Updated May, 2018
The goal of our thesis is to provide investors with a generalized framework to use when evaluating potential distributed ledger token investments. The thesis is meant as a basic introductory framework, which is being greatly expounded upon in our upcoming book.
Released in the depths of the global financial crisis, bitcoin quietly created a paradigm shift in how value can be created, transmitted, and stored.
At the time few realized this was the first time in human history two peers anywhere on earth could enter into a transaction to exchange value without the need for a trusted third party to provide settlement services.
Less than ten years later, we are on the cusp of an entire new internet running on a backbone of peer to peer distributed ledger accounting systems. The graphic to the right illustrates that payments and currency systems are just one small fraction of the total use cases that can be powered by a distributed ledger settlement layer.
Distributed ledgers pave the way for automation of the entire middleman value chain as pattern recognizing artificial intelligence programs will eventually be able to communicate and settle transactions across a web of interconnected distributed ledger protocols.
With this macro narrative in mind, the rest of our thesis will describe how we select projects to include in our diversified basket of platform level distributed ledger technologies.
Introduction to removing the middleman
There is a paradox that blockchains are simultaneously the most and least secure form of ownership ever devised.
As blockchains remove trusted third party middlemen from the transactions process, each user becomes fully responsible for protecting their own investments (or must delegate this responsibility to a new generation of middlemen such as Coinbase, Kraken, Bitfinex, etc).
Existing assets such as cash in bank accounts, stocks, bonds, and real estate work off centralized ledgers where your ownership is entrusted to a centralized custodian. In the centralized world, custodians can reverse transactions in the event of a unauthorized withdrawal.
However, with this power they can also freeze access, steal from you, or be victims of theft themselves as proven time and time again with data breaches like the Target hacks, Equifax hacks, Playstation hacks, etc.
Public and Private Keys
In the blockchain world, middlemen are replaced with two large strings of letters and numbers.
One is the "public key" which functions just like a bank account & routing number.
The second is the "private key" which gives the possessor complete access to (and control of) any amount of value on that address.
In this new system the private key is the key to your "physical bullion" vault. Stretching this analogy further, if you were walking around with a gold coin in your pocket two things could happen:
You could lose it.
Someone could steal it.
There are security best practices that can eliminate this risk, but these techniques require learning a new set of skills unique to blockchain token investing..
To prevent data loss have the private key physically written down in several dispersed locations. Potentially with your own cipher on top of the private key for further protection.
Solutions such as "multi-signature" addresses are available that require multiple private keys to unlock funds. This allows for trusted third parties to optionally be entrusted with part of the access to the account. As an example a 2 of 3 multisignature account can be created that requires 2 out of 3 signers to provide their private keys for a transaction to be sent.
Preventing theft is still problematic as all theft revolves around the attacker gaining access to your private key(s). There is a concept called "air gapping" where public key/private key pairs are generated on clean offline machines that are never connected to the internet. These air gapped machines generate the key pair then are wiped or discarded leaving only the keys behind.
Path to larger adoption
For the blockchain space to evolve into a multi-trillion dollar market, new companies specialized in private key security will need to evolve for two main reasons.
Many consumers will still want the safety and security of outsourcing private key risk to a trusted intermediary. The promise of blockchain meets cold hard reality when thinking about issues like insurance and transaction reversals.
Institutional capital such as pensions, sovereign wealth funds, and private equity legally cannot enter the space unless a third party custodian manages their keys. If fund managers have access to the private keys they would in effect be "self dealing" which is illegal for sanctioned wealth management offices to do.
We predict vehicles such as exchange traded funds will continue to gain traction along with services like Coinbase that manage private key risk for consumers with an easy to use interface.
Biometrics could also offer a solution to this problem by encoding the private key inside of unique fingerprint, facial vein, or even DNA data so the end user would never see an exposed copy of the raw private key. This could pave the way to make verification as easy as looking into your cell phone camera for everyday transactions, or providing a cheek swab for more substantive transactions such as transferring a real estate title.
In the interim, the early stage investing paradigm has been flipped as institutions are limited in their ability to gain exposure to this new asset class, as many of the highest potential projects in the space lack the custodial solutions needed for institutions to hold them.
For the first time savvy retail investors and family offices have an advantage in establishing positions before projects gain wider acceptance and adoption (if they are willing to stomach considerable risks)
Risk premium for early adoption
Returns are greatest before a developing new technology has been "derisked".
Looking the current cryptocurrency landscape (pictured above) compared to the S-Curve of adoption (pictured left) shows the distributed ledger space is still very much in the innovators phase in terms of adoption.
This means many of the most promising projects are still very hard to find and acquire, which creates a significant risk premium/knowledge premium.
DLT investors must not only be willing to risk suffering massive drawdowns, but also must be willing to learn how wallet software and trading platforms work to gain exposure to the space, as formalized products like ETFs and Futures do not exist yet in any meaningful way.
Unique risks to the distributed ledger space further driving risk premium to early adopters are:
Regulatory Risks: Any publicly accountable entity could potentially be barred from investing in blockchain tokens if laws are passed that prevent their use.
Illiquid markets with small order books. Many investments simply cannot be liquidated quickly in the event of a panic as the order books are not large enough to accommodate large sell orders.
Bitcoin as a reserve currency. The value of all blockchain tokens is for the time being tied to the value of bitcoin which sways the value of all other projects positively or negatively.
Exchange Risks: Trusted third parties that convert fiat currencies into blockchain tokens are a source of risk as you lose control of your private keys when funds are sent to an exchange. Tokens on less reputable exchanges are subject to price manipulation, selling tokens the exchange may not even have, or simply shutting down and stealing all of the tokens on the exchange. For this reason we recommend keeping funds on exchanges for as little time as possible and securing your own keys rather than trusting an exchange. This runs contrary to the above "path to larger adoption" as it is a duality that ease of use and security are often opposed.
Knowledge Risks: When investors unfamiliar with a new asset class do not have enough information to make informed investing decisions. This risk can be mitigated by applying a rigorous valuation framework to guide investing decisions.
"Fee-less" network Risks: While we feel a unified public global ledger of provable transactions has immense value, distributed ledgers do not necessarily need to be broadcast globally on a public internet. Private ledgers using DLT can run inside of existing banking, supply chain, etc. systems without needing any external validation. We feel the ultimate security of data will rely on global public ledger(s) to store hashes of private ledger data. (This concept itself is difficult to understand so we recommend reading the book to learn more)
Project specific risks
The first step in evaluating any potential blockchain token investment is to look for obvious red flags. This process will help cull 90%+ of projects from further investigation.
Premining: This is where a large percentage of the tokens are mined by insiders before the coin is offered for general release. Two subtle variants of premining exist:
Instamining where the early difficulty of mining a coin is low allowing insiders and early adopters an outsized advantage in accumulating coins.
Intentional mining bugs. Inserting slowdowns into the mining algorithms can give inside miners an advantage over others running crippled mining code. (Eg. the original Cryptonote protocol)
Dilution: Both mineable and non-mineable currencies are at risk for inflating the currency supply. Non-mineable currencies can be particularly problematic if a central authority can create new coins at any time outside of predefined programmatic rules.
ICO exits: With no vesting period safeguards in place, core team members with large ownership positions can immediately divest after launch if smart contracts preventing this behavior are not in place.
Sidepricing: Tokens are sold off exchange at a lower than market rate to friends and family.
Derivative coin: These coins offer no unique developments beyond existing bitcoin or other alternative coin source code. This is a gray area as some coins such as Litecoin do provide value with minor enhancements to the core bitcoin protocol.
Pump and dump: This is the process of artificially inflating the demand for a coin. This can hurt the future value of projects as investors are less likely to return to a project after losing money. Larger market capitalization coins are less susceptible to this risk, though front running order books and other practices long ago made illegal in traditional markets run rampant in the distributed ledger space.
App token: This is a token commonly called an ICO or "intial coin offering" that exists on top of a platform level project that functions as an individual business raising equity online. While there is nothing explicitly wrong with this new way of raising equity, these projects need to be evaluated on the fundamental merits of their business plans and ability for their team to execute, rather than our focus which is on the fundamental protocols these app tokens exist on top of..
Our platform approach is has a different set of risks, as app tokens are free to migrate to newer and better platforms that offer higher throughput at lower cost. more winner take all
Thus our fund is exclusively focused on platform level projects as we feel these base level protocol layers will eventually form the monetized backbone of a new "tokenized" internet of value.
In effect our fund wants to have small percent ownership in many platform level projects that the next Facebook, Uber, or NASDAQ will be built on top of, rather than investing in individual companies.
An analogy can be made to owning a small percentage of the TCP/IP network routing protocol a company like Facebook resides on. Except in the blockchain world every interaction has a micro cost associated which each "post" "like" or "comment" that can be shared between peers rather than absorbed by a centralized intermediary.
Occasionally new protocol levels projects such as EOS or Tezos emerge which fund their development through the ICO process.
These however are usually offered through ownership tokens on another platform such as Ethereum while the project is being created, thus we will not invest until the actual platform is released and meets our core criteria.
Our framework has five main pillars we use to evaluate protocol Level projects:
Ensuring secure transactions is of paramount importance to the longevity of any protocol level project. As a blockchain functions to replace trusted third party intermediaries with a trusted network, all users of the network must believe the protocol will work. This belief must come from the mathematics and logic that governs the network, rather than any individual(s) working on the network.
Specific security features we look for include multisig support, use of functional programming languages, innovations inside the core protocol to minimize forking risk, deter Sybil attacks, protect users from private key interception through screen capture and keylogging methods, as well as on chain scalability solutions rather than relying on more centralized off chain solutions such as lightning network.
Smart and secure are two intimately intertwined concepts. We look for protocols that support turing complete programming languages, however only as an application layer that exists on top of a core non-turing complete transaction layer. This introduces the concept of the blockchain "stack" or the notion that to be truly robust, systems must separate the lower level transaction layer from a higher level application layer.
While we want the blockchain layer to store an immutable distributed ledger of transaction data across the network, the applications or "smart contracts" that write to this protocol layer must be isolated to make the attack surface as small as possible. The ultimate value of a protocol level token project is that users believe the blockchain is resilient and can be trusted with critical data such as the afore mentioned birth certificates, stock exchange data, or even criminal databases.
Networks must be able perform thousands of transactions per second to handle network loads at significant scale. Visa processes on average 3,000 transactions per second which will serve as the benchmark for currency level scalability. Exchange level scalability for applications like FOREX exchange can require in the millions of transactions per second.
We feel scalability follows the disruptive innovation framework (pictured) as usage starts with low performance needs then quickly ramps to meet mid range needs (payment processing) then finally high performance needs (trading systems and internet of things)
If two given technologies offer the same security and scalability the network that uses less energy per transaction will win. Our fund is skewed towards tokens that do not use proof of work hashing to validate transactions which are inherently more power hungry.
The relationship between efficiently and scalability can be summed up in how many watts of electricity it takes to validate a single transaction. The inherent nature of "proof of work" systems like Bitcoin require massive amounts of electricity to verify transactions through a process where machines compete to find a winning block that validates the transaction. Effectively millions of computers around the world race every ten minutes to find a random string of letters and numbers that will send transactions into the block chain. Currently they receive a 12.5 Bitcoin reward for winning the block, making the process of mining very lucrative if miners have access to inexpensive enough electricity.
Alternative consensus mechanisms function in a fundamentally different way by using network models to verify transactions without requiring a brute force lottery system to work. Instead, alternative mechanisms randomly elect owners of the protocol tokens to validate the transactions. To make this process provably secure, ingenious new solutions must be found drawing from game theory and other branches of mathematics to ensure malicious actors on the network cannot co-opt the ledger.
This is the fundamental value proposition for investors as owners of the protocol tokens receive fee income as "miners".
Thus tokens that offer interest payments for supporting the network will incentivize participants to stay active users in the network. This is where psychology and investor structures meet the underlying protocol. Each project issues different numbers of tokens at different stages of the project. This process needs to be transparent so all parties understand how new tokens are created.
There are three main strategies projects use to create tokens which can used in any combination to calculate the inflation rate of a token project. Typically projects opt for a decreasing rate of new token creation to incentivize early adoption.
Emissions curve: Proof of work tokens become more computationally difficult to solve over time. As this happens the inflation rate decreases as a function of the mathematics becoming more difficult.
Bulk release: At the beginning of non work based projects, some or all tokens may be issued at once. It is crucial to understand how this initial batch of tokens is divided between development fund, founders, and investors. Development funds and founder shares if issued properly can enhance the value of the project as there is a sustainable funding mechanism to support continued development.
Staking & fees: This system rewards holders with additional tokens for supporting the network without the need to mine. Understanding how network fees and new tokens are created and distributed is crucial to understand the dynamics of the network.
Now that we have defined the 5 key areas we look for in platform level projects, we need to layer on a final investment checklist to guide our portfolio allocation strategy.
As technical and data driven as the blockchain space is, we paradoxically rely MORE on qualitative analysis. The mantra "execution is everything" holds especially true in such a difficult and competitive space. We look for founders who have the grit to stick through good times and bad to realize their vision. Digging deeper, competitive projects must excel in the following areas:
Innovation: At the core of any value creation machine is a good idea. In the cryptocurrency world, this process can be highly technical though the value proposition should be explainable in 25 words or less. "
Team strength: An idea is only as good as the execution and perseverance of the developers and other professionals willing to stick with the founders long term. Great projects need an equally great project management to effectively scale the team.
Partnership strength: Connections to existing industries show a path forward for how the new systems will integrate with the old. Even the most amazing new technology will die on the vine without a path forward to real world usage which involves effectively working with existing gatekeepers.
As trite as the hand waving language taken from venture capital seems, these intangibles provide significant insight into the longer term prospects of each project. Simply put, when the last developer quits the project becomes a defacto zombie, unless a new team is willing to come in and revive it.
A variety of metrics can be used to calculate growth and development rates for each potential investment using more existing methodologies from venture capital and corporate finance.
Developer growth: Analyzing Github commits, developer slack channels, and CVs of new members joining the project shows the project is gaining crucial traction with the development community.
Community growth: Follow Metcalfe’s law (the value of the network is the square of the active users). Plot user growth and engagement over time. Analyze Bitcointalk forum, slack channel, Reddit, news articles, etc.
Blockchain analysis: Use the blockchain explorer to calculate the velocity of money through the system. Dump rich lists to understand distribution on the network and calculate Gini coefficients, active wallets vs total wallets, transaction growth over time.
Market analysis: Look at number and size of exchanges hosting the coin. Where paywalls exist on the buyside and sell side. Basic charting strategies such as positive simple moving averages, Fibonacci retracements, etc.
Wallet testing: Download wallet and verify the technology functions as advertised. Transfer funds between wallets. Test network confirmation speed, ease of use, backups, and other key features. Similar to “eat your own dogfood” when vetting new startups.
Code review: Where resources allow a partial to full audit of the open source code to verify there are no elements of the core protocol that could jeopardize the project. (Eg. an event similar to the Ethereum DAO)
The ultimate goal of a protocol based investment portfolio is to generate fee income from the new natively monetized internet. Each automated supply chain transaction, insurance policy, birth certificate, or security transacted on the network generates a micro fee when verified onto a public ledger.
Instead of relying on middlemen for trust, distributed ledgers now fill this role reducing "brokerage" fees from potentially hundreds of basis points, to tiny fractions of a penny per batch of transactions. As the owners of these new digital toll ways, each time a vehicle passes through the system, protocol token holders justifiably receive a small compensation for supporting the network. As supplies of the (winning) protocol tokens are limited, an increase in usage of the network thus increases the demand to own a portion of the protocol to receive fee income.
Distributed ledgers offer the first automated trust engine in history that allows for middlemen inducing friction in our economic system to trend towards zero, leaving only owners of protocol tokens as recipients of middleman income. Your investment in a distributed ledger protocol is thus a small insurance policy towards a future where these new systems are widely adopted.
We have no idea which protocol(s) will win, but we do have heuristics about what winning projects look like, and know a diversified basket of holdings offers the best chance of capturing the immense upside this technology offers.
Blockchain token projects behave similar to any risky startup venture in that 9 will fail all so 1 black swan can hopefully return the fund.
To prepare for such asymmetric returns no one project should have outsized weighting in the fund. Funds should also be frequently rebalanced to maintain an optimal weighting.
Please read the disclaimer before scrolling down to view our approximate portfolio. ALSO MAKE SURE YOU HAVE YOUR PRIVATE KEYS BACKED UP AND ARE USING A CLEAN COMPUTER BEFORE TRANSFERRING ANY FUNDS OFF EXCHANGES
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