At Passport Capital we continue to observe a divergence between LocalBitcoins volume in Developed and Emerging Markets. Volume in Developed Markets is tracking price (speculation) while volume Emerging Markets has stabilized and is growing despite price (utility).
Author: Will Peets, CIO of Passport Digital Holdings, @WillPeets
Last year was an exciting year for the broader digital asset space, with several noteworthy milestones reached. Despite the volatility in the market, we continue to see strong forward indicators with respect to the development of the technology and the surrounding ecosystem. Awareness of the asset class is growing. Our macro thesis can be summarized by the following:
Markets are poor discounters of long-term secular trends, in particular when there is no historical precedent
Blockchain is a transformational technology, which will manifest across large swaths of the global economy. It will create big winners and losers, with ramifications for both new and existing businesses across multiple verticals.
Worldwide developer activity is shifting rapidly towards blockchain technology, a meaningful leading indicator for innovation and technology adoption. We are in the very early innings of a platform shift, but it will come quickly, accelerated by the internet and open source technologies.
Demographic and social trends driven by millennials’ relationship with technology, growing distrust of the banking system, a increased concern about privacy and usage of personal data, and the influence of Gen Z who were “born digital” are a tailwind to adoption
Institutional interest will bring large incremental capital to the cryptocurrency market
While there was consolidation in the market in 2018, our macro view on the importance and trajectory of the asset class remains unchanged.
Distributed ledger technology, digital currencies, and blockchain based peer-to-peer protocols represent early stage technology. This holds true even for Bitcoin, which despite being in existence for 10+ years is just now starting to see innovation that empowers utilization by the masses. While this may be an obvious statement - I think it’s important that we remind ourselves of this as it appears the market may have overlooked this. Liquidity, real-time market pricing, exchangeability, etc.are attributes that are normally reserved for mature assets: stocks, debt of mature companies, etc. The transfer of value peer-to-peer (e.g., money, data, compute) is at the heart of digital currencies and distributed ledger technology; thus, liquidity is a “native” attribute. As a result, the market (and market participants) may have felt that the technology is further along than it really was. Seasoned venture capitalist Fed Wilson captured this well in a recent blog post where he states, “the bubble came early because blockchain technology enabled liquidity earlier in its life cycle”.
The speed of price discovery in the digital asset space is a positive attribute that distinguishes digital assets from traditional early stage investments which are generally illiquid. In the case of digital assets, the liquidity of the asset class and the notion of “liquid venture” was alluring: venture returns in a sub 1yr horizon with immediate liquidity! In reality, price was a reflection of animal spirits and the speculative value the technology, with valuations far exceeding the current state of the technology. This was exacerbated by the fact that market participation was disproportionately retail, with under representation from institutional investors (FundStrat estimates <4%). Last year, this mismatch was partially reconciled, with a large consolidation in price of Bitcoin down -72.9%, and the HOLD 10 index down -79.2% and total market cap as estimated by Bitwise 100 index down -81.9%. Taking this at face value, it may indicate that:
Market valuations got ahead of the technology (adoption/utilization)
While liquidity is a native attribute, it still takes time to develop networks and build companies
Bitcoin is still in the lead in terms of utilization, adoption, network effects (judging by BTC dominance)
For those close to the technology and the ecosystem, this consolidation was required and is a net positive. While there are still several projects that remain overpriced, price behavior and valuations are now becoming a little more rational. An anecdotal observation that reflects this is the lack of price response to headlines. Instead the market is waiting for actual follow through by the company, protocol, regulator, etc.. Furthermore, just as price was a bad indicator of current utility/adoption of the technology during the run up in 2017 (low), the year over year change in price in 2018 is, in my opinion, a bad leading indicator of the long term utility of the technology. There are some strong analogs between the dotcom era and the digital asset space. There is a tremendous amount of hype around blockchain and several ideas that are being discussed now that are simply too early relative to the stage of the technology similar to how Pets.com was too early relative to the state of the internet in 2000 and last mile delivery capabilities. There were many Pets.com equivalents in the digital asset space in 2017 and will likely be poor long term investments. Pets.com however was not an indicator that the internet did not/would not have value it was simply too early. Our expectation remains that the development of this technology will be faster than the market expects. A cheeky comment of one investment manager holds true: “the internet would have been developed faster had we had the internet”.
I’m often asked what I think the catalyst will be for the market to move higher. My view is that this is going to be a slower build based on actual adoption and, proven use cases. There are catalysts that could spark a large price move, specifically around regulation and the activation of new trading venues and consumer/institutional on-ramps that will enable large groups of new incremental buyers but we are focusing our attention on a mosaic of data points that could create a potential floor in the price of BTC and future development in the ecosystem.
Despite the volatile market and the overall downturn in price, there are several milestones achieved in 2018 that bode well for the future of the asset class. Many of these milestones are related to the “fulcrum points of adoption” that we discussed in a previous blog post. These include:
Custody: Coinbase Custody is now live, Anchor Labs came out of stealth at the beginning of 2019, and Fidelity Digital Asset Services confirmed their Q1 entrance into the market
Exchanges: We’re seeing the development of more regulated trading venues, who are adopting technology or directly backed by traditional exchanges (ICE/Nasdaq)
Security Token Exchanges: There were several security token exchanges that came to market and started to list security tokens (STOs). This includes Open Finance, Sharespost, Templum, and TZero among others. Tzero is noteworthy given was among the top 10 ICOs in 2018 (by capital raised) and launched with limited functionality this January. It also owns patents that detail the interoperability of traditional exchanges and security token exchanges which provides a glimpse into the direction of the market. This article does a good job discussing the activity here.
Bakkt, while delayed by the CFTC continues to move forward and is anticipated to launch in Q1 with ICE expected to spend $25M on the platform this quarter
Platforms like Tagomi and OTCXN aim to facilitate rapid order execution while simultaneously reducing the risk of holding assets in hot wallets
Marcos Veremis of Cambridge Associates, an investment management and advisory firm with an institutional client base published a piece that provides an overview of the digital asset space, highlighting that it’s “developing not faltering” and encouraging institutions to start exploring it.
Several endowments and pension funds including Yale, Virginia's police and state employee funds, University of Michigan, to name a few.
J.P. Morgan announced plans to launch JPM Coin, a “cryptocurrency” that will be used to improve settlement efficiencies, at first focused on international settlements by major corporations, helping speed up transactions that currently take a day or longer using SWIFT. While it’s questionable to call this a cryptocurrency, given its initial use is limited to an internal ledger - this is a noteworthy pivot for a firm whose chairman previously called Bitcoin a fraud casting doubt on the technology.
We also saw the launch of some projects that we believe will help bridge the gap between “interesting tech” and real adoption - one of which is Figure/Provenance. Figure is a consumer finance company, focused on home equity loan and purchase-lease back agreements. They are originating loans “on chain” and cultivating the Provenance network which could bring a lot of traditional market participants to the table. Independent of its future success, this is an important milestone as it relates to gaining institutional mindshare.
Despite the drop in volumes on many crypto exchanges which took place in tandem with the drop in price, trading volumes for institutional products on the CME continued to grow in absolute terms but also as a proportion to volume on dedicated crypto exchanges. Daily volume for BTC futures made a new record February 19th with 18,388 bitcoin contracts, which is equal to 91,690 BTC or $360M
This migration to regulated, institutional products reflects market maturation. Furthermore, there are several other regulated institutional exchanges which have come or are expected to come to market in 2019 (Eris X, Seed CX, Bakkt, etc.)
The internal index we compile that aims to track BTC held in “institutional products” continues to make new highs, currently around 287k BTC (just north of $1B dollars and 2% of available circulating supply)
While there are still several blind spots in the regulatory landscape, we’re seeing a lot of legislation being proposed at both the state and federal level as well as in the international arena.
One state of particular interest is Wyoming which has passed and/or introduced several bills which would define three categories of digital assets and treat them as property, grant assets designated as virtual currencies the same legal status as money, create a new bank charter scheme that would allow banks to hold digital assets in custody, allow corporations to issue certificate tokens that represent shares, and create a regulatory fintech sandbox aimed at further diminishing any regulatory hurdles to industry startups
We’re seeing proposed legislation and rulings in several other states
Pennsylvania - rules that crypto exchanges and ATMs are not money transmitters
New Hampshire and Ohio are allowing the state to receive payments in Bitcoin
Florida - a case brought in Florida resulted in Bitcoin being defined as “money” for the relevant Florida statutes.
While all of these examples are not groundbreaking, they’re indicative of the groundswell of legislative activity that will eventually provide greater clarity
ICO Market Normalization/Consolidation
This chart provides a great illustration of the peak to trough ICO issuance:
The dramatic rise and fall of the initial coin offering (ICO) market is the result of several factors:
Regulatory scrutiny/clarity on ICOs and the subsequent change in deal structures (equity, tokens + equity, etc.)
Improved understanding of crypto economic models and the “need” for a native token. The need for a native token is a high bar and largely limited to public permissionless blockchains.
Recognition that it takes time and effort to build a network
Increased venture capital participation, and the demand for more governance and investor/project alignment. According to data provided by Pitchbook, in just the first three quarters of 2018, blockchain and crypto companies raised nearly $3.9B through traditional VC - 280% more when compared to last year (see chart)
While we’ve seen some definite cooling in the ICO market, the structure remains an innovative way for raising capital and is maturing with the development of the STO market and platforms for conducting legal ICOs via reg. CF (crowdfunding)
Consumer Adoption Greenshoots
While still early, we’re seeing some developments that will make it easier for consumers to interact and use this technology. A few examples include:
Native crypto wallet in the next gen Samsung S10
Built-in crypto wallets to internet browsers (OPERA)
User friendly/utility rich applications like ABRA
Facebook’s creation of a team dedicated to evaluating the incorporation of blockchain technology into their platform, as evidenced by their acquisition of Chainspace and reports that they are already in talks with exchanges for listing their coin and plan to have a working product out in the first half of 2019.
Square Cash App, which now has more downloads than venmo, has enabled the purchase of Bitcoin and has hinted at integration of lightning network/payments
Lightning network growth in terms of channels and network capacity is growing exponentially
Bitcoin maintains dominant lead
At the time of writing, Bitcoin is just shy of 60% of the total network market capitalization
This is important for several reasons
There has been a lot of innovation in the space over the last couple of years, which was a primary driver of many “alt-coins” which looked to innovate on and address limitations of the bitcoin protocol
This was supported by the market via the ICO craze which helped to fund many of these projects
Many of these same use cases are now being re-envisioned as applications built on top of Bitcoin in the form of applications or layer two solutions
The network effects and the inherent security of the network given the large capital investment that has gone into dedicated mining chips (ASICs) remains a large and important differentiator
We envision a world where there are less ICOs and competing protocols and more, traditional VC backed companies that will build on top of Bitcoin
While Bitcoin and the companies it will support have a strong lead, we’re seeing a lot of innovation within open finance (also referred to as decentralized finance or “De-Fi”)
This consists of several projects (largely based on Ethereum) that enable peer-to-peer, permissionless lending/borrowing
Active loans outstanding on these platforms rose form $6M as of Dec 31st, 2017 to $72M as of December 31, 2018, an increase of 1,200%
The total loans originated in 2018, as compiled by Blockboard
It is too soon to tell if this momentum will continue, it’s certainly worth watching
While 2018 was a volatile year, paying attention to just the price would be to overlook all of the progress that took place in the industry. The founder of Passport Capital, John Burbank, has famously said “price is a liar”, a comment that price simply reflects the current equilibrium of buyers and sellers and does a poor job of discounting future events - especially those without historical precedent. While it remains early days, there are many encouraging trends spanning technological development, regulation, institutional awareness, and consumer adoption.
Author: Will Peets, CIO of Passport Digital Holdings, @WillPeets
Despite Bitcoin being introduced >10 years ago, we are still in the very early innings of the development and adoption of digital currencies (perhaps the first half of the first inning). We expect the technology to develop, evolve, and be adopted more quickly than is perceived by the broader market. While we expect this to happen quickly, we acknowledge and have identified key fulcrum points in the broader adoption and development of digital assets which play a significant role in our investment thesis. These include:
Infrastructure (custody, trading, etc.)
Legislation & Regulatory Clarity
Refinement of crypto economic models (design, governance, valuation, etc.) and reconciliation of those models and existing business and ownership models
Obfuscation of cryptocurrencies in consumer applications
Mainstream media has, unfortunately but understandably, been focused on the price, value, and volatility of bitcoin and the larger digital asset ecosystem.
The objective of the next few posts is to address fulcrum point #1 (education/understanding): provide an overview of the digital asset landscape, simplify certain of the more technical concepts, and lay out a broad investment case for investing in the digital asset ecosystem. This draws upon the work of several groups and individuals as cited throughout and will be periodically updated as our investment view and the underlying technology evolves. We also expect to publish more detailed pieces that focus on specific topics introduced at only a high level here.
Where did it come from?
Before presenting the investment case for the asset class, it’s important to demystify the technology and core concepts that underpin digital assets and crypto economic systems - the most important of which is the blockchain construct. The main point is that blockchain technology, similar to the internet, is the product of research and innovation progressed by individuals, academia and the private sector over several decades. For a more in depth review - click here.
With blockchain technology now well established having been invented ~10yrs ago and battle tested with the release and the success of the Bitcoin protocol, it has set the stage for an incredible amount of innovation - innovations on blockchain design, contemplation of different use cases, which have the ability to create a step function change for many industries.
What does it provide?
At the most primitive level, blockchain technology enables trustless distributed systems and removes the need of a trusted third party or intermediary. Blockchains and their associated cryptocurrencies have the potential to enable several applications such as the transfer of value and the “internet of money”, trustless execution of code/programs and “smart contracts”, trustless sharing of information and storage of data, digital scarcity that can underpin art and collectibles, a shared immutable database that can act as a “store of state” of public records, and other innovations - many of which have not likely not yet been identified.
Trusted third parties and intermediaries add both a cost and a security risk to existing systems. As stated by Nick Szabo, “trusted third parties are security holes”. Blockchain technology has the ability to remove the need for trusted third parties at the protocol layer (removes the need for an intermediary by design) and thus has the potential to remove a lot of cost and friction in existing systems.
For purpose of discussion, I”ll define nomenclature in the context of Bitcoin but this is generally applicable to the digital asset ecosystem.
Protocols & Currencies: The word protocol refers to a set of rules. Software enables a set of rules (defined in the code of the software). The Bitcoin (capital B) protocol is software that defines the rules of the Bitcoin network. Given that blockchain protocols like Bitcoin are peer to peer networks, protocols define the rules of the “network” (i.e. how information is propagated across the network, how peers/participants interact, etc.). This is analogous to TCP/IP, HTTPS, FTP, and other protocols that dictate the operating rules of the internet. The unit of account on the Bitcoin network is bitcoin (lower case b), it’s native “currency”. It’s important to note that a protocol doesn’t need to have a native token (like HTTPS). A native token however is the incentive mechanism for peers to provide a scarce resource to the network (compute resources in the case of Bitcoin).
Permissionless (Pubic) vs. Permissioned (Private) network: The Bitcoin network is a permissionless, public network. This means anyone can participate in the network - the only requirements are that you need to run a copy of the Bitcoin software (which is open sourced and publically available). A permissioned network, as the name implies, requires that the network administrator (often a company or foundation) allow you to participate.
Distributed Ledger: A distributed ledger is a ledger that is maintained, replicated, shared and synchronized across all parties (nodes) participating in the network (vs. being maintained by a single entity). While it is costly (redundant) to store data this way, the redundancy is a security feature of the network
Tokenization: This is a digital representation of an item, often times a security, on a blockchain. Other items such as digital goods (“skins” in a video game, in-game items, etc.) are prime examples of “assets” fit for tokenization. Tokenization generally comes in two forms: fungible and non-fungible tokens (NFTs). Security tokens can be thought of as a digital representation of a stock - scarcity is important but one share is interchangeable with another. Non-fungible tokens on the other hand could represent digital goods, in-game items, art, etc. - where each token is a representation of something that is truly unique.
Utility Token: This is a term that was coined by the industry to describe the native token (often used interchangeably with currency) that are required to access/use or otherwise participate in the network. As an aside, the industry has framed this as an alternative to a security. From the vantage point of the SEC, there are securities and non-securities and it’s becoming increasingly clear that most ICOs are or will be deemed to be securities.
Base Protocol vs. Application Layer/Application Tokens: Bitcoin is what is considered a base protocol. It is the most primitive layer of the network from which everything is built. Some protocols (Ethereum being the most prominent current example) enable computations and programs to be run on top of the protocol (often referred to as DApps ~ decentralized apps which refer to the underlying platform is itself a distributed system). If the base protocol is analogous to TCP/IP and HTTPS then an application layer token is similar to a FB.com. Unique to the digital asset ecosystem, many of these decentralized applications have a native token which enables access to use the application (this however is an area that is quickly evolving).
Next week’s post will focus on the potential use cases and adoption progression of the asset class. Please check back to this page frequently or follow us on twitter.
Paraphrased from wikipedia with common terminology added: A blockchain can be thought of as an open, distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way. Blockchains maintain a list of records (transactions), called blocks, which are linked using cryptography, and by design are resistant to the modification of the data. Blockchains are typically managed by a peer to peer network collectively adhering to a protocol (set of rules), for inter-node communication (nodes are peers/computers on the network) and validating new blocks (new groups of transactions). New blocks (groups of transactions) are committed to the ledger by specific nodes called miners. Miners contribute a scarce resource (computational power) to the network in order to solve a complex math problems, a process which lends security to the network. Once recorded, the data in any given block cannot be altered retroactively without alteration of all subsequent blocks, which requires consensus of the network majority (majority of nodes) or a tremendous amount of computational power (51% attack). Though blockchain records are not unalterable, blockchains may be considered secure by design and exemplify a distributed computing system with high Byzantine fault tolerance (defendability of distributed compute system to failure/malicious behavior of some nodes). Blockchains therefore claim decentralized consensus.
While the bitcoin white paper, published under the pseudonym Satoshi Nakamoto provides the first specification of blockchain as we know it today, it is noteworthy that it is based on a myriad of research and concepts that date back over 25yrs prior to the Bitcoin whitepaper. The core concepts that blockchain combines include:
Public/Private key encryption & digital signatures
Distributed network consensus
Peer-to-peer distributed systems
It combines these methodologies in a way to solve the “double spend” problem of predecessor systems. The double spend protection is provided by a decentralized P2P protocol for tracking transfers of coins (all network participants have a copy of the ledger and observe that rules are being obeyed). Solving the double spend problem enables digital scarcity. Bitcoin has better trustworthiness because it is protected by computation - a scarce resource that network participants are incentivized to contribute because they are rewarded with the native currency. Bitcoins are "mined" using the Hashcash proof-of-work function by individual miners and verified by the decentralized nodes in the P2P bitcoin network. Here is an abridged list of research and individuals who contributed to concepts underpinning the Bitcoin protocol:
1979 - (Merkle) - Hash trees/Merkle trees
1982 - (Lamport, Shostak, Pease) - Malicious,fault tolerant consensus described in the “Byzantine Generals Problem”
1983 - (David Shaum) - DigiCash, an electronic money corporation, and founder of Blind Signature Technology and additional advancements in public/private key encryption.
1992 - (Cynthia Dwork and Moni Naor) - early research serving as the foundation for proof of work - “Pricing via Processing or Combatting Junk Mail” - “the main idea is to require a user to compute a moderately hard, but not intractable, function in order to gain access to the resource, thus preventing frivolous use”. Expanded on by Adam Back
1985 (Miller,Koblitz) - Elliptic Curve Cryptography
1998 - (Nick Szabo) - Bit Gold - uses proof-of-work and mining to create new BitGold.
1998 - (Wei Dai) - B-Money - protocol outlines aspects of which Bitcoin is based. The concept of proof-of-work, the broadcast and signing of transactions, the decentralized ledger, and the incentivization of currency creators through the mining process.
2001 - (Bram Cohen) - Bit Torrent - Bitcoin shares the peer to peer nature of Bit Torrent and similar to Bit Torrent’s file distribution structure, Bitcoin’s ledger is spread out across many sources (all the full nodes).
2002 - (Adam Back) - “HashCash” used a cost function as an anti-DOS mechanism as it required malicious parties to use the processing power of their devices as a proof-of-work.
2004 - Hal Finney - Reusable Proofs of Work
With blockchain technology now well established having been invented ~10 years ago and battle tested with the release and the success of the Bitcoin protocol, it has set the stage for an incredible amount of innovation - innovations on blockchain design, contemplation of different use cases, which have the ability to create a step function change for many industries.
Author: Will Peets, CIO of Passport Digital Holdings, @WillPeets
At Passport Capital, a singular mantra has guided many of our most significant investment themes: invest in that which has never happened before. We combine a top-down and bottom-up approach to investing. From a top-down perspective, we are macro thematic investors, searching for and anticipating multi-year secular trends through a global lens. Once we identify a theme, we take a bottom-up approach to identifying and acquiring the requisite skill set to best express our investment view. This orientation helps us anticipate and uncover unique opportunities and navigate the ever-changing investment landscape.
As a firm, we’ve invested in themes that have had spectacular growth as well as bet against those sectors or markets that have systemic problems or are being disrupted as the result of change. In the early 00`s, we invested in commodities that underpinned the development of industrial China and later pivoted our view and invested in the Chinese Internet sector, which flourished as China transitioned from an industrial economy to a consumer-centric economy. We anticipated the financial crisis of the 2008 and bet against the subprime market – which we perceived to be a byproduct of excessive risk-taking, greed, misalignment of incentives and opacity. Post-financial crisis, we focused on those industries and regions where there was a large and growing concentration of high quality human capital which focused our attention on the technology sector. While Passport has a long history of investing in technology, our recent focus has been on the deflationary impact of technology. Over the past 10 years, the impact of this secular trend has been most apparent in the consumer sector with large innovation and deflationary pressure coming from the likes of Amazon and Google and the development of the sharing economy.
We believe the advent of distributed ledger technology and the adoption of cryptocurrencies will continue this deflationary trend/impact of technology. This emerging asset class will have application and sector specific use cases that will not only be disruptive at the micro level but have far-reaching implications for the broader macro landscape. It will have large implications for developed and emerging markets alike. We are in the early days of understanding the opportunity set unlocked by these technologies, but some potential applications we foresee include:
Eliminate financial intermediaries
Democratize capital markets
Enable the sharing economy
Decentralize the internet
Align companies with their customers
To better contextualize and analyze the opportunity set, we will discuss the asset class in terms of three cohorts that serve to delineate both the use cases and the potential sequence of adoption:
Currency Tokens - digitize existing currencies or creation of new ones
Utility Tokens - enable new economic models and incentive structures (distributed storage and distributed compute)
Representative Tokens - tokenize existing assets (security tokens and non-fungible tokens)
We will make the case that while the development and evolution of “potential use cases” have evolved in the above order (currencies > utility tokens > representative tokens), adoption is likely to occur in the reverse order (representative tokens > utility tokens > currencies). While there is a case to be made for digital assets as a hedge to larger macro risks, the immediate investment case is as a hedge to the many companies and business models that may be disrupted in the next one to three years and that are currently held in a typical investor portfolio. We see the most immediate impact in the financial sector. Distributed ledger technology has the potential to greatly improve the efficiency of capital markets enabling access, transparency, liquidity, and fungibility of assets and data. It can also serve as the base layer for future innovation and development of new financial products and services.
In short, we believe digital assets will have a profound impact on global markets, both directly and indirectly, and fit squarely into Passport Capital’s long held investment philosophy— markets tend to do a poor job discounting change—especially changes that have no historical precedent. We expect the disruption brought to bear by this technology to happen much faster than the market expects. In the context of a traditional portfolio, we believe the narrative will quickly shift from one focused on the risks of allocating to this asset class to the risks associated with not being allocated to this asset class.
We will be posting a deeper dive into various portions of this asset class over the coming weeks and months. Topics we will cover include: the “Fulcrum Points for the Adoption of Digital Assets” which we believe are the important changes and improvements the asset class needs to allow large institutions to make meaningful commitments; the case for the asset class within an institutional portfolio; and a discussion on ways to invest in the asset class as well as the associated “pros & cons” of various approaches. Additionally, we will post occasional case studies on sub-sectors and themes driving changes in the industry. Please check back to this page frequently or follow us on twitter.