consumer brand company, more comparable to something like Coca-Cola.  The winning cryptocurrency in a niche will usually not be decided predominantly based on marginal technological differences relative to competitors.  Launching a new cryptocurrency that aims to copy a market leader with a slight improvement is kind of like saying I’m going to create a product to compete with the Iphone with a better camera, or that I’m going to launch a competitor to Coca-Cola that tastes the same but with 10% fewer calories.  I’m unlikely to get very far because the specs and price are just one small part of their success.

++Turning back to cryptocurrency, there’s a critical idea that’s often overlooked: the role of community.   In cryptocurrencies, governance is driven by that cryptocurrency’s community (developers, miners/stakers, users, service providers, etc).  There’s often a positive feedback loop that makes the community more homogenous over time.  Consider Ethereum’s hard fork after the DAO bug was exploited.  Many of the community members (holders of ether, miners, developers) who strongly opposed the fork abandoned the ETH chain.  Alternatively, people who liked the philosophy that led to the hard fork were attracted to the ETH chain.  The result was that the community post-fork was substantially more homogenous than the community pre-fork.  The community is often a key feature of a cryptocurrency because it contributes to governance via game theory.  While the community can certainly change over time, it needs to be thought of as a core part of how a cryptocurrency functions, almost on par with the scripting language.  To put it simply – the community makeup of a cryptocurrency directly influences how that cryptocurrency behaves.  Cryptocurrencies are differentiated not only by their code, but also by their communities.

++Bitcoin has a community that is mostly committed to stability.  To the majority of Bitcoin users and developers, Bitcoin is IBM, it’s Lloyd’s of London.  This makes technical innovation at the protocol layer very difficult in Bitcoin, but also lends it a great deal of stability.  By “stability”, I don’t mean price stability, but rather protocol stability.  If I buy 1 bitcoin today, I can be fairly confident that in 5 years I’ll own pretty much the same thing.  In contrast, the Ethereum community has adopted a “move fast and break things” mentality.  Ethereum is Uber, it’s Facebook 10 years ago.  This community facilitates breakneck technological progress, but increases the risk of bugs, and makes it impossible to know what ownership of 1 ether will mean in 5 years.

++We see a similar dichotomy in the protocols themselves.  Bitcoin has a very simple scripting language which makes it difficult to build new features, but also relatively easy to avoid devastating bugs.  In contrast, Ethereum has a complex Turing complete language which lets it do pretty much anything, but greatly increases the chance of serious error.

++I don’t view one of these communities or scripting languages as superior to the other.  Rather, each is optimized to fulfill a particular need.

What does the world need?

++The world needs “digital gold” – an unseizable store of value, with great liquidity, a high market capitalization, stable protocol, and great security.  While it would be nice if the cryptocurrency that filled this niche also had a quick confirmation and low fee, those things are not core to the value proposition, and those factors are unlikely to determine which cryptocurrency dominates this niche.  I think this niche is likely “winner take all.”

++The world also needs cheap, fast, and private, monetary transmission.  Much of the infighting in the Bitcoin community today stems from the growing realization that it might not be possible to optimize a single cryptocurrency for both the “digital gold” and “monetary transmission” niche.  For Bitcoin to do both well will probably require a secondary layer like the Lightning Network.  Alternatively, the “monetary transmission” niche may be best served by an entirely separate cryptocurrency that may eventually be made interoperable with Bitcoin via parachains.  Cryptocurrencies like Monero, Litecoin, Dash, and Zcash are primarily competing for the “monetary transmission” niche.  For this niche, protocol stability and extreme defense against doublespends, is less important than speed, cost, and/or privacy.  I don’t need $1 billion worth of security if I’m only paying an $80 restaurant bill.  Because there are different levels of security demanded for different transactions, this may not be a “winner take all” niche.  I can imagine a scenario where there are 3+ cryptocurrencies providing varying combinations of speed-security-cost-anonymity for monetary transmission.  For example, Zcash may offer the best anonymity, but relatively slow execution if you’re on a smartphone since the algorithm is so intensive – this might be a welcome tradeoff for some uses, but highly inefficient for others. We may soon have a world were crypto A is used for maximum speed and lowest cost, crypto B is used for perfect privacy, and crypto C is used when users want a hybrid compromise.

++The world needs a platform for decentralized applications (dApps).  The cryptocurrency to provide that platform has to have a complex and evolving scripting language, and a community that embraces constant innovation (at least for the next few years until the technology is more mature). This is such a new area that I find it impossible to predict if the equilibrium is one dominant platform or multiple competing platforms with different network architectures and communities.

++So far I’ve only explained why Bitcoin and Ethereum are the two biggest cryptocurrencies by market capitalization by far.  I can’t say if Bitcoin and Ethereum will remain the dominant players in their respective niches forever, but if they get replaced, it will probably be by something that looks very similar to the incumbent in terms of both the code and the community.

What *else* does the world need?  That will be the topic for Part 3.

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How To Think About Investing In Cryptocurrency (Part 1 of 4): Why Exceptional Opportunities Exist

++ In this series, I’m going to start with high level investing concepts in part 1 and get increasingly specific and detailed through part 4.

++Part 1 is an exploration of why extraordinary investment opportunities exist in cryptocurrency. To an engineer, that might seem like an obvious and uninteresting question, but professional investors generally start with the premise that it’s nearly impossible to find the kind of returns that we’re seeing. This is the essay that uses traditional financial theory to explain to your broker or pension fund manager why such a great opportunity exists.

++Professional investors think of markets as mostly efficient most of the time. This comes from both academic research and experience. While market inefficiencies certainly occur, there are thousands of brilliant traders and investors competing to immediately exploit and eliminate those inefficiencies. It’s hyper competitive. This makes it extremely difficult to beat the market consistently. 90% of mutual fund managers and hedge fund managers underperform a passive index, and these are mostly brilliant and very hard working people. Competing in public markets is like playing in the NBA – you’re competing against a field of amazing athletes in what is effectively a zero sum game: for every outperformer there has to be an underperformer (and usually many more than one because of expenses).

++But what if instead of playing in the NBA, we had the option of playing in a middle school recreational basketball league? What if we found a league where the best basketball players in the world couldn’t, or wouldn’t compete against us?

++My personal investing idol is Seth Klarman of Baupost group – one of the best performing, most insightful, and most ethical investment managers. Klarman notes that investors are compensated by the market for taking on market risk (i.e. beta), and for illiquidity. Many investors stop there, but Klarman notes that we’re also compensated for complexity, operational challenges, and “psychological risk.”
Why do such compelling investment opportunities exist?

1. They’re complex along many axes: understanding the technology often requires a degree in cryptography and engineering (for which I depend on a growing network of professional blockchain developers). They’re also complex economically; similar to investing in Facebook before there was any serious monetization plan. Few people have thought seriously about how to value a cryptocurrency fundamentally – there’s no textbook to reference, and currently no consultants to query. And lastly, they’re complex in execution.  Consider Initial Coin Offerings (ICOs) – every ICO is unique, but they increasingly require submitting customized data to an Ethereum “smart contract.” This complexity – in technology, in economics, and in execution, scares off much of the competition.

2. They’re operationally challenging. There are no established regulations, operational procedures, or accounting standards to deal with investments in cryptocurrency. Best practices for securely storing cryptocurrency are constantly evolving and the storage cannot be delegated. Storing cryptocurrency in a way that is both extremely secure, but redeemable in case I’m incapacitated, is a very time consuming process. These operational challenges discourage many potential investment managers.

3. They entail “psychological risk.” In 2008, many of the largest US bank stocks lost 80% of their value, some lost 100%. The stocks of big US companies are risky, but we don’t perceive them as such – if you lose your money owning Citibank or AIG, you won’t feel all that foolish and as a professional investor, you probably won’t be fired. In contrast, cryptocurrency investments are risky, but if we size the position appropriately for our portfolio, they’re no different from any other volatile asset. The main concern many people have is psychological. If someone ran a pension fund and lost 15% of their portfolio in financial sector bonds in 2008, they were “unlucky.” If that same pension manager loses 2% of the fund in a cryptocurrency pool, they fear they will be fired for being foolhardy. As investors, we’re surprisingly well compensated for the risk of appearing foolish. it’s a risk that most of the biggest money managers refuse to take, and thus they leave many of the best investment opportunities on the table.


++ Investing in cryptocurrency is currently like playing basketball in a middle school rec league. Most of the best basketball players aren’t yet in the game. This allows us to earn outsized returns by providing capital to the best cryptocurrency projects. In a few years it will be far harder to earn such returns because there will be a great many talented investors competing to provide capital to the same projects. As we see in the traditional venture capital industry today – this competition drives up the entry price, and drives down expected returns.

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