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.
Fulcrum Points for the Adoption of Digital Assets
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).