From the outside digital assets may look like a volcano of hair-raising volatility chaotically bursting from the earth’s surface. But below that surface there are various sources of digital asset returns. In this article I define those sources and provide the models to assess the opportunity set. TLDR: Bitcoin remains the key source of digital asset return but, depending on your knowledge and risk appetite, there are a host of alternative return drivers that could play a role within a balanced portfolio. This approach contextualizes the space for traditional asset allocators and provides a framework for future research.
Bitcoin is the key innovation of our generation – it provides the first 3 sources of return (you can read more about these characteristics HERE). Some view bitcoin as a digital store of value alone, which causes them to underappreciate the value-add of digital payments and property rights. It is obviously difficult to determine the precise value of each component but here are three ways to think through them:
Buying and holding bitcoin is the foundation of digital asset investing. Most returns will accrue to this strategy and for many investors, this strategy is sufficient. I would characterize it as an asset allocation decision. Which is traditionally conceptual and big picture. Asset allocation still involves research and data analytics, but allocators don’t get caught in the weeds. They buy into the idea, have a rough long-term return objective, a desired portfolio weight and may or may not re-balance towards that weight as the theme plays out.
It is often said that “asset allocation is the most important driver of returns” because these big picture decisions really turn the needle. This applies to bitcoin too. Investors might diversify into other strategies but the decision to allocate to bitcoin, or not, is the most important. There is a stark difference in performance between portfolios with bitcoin, and those without. I expect this differentiation will persist.
Despite the power of the asset allocator strategy, not all investors are satisfied, and some have a different perspective on the opportunities in the ecosystem. So, what else is on offer?
A simple way to view the difference between bitcoin and the rest of the ecosystem is to view bitcoin as the primary infrastructure like plumbing and power generation, whereas the rest of the ecosystem are building features like markets, communication services and shopping centres. And at the extreme, building products like art-work and music.
Bitcoin is the best at providing the first 3 sources of return (the infrastructure), but it is not the only provider. Ethereum and a host of other blockchains aim to provide infrastructure characteristics, in addition to features. In some senses these blockchains overlap with bitcoin because, unless they leverage directly off bitcoin, each chain must be a reasonable store of value with its own security features. But in other ways, they are something completely different because of the higher order utility provided.
Feature rich, decentralized applications include decentralized exchanges, betting markets and publishing platforms. The platforms are entirely native to the internet. Relationships between participants are governed by smart contracts. Instead of a centralized exchange run by a company, a decentralized exchange is run by code. They involve lending protocols where asset holders can stake their assets to traders on the exchange and earn yield. Hence, the term decentralized finance (defi).
Tokenization has numerous different arms. Users and or developers can tokenise all sorts of assets in a blockchain including digital art, gaming rewards or online file storage. Once these tokens are minted, they are freely tradeable on secondary markets. Additionally, there is even the hope of tokenised physical assets, like property and potentially even human identity, which could allow easier transfer of information.
In a centrally planned society, the features would all be built on top of the same infrastructure. But digital assets are a decentralized ecosystem with intense innovation and competition. Many innovators choose to build their own infrastructure on separate blockchains to speed up execution.
As you can see, there is a wide range of potential applications and tokens that could be created. Some useful, some less so. You could create decentralized application for babysitting if you wanted, but that does not mean that anyone’s going to use it. Questions like “Do we need a token for this?” and “is the centralized participant such a terrible actor?” are important to ask. The point being, features are both exciting and risky because it is possible that the innovations are unnecessary. Short-term interest could merely be fueled by liquidity sloshing around in the broader ecosystem.
Investors who focus more on the tokenization and decentralized applications tend to take a slightly different approach. Rather than merely allocating to bitcoin from a high-level asset allocation perspective, they may spend resources researching new protocols, understanding the development team, appreciating the economics of the project and gauging the community support. This approach as more akin to fundamental investing in equity or bonds. The smaller the projects, the more like small cap investing it becomes where the returns are large, volatile and risky.
Bitcoin bull and bear markets centre around its halving cycle. Read more about that HERE. These cycles are an opportunity to shift one’s digital asset strategy and are another source of investment return. The simplest approach is to dial up allocation during a bull-market and dial it down during a bear-market. At the extreme, short positions during a bear market and leverage during a bull-market. The bull-bear cycles are also a major driver of capital flowing into the rest of the crypto ecosystem. This doesn’t imply there is no additional value, but we must appreciate that interest in bitcoin is a critical driver of broader exuberance, or lack thereof. Larger allocations to smaller projects makes more sense during a bitcoin bull-market than a bitcoin bear market.
Waxing and wane exposure to digital assets resembles macro investing where business cycle cyclicality is a key determinant of risk budget and sectoral exposure.
As Bitcoin ascends towards the world’s pre-eminent store of value, it becomes an institutional grade asset. It has already grown to a $1tn market cap asset class in 2021. Financial infrastructure is being built in this asset class, including lending markets, futures, options and forwards. There’s tremendous demand for these instruments by different market participants as they capitalize on volatility. In some senses, digital assets are the new free market. At one extreme, it’s the wild-wild-west like the ICO’s of 2017. But in other sense, there’s a whole new market of risk and volatility for investors to exploit.
A portion of this opportunity can be harvested in a sensible manner, without any of the regulatory risk of ICO’s. In fact, in some strategies one can remove digital asset exposure altogether.
Example A: Bitcoiners are willing to pay between 10% and 20% interest annualized for leveraged long exposure to bitcoin because they’re supremely confident about the return potential. On the other side of the trade, many are willing to provide capital for a 10% to 20% yield in USD. A large capital allocator can short bitcoin futures, hold the underlying and pick-up the yield differential at exceptionally low risk.
Example B: bitcoin trades at a premium in some markets due to large internal demand vs. supply shortages. This could be due to limited domestic mining supply or perhaps capital controls prevent arbitrage. Either way, investors can trade this arbitrage creating decent, low risk returns, without digital asset exposure.
Operators who understand the instruments, build systems, manage capital flows and execute diligently can capitalize upon these opportunities. In traditional markets, there are limited returns to operations and execution because it’s a highly competitive business where large institutions have whittled down the margins. But digital assets aren’t there yet. The early movers have earned strong and sustained returns.
Looking back to 2017 and 2018, I was naïve in thinking that the arbitrage opportunities would disappear by 2020/2021. On reflection, it’s possible that they persist for a while longer. Bitcoin’s monetization path still has a lot of runway and it will likely be quite volatile during the next +-5 years as people grapple with this revolutionary but sometimes confusing technology. Operators and arbitragers are effectively just managing the volatility for their clients and providing different services to different pools of capital. I think there is a decent argument to be made that this service will remain valuable until such time as volatility converges on traditional financial markets.
I view bitcoin as the key asset allocation decision but there are also opportunities for fundamental type research across various use-cases, macro style investing through the bull and bear markets and operator skills to capitalize on volatility & inefficiencies within these nascent markets. Returning to the volcano analogy, bitcoin has ruptured the earth’s surface. Other streams may end up creating new islands, others will go nowhere, but none are likely to compare to bitcoin’s impact. I continue to direct newbies towards bitcoin alone because there is a risk of over-diversification and potentially scams as you head further out on this spectrum. But there is certainly value in the broader decentralized world. Plus, it is useful to differentiate the various sources of investment return and draw the analogies to traditional investment styles. Institutional asset allocators can now approach digital assets in a more structured fashion, picking which opportunity sets that suit their vision.
Good luck out there.