Crypto Investing Themes

A general framework for investing in crypto

Mar 15, 2022

Hello readers,

President Biden signed an executive order this week that will direct federal agencies to take a unified approach to regulate crypto, tasking them with working together to address the risks of crypto - consumer protection, national security implications, and threats to the financial system. The EO also calls on these agencies to support crypto innovation and ensure the U.S. maintains “technological leadership in this rapidly growing space.”

Per Treasury Secretary Janet Yellen: “this approach will support responsible innovation that could result in substantial benefits for the nation, consumers, and businesses. It will also address risk related to illicit finance, protecting consumers and investors, and preventing threats to the financial system and broader economy.”

If you are bullish on the long-term possibilities for crypto to transform many of the foundational services in our lives, this recognition by the federal government of crypto’s fundamental importance can only be viewed as an affirmation of that position.

The debate is no longer whether crypto will survive; the debate has shifted to encouraging innovation and how the US can maintain a leadership position in this innovation.

As such, I thought it would be a great opportunity to share a report on a general framework for how I think about investing in crypto. This is not investment advice - I just thought it might be helpful to share how I think about the space and the various opportunities.

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In this report, we’ll cover 6 broad categories in crypto and how to express a long-term opinion on each of them.

Let’s go.

Sound Money

There is only one play here: Bitcoin. Bitcoin owns the category and there is no competition. Said another way, Bitcoin already won. Bitcoin is a monetary asset that does not compete with any other cryptoasset. Ethereum and other Layer 1 blockchains like Solana, Avalanche, and Near are smart contract platforms. Protocols built on top of these blockchains are providing services such as DeFi, NFTs, Gaming, etc, and are leveraging the features of these smart contract platforms. We’ll get into these categories later in the report.

Bitcoin’s features are perfectly suited as sound money. I highly suggest checking out Fidelity’s recent report on Bitcoin: Bitcoin First. This will help to fully grasp the key distinctions that separate Bitcoin from all other cryptoassets as sound money. Here is a quick glimpse:

Source: Fidelity

Bitcoin has absolute scarcity. It has a perfectly predictable monetary policy. It is the most secure crypto network. It is the most decentralized crypto network. It has more regulatory clarity than any other crypto network (deemed a commodity by the CFTC) and is even separated from all other cryptoassets by the Chairman of the SEC, Gary Gensler himself. It is the only cryptoasset that is backed by something that has had value throughout history: energy.

A long-term bet on Bitcoin is a bet that money changes throughout history. It is a bet on increasing geopolitical instability. It is a bet against modern monetary theory. It is a bet on inflation. And it is a bet on non-sovereign, incorruptible, permissionless, first-layer money. Similar to gold, Bitcoin is the only other monetary asset in existence today that is no one else’s liability. With what is happening in Ukraine and recent sanctions, this is starting to rise to the consciousness of more and more people.

A recent Wall Street Journal article highlights this fact. Per the WSJ: “sanctions have shown that currency reserves accumulated by central banks can be taken away. With China taking note, this may reshape geopolitics, economic management, and even the international role of the U.S dollar.”

Historically, the best time to buy Bitcoin is during bear markets or when there is some sort of negative news impacting investor sentiment. FUD in bitcoin is typically driven by information asymmetry. Information asymmetry is prevalent in any nascent market and it drives volatility. Remember: Bitcoin is not volatile. It is actually incredibly consistent and predictable due to its transparency and unchanging monetary policy. However, people are volatile. Human behavior is volatile. Emotions are volatile. Volatility can create opportunities for those looking for signals while ignoring the noise. A good signal for the absolute bottom of bear markets is the 200-week moving average. The price of BTC has never fallen below this level. It is currently $20.4k. Another strong buy signal is bitcoin’s realized price. This is the average price that all BTC in the market was purchased at. It currently sits around $25k. This doesn’t mean we’ll get to these levels. But if we did, it would likely be a fantastic buying opportunity.

DeFi

Things get murkier when we start to wade into the DeFi sub-sector of crypto. For simplicity, we’ll refer to DeFi in this report as decentralized exchanges, decentralized lending/borrowing, and decentralized insurance.

If you believe that there are gross inefficiencies embedded in traditional finance, look to DeFi to solve some of these issues. If you believe that digital assets offer superior asset settlement features (instant), security (immutability of blockchains), transparency, and user control, a bet on DeFi is probably prudent. Smart contracts can fundamentally change the business models of traditional financial services by removing the middleman while reducing costs and creating a more efficient user experience. This is what good tech does - create efficiencies, drive down costs, and deliver a better user experience. Finally, the market that DeFi seeks to disrupt is absolutely massive. Below we can see the efficiencies of DeFi already at play.

Source: Ark Investment Management

Decentralized Exchanges

A bet on DEX’s could be expressed through some of the larger incumbents today: Uniswap, Sushiswap, Curve, etc. There are many in the space and we are starting to see some Layer 2 DEXs like Quickswap (Polygon) start to pop up as well. Look for volumes, TVL, revenues paid to liquidity providers, and the size of their treasury. Look for the projects that are deploying on layer 2 scaling solutions and other chains as well.

Lending/Borrowing

The large incumbents in this space are Aave, Compound, and MakerDAO. Aave recently released a permissioned version of the app that is geared toward institutional finance. We should expect Compound to move in this direction as well. MakerDAO is the OG and is moving toward lending on real-world assets such as real estate tokens and energy-efficient projects. I’m also looking for projects that are deploying on more than one blockchain. For example, Aave recently launched on the growing EVM compatible layer 1, Avalanche.

Insurance

Nexus Mutual is the one to look at in this space. Risk Harbor is another but has not yet released a token.

Final Note on DeFi

When analyzing various protocols, I try to look for the following: Volumes of trading activity (for DEXs). Total Value Locked (Lending/Borrowing). Strong Management/Founding Teams. Reputable investors (VCs backing them). Governance. Track record. Look for positions that institutional finance players are taking. Arca Labs does some fantastic research in the space - check out their “That’s our Two Satoshi’s” weekly newsletter for fantastic information from an investment manager in the space that is servicing institutional wealth. The addressable market for DeFi is absolutely massive. That said, there are also risks in DeFi. The primary risks today are smart contract hacks and regulatory uncertainty/risk - primarily in the decentralized exchange area of DeFi.

NFTs

I believe NFTs are going to be huge because they represent digital property rights. But I have no interest in owning them right now - the NFT market looks more like a casino to me than an investable asset class. At the same time, I know that they are very popular and lots of people want to own them. A way to express a bet on NFTs is through NFT infrastructure. Enjin Coin is one that is working with Microsoft on a few projects. They make it easy for individuals, businesses, and brands to use NFTs across gaming platforms.

Immutable X is a layer 2 validium/zk-rollup built on Ethereum that facilitates a fast and gas-free NFT market. This is an easy, pure-play bet on the growth of NFTs without actually owning any NFTs yourself.

Metaverse

If you believe that the next iteration of online social communities and interaction will occur in the metaverse, you may want to look at the Decentraland and Sandbox platforms. Large brands like Nike, Adidas, JP Morgan, Dulce & Gabbana, Tommy Hilfiger, PwC, Samsung, etc have all made moves on these platforms of late, with many of them buying virtual land.

Gaming

Which blockchain game will be the next Axie Infinity? I have no idea. But I do think that blockchain gaming will be big. Blockchain games allow users to be paid to play. And they allow gamers to own their in-game assets, monetize them, and trade them. Blockchain gaming economies will likely be a real thing. It seems only a matter of time before all games are constructed using blockchain technology. Again, an infrastructure play seems prudent here for an investor with a long-term outlook on blockchain games. Ronin is a layer 2 sidechain that is built on Ethereum designed to service pay-to-play games like Axie Infinity. Ronin is founded by Sky Mavis which is backed by powerful VC firm Andreesen Horowitz.

Fan Experience

The internet connected fans to their favorite players, athletes, celebs, etc. Blockchains connect them financially. Chilliz has a massive lead on fan tokens. They have partnerships with some of the most established sporting institutions in the world, including Barcelona FC, AC Milan, Manchester City, Arsenal, Juventus. With entrenchment in Europe, they recently announced a $50 million expansion into the US market. They already have a partnership with the UFC and recently opened an office in NYC with plans to expand into all major sports in the U.S. 24 NBA teams have already signed on. The NY Islanders, Vegas Golden Knights, and LA Kings have announced partnerships in the NHL already. The New England Patriots recently announced a partnership in the NFL as well as the Revolution in the MLS.

Conclusion

There is a ton of noise in crypto. There are over 18,000 cryptocurrencies listed on coinmarketcap today. It can be a wildly confusing, abstract space. I’ve found that the best way to invest in crypto is to identify high-level themes within the space. Once we understand a certain sector or industry that looks poised to utilize blockchains, we can start to form a thesis as to why that is the case. And from there we can exercise that thesis with simple pure plays.

As a general rule, I only invest long-term and when I have a strong conviction about a theme. This way the volatility is simply noise. I also typically will only buy a cryptoasset that I like during periods of extreme volatility to the downside. When everyone is running for the exits, that is usually the best time to buy (for those with long-term conviction). Never, ever FOMO into crypto. Keep your allocations small relative to stocks, real estate, commodities, etc. Never invest in crypto with leverage. Keep abreast of the markets and trends. Follow the data. Be willing to change your mind. And never buy something you do not understand.

Please do not take this as investment advice. I’m simply sharing my thinking for those interested in developing a framework for investing in the space. The fact of the matter is that investing in crypto is risky and most investors are not well suited for it. My advice is to do your homework. Develop conviction. Keep allocations small. Be a continuous learner and stay open-minded as market conditions evolve.

That’s all for this report. Please note that I left the Layer 1 smart contracts out of this analysis (Ethereum, Solana, Avalanche, Near, etc). We’ll do a separate report looking at how we can think about and project out the long-term viability of these platforms. We’ll also be doing a separate upcoming report on blockchain interoperability and layer 2 scaling solutions.

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