fundamental

Sources of capital: the path to one trillion

Understanding the sources of capital flowing into the blockchain space is the first macro step towards attempting to value of the future growth of the market. 

Estimated marketshare by investor type 2022

As of Q3 2017 the market continues to be dominated by primarily retail buy and hold investors. Moving forward we will examine how new categories of investors will effect valuations painting with a wide speculative brush. 

Market Size

Global M2 cash reserves stand at between 80 and 100 trillion US equivalent dollars, the highest level in human history. This places the current value of blockchain tokens at 1 out of roughly every 650 dollars on earth (or .15%)

Note: This excludes the development of futures, options, and other derivative markets. Thus a one trillion dollar market capitalization would represent roughly 1% of global cash reserves. 

Assumptions

  • Linear growth rates: The percent year-over-year each category is projected to grow. Better models for shaping growth rates can be added in the future, though for our purposes we intentionally kept the assumptions as simple as possible. 
  • Corrections: There will continue to be large draw downs as the space expands. We will assume continued every other year major draw downs that lessen as an overall percentage of market capitalization as the market matures.
  • Contributions by category: More opaque categories such as pensions, private equity, family offices, and professional traders as a percentage of the current market capitalization must be inferred from limited data sources. 
  • Barriers to entry: We have broadly ranked each category by how high the barriers to entry are before a category can enter the space. We roughly assume the more third party custodial work needs to be done, the higher the barrier to entry. 
  • Institutional desire for exposure to uncorrelated returns. Basic portfolio theory would lead institutional capital to blockchain token assets over time as a risk management strategy. This sounds counter-intuitive, but most fund managers ascribe to modern portfolio theory where pairing two types of uncorrelated risk together mathematically lowers the overall risk profile of an investment portfolio. 

Calculator

We have created a very simple calculator to project marketshare by investor class and market capitalization moving forward. Feel free to change any of the variables as you see fit or reach out to us with a better model. 

While largely arbitrary in percentages, this shows as the market matures retail buy and hold investors will make up less of the overall market. If retail early adopters holding their own private keys make up less of the market share over time, who will take their place?

New Entrants

Let's examine each new category entering the space from highest to lowest barrier to entry. Using this frame helps infer which investor classes will be able to enter first, and how laggard classes will ramp up over time to reach similar levels of exposure. 

Pensions & Sovereign Wealth: This category has the highest barrier to entry. 

  • Fund managers have a fiduciary responsibility to protect the long term value of their underlying pension assets and typically invest in less "risky" asset classes like corporate bonds and real estate.
  • Pension fund managers also have significant personal career risk by recommending an asset class to clients who do not understand the underlying technology have only been exposed to "tulip mania" hype stories. 
  • Self dealing is also a significant hurdle to overcome. Processes for third party intermediaries holding and insuring private keys must be in place before large investment groups can move into the space in a major way. 

Blocktower Capital founder Ari Paul sees pensions as one of the last capital sources to incorporate blockchain tokens into their investment portfolios starting in 2018 at the earliest as the liquid simply does not exist yet to open and close major positions without significant slippage. 

Private Equity: Depending on the structure, private equity can behave closer to pension funds or closer to venture capital. The same self dealing and career risk barriers also apply to private equity though to lesser degrees in smaller, more nimble funds.

New funds take time to form, fund, then finally deploy capital. The formation stage can give some insight by analyzing SEC filings, though actual amount raised by private funds can remain elusive to quantify.

Family Offices/High Net Worth: These categories have even less reporting requirements, with less career risk and self dealing requirements. Many high profile wealthy individuals such as Richard Branson, Michael Novogratz, Mark Andresson, etc. have publicly commented on their investments in the space. 

Public ETFs: This category could overlap significantly with the above categories if institutional capital decides to use ETFs as vehicles to hold blockchain tokens rather than holding the private keys themselves, or trusting services like Coinbase.

While ETFs fly in the face of decentralization and individuals controlling their own wealth peer-to-peer, they do make owning blockchain tokens significantly easier for both retail and institutional investors. 

Professional traders: This category has also yet to enter the space in a major way. Arbitrage liquidity providers have not managed to eliminate arbitrage opportunities between markets showing how nascent professionals in the space still are. Major trading desks like Goldman Sachs have been dealing in cryptocurrencies for years mostly by employees in off hours, but have yet to establish dedicated divisions. 

Retail investors: The original category of investors in the space will continue to grow as individuals look for inflation and geopolitically resistant places to store their wealth. New services that make it easier to buy, store, and use blockchain tokens must evolve for the market to grow beyond its current early adopter phase. 

Takeaways

While not an exhaustive analysis of potential capital sources, a general macro view of capital flows into and out of the space is crucial to position investments for long term success. Over the medium to long term, substantial capital from new sources needs to find its way into the blockchain token ecosystem.

As most projects worth investing in have finite supplies of tokens available to the market, a sawtooth uptrend in appreciation is expected as capital from sources other than retail buy and hold enters the market. 

While most individual projects will likely FAIL, the market capitalization as a whole will continue on an upward trajectory as the market solidifies into a handful of winning projects. 

In the short run, the market is a voting machine but in the long run, it is a weighing machine.
— Benjamin Graham

J-Curve and the Hype Cycle

The changing relationship between the underlying value of an asset and its perceived market value is a complex and often befuddling process. A "J-Curve" attempts to fit a function on top of this process to predict future price action. 

Applying the J-Curve concept to crypto assets was recently explored in a blog post by Chris Burniske. In the article he compares the Bitcoin price performance to the J-Curve function.

The J-Curve is a concept originally developed in the private equity world to value non-crypto assets that consists of the relationship between:

  • Current Utility Value: The "real" value of the underlying asset and..
  • Discounted Expected Utility Value: The "perceived" value of the asset relative to expected future value

In traditional revenue generating assets CUV can be approximated using WACC and APV methods.

Moving into the blockchain token space CUV becomes much more difficult to define.  We can borrow some elements from traditional analysis methods such as discounting or what risk premium is put on an asset to justify the investment. Though for the bulk of the analysis we must get more creative in defining what underpins the "real" value of the network. 

Note the following J-Curve plotting the "hype cycle" of a new technology relative to Burniske's "crypto J-curve".

hypecycle.png

As we can see there in an uneven distribution in demand (eg price action) for the same underlying asset. First DEUV deviates from CUV during the initial hype phase, followed by a large contraction as hype fades and the value comes back into line with the underlying value of the asset. If the project is strong, eventually both the DEUV and CUV will rise over the long term. 

crypto-jcurve.png

Bitcoin and CUV

Let's start with a basic transnational blockchain like Bitcoin. The value of Bitcoin can be derived from a few different sources.

  • The electricity cost of mining new bitcoins. Comparisons to mining costs for precious metals vs their market value. 
  • The value a non correlated asset has as a hedge to fiat currency. In this case equating the value of Bitcoin as a percentage of the value of the precious metals market. 
  • The value of a transactional network that can send large amounts of money globally with low fees and no disclosure requirements. Comparisons to payment processors like Paypal, Visa, etc.
  • Metcalfe's law and the value of the network as the square of the number of active users.
bitcoindeuv.png

Price action shows Bitcoin as exiting the first major J-Curve and entering into the next.

Again see the Burniske article for reference ->

 

Platform Projects and CUV

Unlike bitcoin, asset registration and smart contracting platforms have an underlying value derived from a different set of metrics as they attempt to disrupt an even larger market than Bitcoin. 

Projects like NEM, Ethereum, Stellar Lumens, and NEO approach the "decentralized internet" in different ways, though they all seek market share to become the dominant "fat protocol"

Success on this level revolves around how many new projects are being created on their platform (eg ICOs), and how many asset transactions are flowing through the system. 

Plotting J-Curves

As Bitcoin's J-Curve takes off with increased real world usage, alt token projects as a whole might be in for a significant correction before a bottoming and an eventual resurgence. 

The recent run up in the price in terms of bitcoin (eg crypto marketshare) for alt coin projects seems to be following the first major J-Curve correction. As these quality platform level projects bottom out, smart money will move in and begin accumulating positions at 75-90% corrections in terms of bitcoin value. 

This logic would set buy targets on NEM in the 3000 to 5000 Satoshi range.

nemfib.png

Stellar lumens has made a complete retracement back to the 400 satoshi level.

stellarfib.png

Note: the Stellar retracement is complicated by their token giveaway strategy. The 11 billion XLM tokens in circulation only represent 10% of the fully diluted value of the project. This is in line with the project strategy to distribute the tokens as widely as possible and spur network effects.

Thus comparing the NEM J-Curve to the Stellar J-Curve becomes difficult given NEM is fully diluted while Stellar is not. 

Takeaways

Visualizing a J-Curve overlay on top of any blockchain asset can help when making macro level investing decisions. J-Curves also pair well with traditional moving average rollover and overbought/oversold technical analysis as they both track changes in the perceived value of projects by market participants.

Markets signaling "risk on" and the case for NEO

The flow of capital back into the alt token market post fork points to "risk on" behavior which is favorable for projects like NEO. 

Grossly oversimplified the blockchain market behaves into two main patterns:

  • Risk on: Market participants in a bull market look for opportunities to diversify into smaller projects with higher risk/return. This creates a levered effect for alt token returns. 
  • Risk off: Conversely in a bear market participants "flee" into Bitcoin and other large market capitalization tokens as a safe haven. While bitcoin also falls in value during bear markets, the drawdowns are less due to the inertia a higher market capitalization provides. 

For the time being the entire blockchain token market is intimately tied to Bitcoin price action, though as the market matures this will become less of an issue. Given the pro alt token backdrop presented, let's examine our largest holding NEO (formerly Antshares) from a fundamental and technical perspective.

Fundamental

NEO continues to gain traction in western markets with Bittrex accounting for 40%+ of volume in recent days. CEO Da Hongfei continues to grant more interviews in English, and updated technical documentation gives a clear direction forward. 

Key takeaways from the updated documentation

NeoX: Cross chain protocol to connect blockchains together into an "internet of blockchains". Other projects focused on this area include Ark, a Lisk offshoot delegated Proof of Stake system with cross chain support at the core of their value proposition. Potentially the largest competitor in the cross chain space is the upcoming EOS token.*

NeoQS: Quantum resistant security. This shows NEO is one of the few forward thinking blockchains concerned about the implications of quantum computers brute force attacking the mathematics that underpin transaction security. Nexus (another large AlphaBlock investment) is one of the few other tokens in the space focused on this issue.**

NeoFS: File storage on the blockchain. Not only does this potentially disrupt storage projects such as Burst, Storj, and Siacoin, but unlocks the key to true scalability. 

"In the future, the old block data can be stored in NeoFS, so that most of the full nodes can release the old data for better scalability and at the same time, ensure the integrity of historical data." 

Pruning the blockchain as it becomes excessively large is crucial to both scaling and decentralization. By storing old block records into the file system each individual node will not need to store the entire blockchain. Thus book keeping nodes will remain affordable to run as each node does not need to store the potential thousands of terabytes of data the blockchain will create at scale.

This gives the added security benefit of onchain transactions, without the downside of excessive chain bloat or need to explore offchain solutions like segwit/lightning network. As the fundamental value proposition of NEO is storing critical transaction data such as property titles and birth certificates, understanding how NEO hopes to achieve onchain scalability is key to fundamental analysis. 

Technical

NEO exhibits the strongest bullish technical indicators possible on the one day candle chart.

  • A bull cross above the cloud
  • RSI crossing 50 
  • Further moving average verification from the MACD crossing the signal & histogram switching from negative to positive.
  note NEO still traded under symbol "ANS" on Bittrex for time being. MACD/Ichimoku presented with fast SMA in red and slow SMA in blue.

note NEO still traded under symbol "ANS" on Bittrex for time being. MACD/Ichimoku presented with fast SMA in red and slow SMA in blue.

Notes

*The EOS platform does not exist yet with EOS currently offered as an I.O.U. on the Ethereum network tradeable for the real EOS tokens when the platform launches. EOS marketing literature claims millions of transactions per second in theory though it is AlphaBlock policy to not invest in ICOs before they prove network viability.

**Nexus approaches the quantum problem from a more traditional proof of work/proof of stake architecture focused on providing onchain transactions at scale through advancements in lower level database architecture, and security through 1024bit hashing and 571bit private keys. 

Takeaways from the immediate aftermath of the hard fork

As we wrote yesterday, the blockchain token market is at a crucial crossroads. The market will either break much higher, or much lower post fork.

Preliminary market action in the hours post fork point to a break towards the upside. This could easily be a temporary euphoria rather than a definitive market move. Two macro cases are still possible...

  • Bull case: Uncertainty eliminated. Similar to S&P 500 performance post US elections last year, investors react positively once a choice is definitively made. 
  • Bear case: Sell the news. Investors hyping price leading up to a major event which cannot sustain and breaks to the downside.  

Bitcoin and Bitcoin Cash combined market cap

Fork seems to have slightly inflated the overall marketcap of the two tokens. BTC falls from ~2900 USD pre fork to ~2700 USD post fork. Difficult to tell but BCC futures  are trading ~350 USD  on HitBTC (only exchange currently posting rates to coinmarketcap.com)

bcc

Alts surge

Narrative fits that investors flocked to BTC for the fork to claim "free" BCC tokens. Post fork many alts have surged 10-20%. This brings them roughly back to level before the outflow of capital into BTC immediately before the fork. 

Onchain vs offchain

The scaling debate continues now with two separate options. BCC claims onchain is closer to Satoshi's original vision, offchain promises more efficient scalability. Reddit user ydtm offers a detailed and enlightening (if not conspiratorial) rational behind onchain vs offchain growth of the bitcoin protocol. 

BCC has also not achieved full viability. It remains to be seen if the hashing difficulty settings can be lowered to allow for the new network to process transactions. 

Fintech movers and shakers moving and shaking into blockchain

A recent Bloomberg article showcases how movers and shakers in high finance are leaving high paying corporate jobs to jump into Blockchain, lured by the lack of regulation and large potential profits.

Paying close attention to the flow of institutional capital into the Blockchain token space helps make more informed investing decisions.

Takeaways for this article:

1. Beware the ICO... picking protocols vs picking companies

2. Institutional managers front running clients

3. Institutional capital is waiting on the sidelines for regulatory go ahead

This fits with the narrative that smart money is yet to enter the space in a major way. 

Mark Hart, Founder of Morgan Creek Capital Management, details 5% of professional managers have personal exposure to Bitcoin, while only .5% of the institutions they manage have exposure.

This makes sense as few funds want a legally murky asset on their books. As regulation comes to pass, a tidal wave of institutional money sits on the sidelines waiting to enter. 

Our hope is owning percentages of the fundamental protocol layers will shield us from company failures as the space develops, even if several of the protocols we invest in also fail along the way. This venture capital risk/return mindset is important when investing in such volatile assets. 

Our next article will explore the ICO market further with different types of ICOs offered, and what their valuation propositions are. 

Further Reading

Explanation of fat protocols - http://www.usv.com/blog/fat-protocols

Polychain Capital takes protocol layer approach - https://dailyfintech.com/2017/03/28/polychain-capital-a-hedge-fund-investing-at-the-protocol-layer-of-web-3-0/