“That’s Our Two Satoshis” — Identifying “Pure Play” Investments

Jeff Dorman, CFA
Mar 28, 2022

What Happened This Week in the Digital Assets Markets?

Week-over-Week Price Changes (as of Sunday, 3/27/22)
Week-over-Week Crypto Price Changes (as of Sunday, 32722)
Source: TradingView, CNBC, Bloomberg, Messari
 
 
Are Digital Assets Recession-Proof?

Digital assets gapped higher last week, following the lead of equities—both of which have put up back-to-back winning weeks. This acceleration is polarizing investors, who are now trying to ascertain whether this is just a classic dead cat bounce or the start of a more sustainable uptrend. So let’s peel back the onion a bit. 

Financial assets have been battling three major themes so far this year:

  1. Rising rates – It has been an absolute blood bath for bonds thus far as we’ve entered the worst drawdown on record, with no end in sight as markets are now forecasting as many as 9 hikes this year alone. 
  2. Geopolitical Tensions – The Russo-Ukrainian war, subsequent reactions from oil’s rise, trade sanctions, and projecting China’s next move have markets on edge.
  3. A Looming Recession – Caused mainly by #1 and #2, the recent flattening of the U.S. yield curve has led economists to increase the probability of a recession; Goldman Sachs predicts a -20% selloff in U.S. equities as a result of a slowdown in earnings and a compression in price/earning multiples.
Both digital asset and equity markets have begun to look past #1, as rising rates have historically led to positive outcomes for risk assets. The market is increasingly looking past #2—there have been recent signs of de-escalation, and eventually, this war will end. That leaves us with #3; are we heading towards an inevitable recession? If so, what will be the impact on digital assets?

Let’s assume a recession is certain, and we’re staring down the barrel of years of stagflation (high inflation and low growth) and rising rates—a situation in which few asset classes would be safe. In this scenario, the different value drivers of equity, debt, and digital assets may begin to manifest. All three asset classes arguably comprise the new "capital structure," but each creates value differently. As we’ve argued numerous times in the past—most recently during a fascinating interview with Raoul Pal of Real Vision—we can break down the capital structure as follows: 

  • Debt = Claim on assets
  • Equity = Assets minus liabilities or a claim on excess profits/cash flows 
  • Digital Assets = Claim on network growth and brand loyalty

Given this backdrop, it’s possible digital assets are the only asset class that a recession wouldn’t negatively impact. Tokens allow companies to turn intangible assets like their brands, customer loyalty, and networks into tangible assets. Companies and projects in the digital asset world pre-fund themselves via the sale of tokens, thereby creating a service liability in how the token is ultimately redeemed in the future. The token can unlock usage of the product, can be used for discounts on services rendered, or in some cases, can even gain economically via direct claims on future revenue. This process is similar to companies that sell gift cards, which tend to speed up revenue recognition (booked upfront), but create a liability for the company in terms of future services/products delivered. Notably, these future services don’t disappear during a recession and, as such, technically do not lose value.

In an inflationary bust environment, inflation wreaks havoc on costs, but demand decreases, lowering revenues and profits. Ultimately, equity value gets destroyed. Similarly, asset coverage decreases and interest expense rises, destroying debt value and recovery values. But none of these recessionary factors really affect customer loyalty or future service claims. Further, most companies with debt and equity rely on physical customers, physical locations, and supply chains (except certain e-commerce companies). 

Conversely, most digital asset companies and projects don’t have physical stores, customers, or supply chains. They are the epitome of a truly digital world. From digital asset trading exchanges to video games and the metaverse to decentralized finance and web 3.0, the shift from physical to digital is happening, and it is largely immune to rising rates, decreased earnings, and lower GDP. Further, while debt and equity valuations are hampered by lower terminal values when interest rates rise, digital assets act more like a perpetual annuity. Therefore, valuations are not heavily impacted when doing a discounted cash-flow model. 

The prices of digital assets may, of course, still go lower. After all, risk is risk. But fundamentally, digital assets are not actually losing value, whereas the value of stocks and bonds most definitely will. Equity value declines as profits decline. Debt value declines as asset value declines. Fiat currency devalues due to a loss of confidence and inflation. While some may argue that digital assets never had value to begin with, it is hard to make an argument that their value decreases due to recessionary factors. In fact, it may be the only asset whose true value remains unchanged or even grows.

Therefore, it’s unsurprising that we continue to see more TradFi participants entering the digital assets arena. For example, just this past week, we saw:

  • Cowen Inc, a +100-year-old investment bank, will be offering spot trading capabilities to institutional clients.
  • Goldman Sachs launched a new website design that features the words ‘cryptocurrencies’ and ‘metaverse’ on the front page. The company also executed its first OTC Bitcoin derivatives trade.
  • Blackrock, the world's largest asset manager, is exploring how to serve clients with digital currencies.
  • Bridgewater is preparing to back its first digital assets fund.

Overall, investing becomes more difficult when investors focus on “return of capital” over “return on capital.” But a "sell everything and move to cash" approach isn't practical—shorts/cash get tired/anxious, and money has to flow somewhere. Fixed income is largely uninvestable right now, and so is half of Europe/South America/Asia due to geopolitical tensions and restrictions. S,o where do we expect money to flow? 

  1. U.S. equities/U.S. real estate
  2. Digital assets 
Finding “Pure Play” Thematic Investments in Digital Assets

The easiest part of investing is finding a good idea. The hardest part of investing is finding the best pure play way to express that idea. 

For example, Paul Tudor Jones’s now 2-year old Bitcoin thesis wasn’t a Bitcoin thesis at all; it was an inflation thesis. His fund expressed this inflation theme in four ways—two failed miserably (long gold, long 2s/30s steepener), and two succeeded (long Bitcoin, long Nasdaq 100). 

As the digital assets market matures, more and more investing themes emerge. One could argue that there have been four real successful applications of blockchain technology to date:

  1. Bitcoin “Store of Value” – Whether you believe in Bitcoin’s utility or not, it has undeniably grown as a brand for hard money
  2. Stablecoins – From non-existent to almost $200B in AUM in just over two years
  3. Decentralized Finance (DeFi) – If the entire DeFi market were a single bank, it would be the 19th largest in the U.S. That’s pretty incredible given the speed at which it was accomplished.
  4. NFTs/Gaming – Perhaps these need to be separated into two categories, but the growth of NFTs, led by gaming and art/collectibles, is nothing short of extraordinary. 

If you predicted all of these investment themes, congratulations! But it was just as important to determine the best way to invest in the success of these themes. Many Bitcoin copycats failed. Many stablecoin projects died. Most DeFi projects never got off the ground. Most NFT collections and marketplaces are in the rear-view mirror of the clear market leaders. Even so, there were a lot of winners with unicorn status.

“Pure play” investing allows you to simplify a view down to a single investment that takes other factors out of the equation. Let’s look at a few of today’s investable themes and a few examples of “pure play” ways to express those themes. 

  1. Sound Money – Example: BTC
    This is as easy as it gets. It's a simple narrative, and if you believe that Bitcoin will one day be a global store of value and potentially even a medium of exchange, it's an ownable asset (though difficult to value other than via relative value).
  2. DeFi – Example: SUSHI
    One of the best pure play ways to bet on the continued rise in DEX trading, lending, and token offerings. Basically, it's an on-chain prime brokerage (a one-stop-shop) for all DeFi transactions (and also incredibly cheap, though not without hair on the execution story).
  3. Stablecoins – Example: LUNA
    Stablecoins rose from $0 to $180B in AUM in the past two years, and algorithmic stablecoins have gained market share at the expense of centralized (USDT/USDC) and debt-based (DAI). As UST continues to rise, LUNA rises. LUNA remains a pure play on the growth of stablecoins.
  4. NFTs – Example: IMX
    There are plenty of pure plays in the NFT space (OpenSea equity, LOOKS, even the new APE token), but IMX is a Layer 2 Validium/ZK-rollup built on Ethereum that facilitates a fast and gas fee-free NFT market. It’s an easy, simple, pure play thesis on the growth of NFTs that avoids being locked in to a single platform’s success.
  5. Cross-Chain Interoperability – Example: ATOM
    Because IBC is a consistent standard, any IBC-enabled blockchain can connect with any other IBC-enabled blockchain. Cosmos can win in a multi-chain future, which appears increasingly likely to happen. Simple, pure play x-chain growth theme.
  6. Digitization of Fan Experience – Example: CHZ
    The internet connects fans to their favorite players, athletes, and celebrities; blockchain connects them financially. In this space, Chiliz has developed a massive lead, with over $350 million in market value of fan tokens. CHZ has become a simple, pure play way to express growth in fan connections.
  7. Blockchain Gaming – Example: RON
    Ronin is the first and only heavily used Layer 2, and it can be viewed as an NFT platform, a DEX, a Layer 1/Layer 2, and a gaming token. Due to its ties to Sky Mavis and its goals to be utilized by all future gaming platforms, RON becomes a pure play way to express the growth in blockchain games (YGG would be another).
  8. Decentralized Storage – Example: AR
    The leader in permanent storage, Arweave, is now servicing all Layer 1s. So combined with the 1000+ dApps building on it, its potential market is likely the same size, if not bigger than all L1s combined. Arweave becomes a pure play on the growth in storage needs.

This is not meant to be an exhaustive list—many other tokens fit in these categories. Some will be winner-take-all, others will benefit from the rising tide that lifts all boats. And I certainly left off some investable themes—either because I don’t agree with them (privacy tokens) or because I haven’t thought of them yet (TBD). But in today’s market, simplistic "pure-play" thematic investing will likely help investors hone in on a specific outcome. 

 

What We’re Reading This Week
 
And That’s Our Two Satoshis! 
Thanks for reading everyone!   
Questions or comments, just let us know.  
 
The Arca Portfolio Management Team
Jeff Dorman, CFA - Chief Investment Officer
Katie Talati - Director of Research
Hassan Bassiri, CFA - Portfolio Manager 
Sasha Fleyshman - Portfolio Manager
Alex Woodard - Research Analyst
Nick Hotz, CFA - Research Analyst
Bodhi Pinker- Research Analyst 
Wes Hansen - Director of Trading & Operations
Mike Geraci - Trader
Kyle Doane - Defi Trader
David Nage - Principal, Venture Investing
Michael Dershewitz - Principal, Venture Investing
Michal Benedykcinski - Research Analyst
Andrew Masotti - Trading Operations
Topher Macpherson - Trading Operations
  
To learn more or talk to us about investing in digital assets and cryptocurrency
call us now at (424) 289-8068.
 

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