Rebuilding the Financial System From the Ground Up

 ICE, the owner is NYSE just announced a crypto platform bringing crypto to Wall Street. Smart contracts will bring Wall Street to crypto.

ICE, the owner is NYSE just announced a crypto platform bringing crypto to Wall Street. Smart contracts will bring Wall Street to crypto.

Applications for Crypto and Blockchain technology can be divided into use cases that on one hand provide incremental improvements to existing processes and on the other hand offer completely new and groundbreaking use cases that weren’t possible before.

The former group includes implementations of private, permissioned blockchains. It also includes the potential tokenisation of existing investment products such as real estate. These have the potential to incrementially improve exchange of information, settlement times, make previous illiquid markets liquid and fractionalise all kind of assets. As an example, the stock exchange in Australia, the ASX, is implementing blockchain technology for their settlement system. Two years ago it was supposed to be implemented in 18 months. Now they are targeting a launch at the end of 2020 which will take settlement times from T+3 to T+1, an improvment, but hardly a revolution. Meanwhile, Bitcoin has provided global settlements in 10 minutes for nearly a decade.

At Apollo, we think the more interesting use cases are the groundbreaking possibilities of crypto rather than the more incremental, blockchain improvements. This includes fundamentally distrupting how ‘money’ works; the creation of native digital goods; smart contracts that can disintermediate a number of industries. Put simply, the real revolution is about digital ownership and contracts between parties without a trusted third party. This wasn’t possible before Satoshi Nakamoto put the wheels in motion almost 10 years ago.

We believe a particular low-hanging fruit for smart contract technology is financial contracts. Some of the areas being built right now include;

  • Lending and borrowing. This will first happen with cryptocurrency. Dharma provides a peer-to-peer lending market in crypto based on smart contracts. Apollo Capital just partnered with Compound to provide liquidity for the lending and borrowing of crypto assets. Compound will provide a trustless (without a trusted third party) way using smart contracts to increase the price discovery in crypto assets. Investors in Compound include the likes of Bain Capital. dYdX is another Silicon Valley firm creating price discovery through smart contracts. As an example, they are set to launch tokens that represent a short position in a particular crypto assets — we will then be able to trustlessly take a directional bet or a leverage long position by simply buying a single token.
  • The next evolution will happen once we marry smart contract technology with stablecoin technology. Some very smart people at organisations such as Circle, TrustToken, MakerDAO, Basis and Fragments are working on creating a stable cryptocurrency that is pegged to fiat currrency, a basket of fiat currencies or in the future, CPI. Once we have a reliable and trustless cryptocurrency that is stable, not only will merchant adoption for the first time be feasible but we can start doing lending, borrowing etc. pegged to our everyday currency.
  • Derivatives are well defined contracts that can be entered through smart contracts. With smart contracts, we can take derivative positions peer-to-peer without counterparty risk. Firmo is an example of a start-up creating a programming language for these type of contracts. Once Oracle technology (these provide a method for ‘real world’ data to be referenced in smart contracts) is developed, we will be able to make trustless derivatives based on any asset. Prediction markets like Augur are related to this development. Augur’s prediction market based on the Ethereum blockchain recently went live.
  • We have been writing about how all assets will eventually be tokenised. Once we have tokenised real estate, we will be able to put real estate in smart contracts which will open the market for mortgage-like products to be based on blockchain technology.
  • Oracles and smart contracts can provide the basis for insurance products that are running on a blockchain without a central company or decision maker — this is a potential Nick Szabo explored on the podcast with Tim Ferriss. One smart contract/DAO based insurance project is Nexus, they will start with insuring smart contracts. In the future we might see a wide range of insurance products being build on blockchains.

The future of finance might look radically different. The technolgy is here and the first applications are being built right now. Kevin Kelly describes in the book The Inevitable the unstoppable force of the momentum of an ongoing technological shift. Kevin explains that banning, prohibiting and trying to stop the inevitable is ususally counterproductive. We can and should regulate but change is inevitable. Crypto assets and blockchain technology is not going away, it is a force for good that can unlock tremendous value by disintermediating today’s trusted third parties. Some might say the future financial revolution is inevitable…

Henrik Andersson is the Chief Investment Officer of Apollo Capital — Australia’s Premier Crypto Fund. The Apollo Capital Fund is a professionally managed portfolio of crypto assets, offering investors exposure to the fast growing crypto market. For more information, please head to apollocap.io

7 Reasons You Should Definitely Not Invest In Crypto - From a Guy Who Co-Founded A Crypto Fund

“I hate crypto”
“What’s all this bitcom (sic) business about”
“Crypto is a scam”

I have spoken to over a thousand investors since launching  in November 2017. Despite meeting a number of savvy investors, many of whom have invested in the Fund, the overwhelming response to crypto has been one of caution and scepticism. By now, I’ve heard just about every response to why you should not invest in crypto. While some reasons for not investing in crypto are sound, others highlight common failings in investor psychology.

Let’s dive in and explore the 7 reasons why you should definitely not invest in crypto.

1. I Don’t Understand It

This is clearly the best reason not to invest in crypto.

Investors need to understand what they’re investing in, whether it be crypto, derivatives or exotic fish. A basic understanding is essential. Warren Buffett has said repeatedly, “don’t invest in something you don’t understand.”

Without an understanding, investors will not have conviction in their investments, will not be prepared for the investment journey and will likely make a poor sell decision.

There are two options for an investor that doesn’t understand an investment opportunity.

The first is to move on. If you don’t understand crypto, if it’s too complex or you simply don’t have the inclination to learn, the wise decision is to move on. Investors cannot be faulted for knowing their limitations.

Many investors don’t realise there is a second option: homework. Read, listen, watch, discuss and learn about the investment opportunity. Warren Buffett avoided investing in many of today’s most successful tech companies because he didn’t understand them. Perhaps he would have been even more successful if he made the effort to understand Internet companies? Applying this lesson to crypto, today’s investors might be more successful if they do the homework to understand crypto. For those interested in learning, our resources pageis a wonderful place to start.

2. Volatility

Crypto is volatile. Apollo Capital recently analysed the average returns of crypto Fundsand the results are fascinating. In a series of returns from June 2013 to April 2018, monthly returns varied from over -30% to over 400%. These returns are not for the faint hearted.

Investors need to know themselves. This sounds like a cliche, but it is true, especially when it comes to investing in crypto. Some investors can stomach volatility, some cannot. If the thought of the value of your crypto portfolio dropping by 20% in a given month makes you weak at the knees, crypto is not for you.

Volatility is relative to position sizing. The volatility of a given investment is relative to how much is invested. If an investor invests their life savings in crypto, the volatility would be extremely difficult to manage. The thought of losing 20% of your life savings in one month is frightening. However, a position of 2%, 5% or 10% of an investor’s portfolio in crypto might mean the volatility is less daunting.

Let’s take an example of investing 2% of a portfolio in crypto. If crypto goes down by 50%, the investor will lose 1% of their portfolio. While not desirable, most sophisticated investors can handle such a loss. Many investors don’t realise the potential upside from a 2% position. In a recent study by Apollo Capital, a 2% allocation to crypto from Jan 2016 to Apr 2018 accounted for 50% of the portfolio’s return.

It is also important for investors to distinguish between the volatility of an investment and the volatility of a portfolio. Including a volatile investment, such as crypto, in a portfolio does not necessarily increase the overall volatility of the portfolio. It all depends how that investment is correlated to the other assets in the portfolio. Crypto assets have shown not to correlate to traditional asset classes. Put simply, even though crypto is volatile, including it in a diversified portfolio doesn’t make the portfolio more volatile. Investors can have the benefit of the return potential of crypto, while keeping the volatility of their overall portfolio constant.

3. Crypto Has No Use

Here, I will go no further than to quote Marc Andreessen’s New York Times’ article “Why Bitcoin Matters”:

Critics of Bitcoin point to limited usage by ordinary consumers and merchants, but that same criticism was leveled against PCs and the Internet at the same stage. Every day, more and more consumers and merchants are buying, using and selling Bitcoin, all around the world. The overall numbers are still small, but they are growing quickly. And ease of use for all participants is rapidly increasing as Bitcoin tools and technologies are improved. Remember, it used to be technically challenging to even get on the Internet. Now it’s not.

Crypto is not perfect. Nothing at this early stage of its development is faultless. We constantly remind investors of two crucial facts. The first is crypto is a technological breakthrough. The second is many of the world’s smartest computer scientists and technologists are working in crypto. And now after the ICO boom, some of the smartest minds in tech are working on delivering on the promise of this technology.

4. Illegal Uses

One of crypto’s first popular use cases was for nefarious purposes. Silk Road was an online marketplace where users could buy and sell illegal goods, including illicit drugs and firearms. Users generally paid for goods with Bitcoin, thinking it was untraceable and anonymous. Many bad actors have moved on from Bitcoin, realising that it is in fact traceable.

The question becomes whether these cryptos are used solely for illegal activities, or whether this is just one use-case. For example, the Internet is used for illegal activities, including piracy, identity theft and terrorists communications. Should we call for a ban of the Internet because it is used for Illegal activities? Yes the Internet is used widely for illegal activities, but this is a tiny percentage of the overall use of the Internet. Applying this to crypto, what percentage of the use case of crypto needs to be for illegal activities before it is worth banning? 10%? 50%? 100%? This is a tough question and different people will have different answers.

It’s impossible to know how widely crypto is used for illegal activities. Top researchers in the space have stated that any reported figures are, at best, an estimate. There needs to be a clear distinction between something that is designed for illegal activities and something that might be used for illegal activities. If something is designed solely or primarily for illegal activities, it should be shut down. Silk Road is a clear example. However, we know there are many use cases for crypto which is not illegal and indeed, is a force for good. It appears naive to avoid investing in something or using it, simply because it can be used for illegal activities.

5. Another Bitcoin


A common response I have heard from wary investors is will Bitcoin be the Myspace to another crypto’s Facebook? It’s a good question and there are two key responses.

The first is network effect. Network effects have been called the business model of the Internet. Bitcoin has the largest network and the most number of users. At the time of writing, Bitcoin’s market cap and daily traded volume is roughly three times that of Ethereum, the second largest crypto. This is not to say that Bitcoin will be dominant for eternity. Network effects can be competed away. Myspace and Facebook is a well-known example. However, currently, Bitcoin is the dominant crypto and it will be extremely difficult for another “money-like crypto” to compete.

The second response is a portfolio approach. Investing in crypto is best done in a diversified portfolio. There is no reason why an investor cannot invest in both “Myspace” and “Facebook.” We don’t need to be exactly sure of which one will win, we don’t need to put all our eggs in one basket. With a technology this young, the best approach is to invest in a range of crypto projects which show enormous potential.

6. Crypto Has No Intrinsic Value

Another reason not to invest in crypto is because it has no intrinsic value. Crypto does not pay dividends, is not tied to cash flows, has no right to other assets.

This line of thinking requires a broader perspective. Let’s consider fiat currency. A $5 note has no intrinsic value, it’s simply a fancy piece of paper. The piece of paper is worth $5 because we all believe it’s worth $5. Some will argue that it’s backed by the government which issues the currency, but this doesn’t point to any intrinsic value. There have been plenty of cases where this backing has become worthless, like the current crisis in Venezuela.

Another example is gold. Gold has been the worldwide store of value for thousands of years, yet where is its intrinsic value? Gold is valuable because we all believe its valuable. In both cases of fiat currency and gold, neither has any intrinsic value. Yet they are valued because we are told to value them and we collectively believe in their value. We all believe they have value until we stop believing.

We could argue that this applies to any asset class — there is no such thing as intrinsic value. The value of all assets comes from the perception that other investors, often called the market, would be willing to pay for that asset. In some asset classes like equities and real estate, the models used to value the asset are well established and well known by market participants. The value of other assets, like commodities, currencies and crypto, are determined by the forces of supply and demand. Investors point to discounted cash flow models and net present values, but the only model that truly works to value an asset is working out what someone else is willing to pay for it. That’s where value comes from. In crypto, the asset class is young, scarce, not well understood, is a technological breakthrough and we believe the demand for these assets will increase in the future.

7. Wait and See

At the start of the article, I mentioned that some of the reasons for not investing in crypto are examples of failures in investor psychology. The “Wait and See” approach is the most serious of these failings. In most cases, it will only lead to worse investor outcomes.

Let’s analyse the scenarios for the Wait and See investor after crypto prices go up, go down or go sideways

  1. Crypto Prices Go Up — prices have gone up, therefore crypto is great and I’m now comfortable to invest, albeit at a higher entry point
  2. Crypto Prices Go Down — the investor gets scared, there must be something wrong with crypto, and decides not to invest
  3. Crypto Prices Go Sideways — crypto isn’t that impressive, what’s all the fuss about?

One of the biggest lessons from co-founding Apollo Capital is how I have observed countless investors, including sophisticated and professional investors, using price as a proxy for quality. At Apollo Capital, the interest we have received in investing in crypto has been directly correlated to the price of crypto. Prices goes up, everyone wants to invest. Prices go down, no one wants to. We all like to believe we are capable of going against the heard, being the contrarian investor who reaps the uncommon gains, but most of this is self-delusion. I haven’t heard one investor say “I’d like to invest, but I’d like to see prices drop to buy in cheaper.”

The approach we advise is the same as analysing any other asset class: it comes down to fundamentals. While crypto assets don’t have fundamental earnings, business plan or asset backing, the fundamentals in crypto is the technology. Investors need to understand or at least appreciate that crypto is a technological breakthrough, it is early, and that there could be huge demand for these assets in the future. Price action should have no impact on investors’ decision making.

Conclusion

Crypto is not for everyone. In the basket of alternative assets, it is an alternative asset. There are a number of sound reasons why investors should not invest in crypto. Yet, through my own personal journey in crypto, I learnt an important lesson. When I first heard of Bitcoin, I dismissed it almost instantly. It might have been fear of the unknown or because crypto is difficult to understand. It was easier for me to dismiss crypto and move on, than to keep an open mind and learn about it. Now, with the benefit of perfect hindsight, I realise I should have set aside a few hours and learnt about this fascinating new technology. It would not have cost much to invest a small percentage of my portfolio. At worst I would have lost my investment, shrugged it off and moved on. Instead, I was later than I would have liked to what is shaping up to be the biggest investment opportunity of my lifetime. I wonder whether the same applies to investors today who are yet to invest in crypto.

Tim Johnston is the Managing Director of Apollo Capital — Australia’s Premier Crypto Fund. The Apollo Capital Fund is a professionally managed portfolio of crypto assets, offering investors exposure to the fast growing crypto market. For more information, please head to apollocap.io

Should you add crypto to your investment portfolio?

Investing in crypto assets before 2017 was a very niche activity, largely limited to technologists, libertarians, and some speculative investors. This is changing, and fast.

Goldman Sachs, perhaps the most storied name in finance, has confirmed their intention to trade bitcoin. And just last week Larry Fink, the CEO of the largest asset manager in the world, BlackRock, confirmed that they have a assembled a working group to look into cryptocurrencies and blockchain technology.

Bitcoin was the first crypto asset, the first asset that enabled outright digital ownership. The Bitcoin blockchain is used to transfer value over the Internet while disintermediating financial institutions. General purpose blockchains such as Ethereum could dis-intermediate many other industries. Today, there are 1,600 crypto assets, trading 24/7. 

Here we try to understand how these assets perform when placed within a diversified portfolio of traditional assets, and not just as an independent, emerging asset-class. 

Crypto in Australian Portfolios

This article analyses a portfolio of crypto assets together with Australian stocks and bonds. 

The four hypothetical portfolios analysed here are:

   1.    60% Australian equities; 40% Australian Bonds;

   2.    59% Australian equities; 39% Australian Bonds; 2% CryptoAssets;

   3.    57.5% Australian equities; 37.5% Australian Bonds; 5% Crypto Assets;

   4.    55% Australian equities; 35% Australian Bonds; 10% Crypto Assets.

We tested these portfolios from December 31 2016 until April 31 2018  using monthly rebalancing. This period includes a sharp downturn in crypto prices.

Results

Even the portfolios with a minor allocation of crypto performed significantly better than the portfolio without exposure. 

 For this time period, there has been a direct correlation between increasing crypto exposure and outsized investment returns. 

For this time period, there has been a direct correlation between increasing crypto exposure and outsized investment returns. 

 Source: Apollo Capital

Source: Apollo Capital

The return with 0% allocation to crypto assets was 17.10%; with 10% crypto allocation, the portfolio returned 124.40%

    •      Allocating 2% crypto in the portfolio was responsible for almost 50% of investment returns; 5% translated to 72.89% of returns; with 10%, 86.22% of returns. 

    •      The Sharpe Ratio increased in line with increasing exposure of crypto assets. The Sharpe Ratio determines how much an investor is compensated per unit of risk taken on. It is calculated by determining the average return earned in excess of the risk-free rate (in this case the 10 year Australian government bond return) per unit of volatility. Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return. It’s a really useful way to analyse crypto assets because while the returns have been substantial, so has the asset class’ volatility.

We can see that for these portfolios investors have been compensated generously for any added volatility in the portfolio due to crypto assets.

Three Take-Aways

1. Non-correlation

Crypto asset class have a low correlation to other asset classes and can thus provide a diversification benefit. The below correlations were completed for the time period June 2, 2017 to June 8, 2018. 

 The correlation of crypto with other crypto assets and asset classes. Source: Apollo Capital

The correlation of crypto with other crypto assets and asset classes. Source: Apollo Capital

“Diversification is the one free lunch of investing, and when you see a free lunch, the only rational thing to do it eat” — Cliff Asness, Managing Principal and CIO at AQR Capital Management 

2. Efficient Frontier, Optimised 

An ‘efficient frontier’ of portfolios can be built, where returns are optimised per unit of risk. 

As we’ve seen, crypto assets aren’t correlated with other asset classes, and they have experienced significant capital growth. These attributes make it ideal in portfolio construction. Despite this, the vast majority of portfolios fail to include even a small amount. We believe that this omission means that current portfolios are less than ideally constructed. 

We believe that the efficient frontier shifts up if we include crypto assets in our portfolio. In other words, the risk-return profile can improve with the inclusion of crypto assets. 

3. Barbell Investing with Crypto assets

The barbell investment thesis was made famous by Nicholas Nassim Taleb, the investor and author.

The barbell theory’s prime directive is unambiguous: Stay as far from the middle as possible. Taleb invests in emerging, even speculative, investment products with very high potential upside; his other investments are the safest possible assets to invest in. 

“If you know that you are vulnerable to prediction errors, and … accept that most “risk measures” are flawed, then your strategy is to be as hyperconservative and hyperaggressive as you can be instead of being mildly aggressive or conservative.” — Nicholas Nassim Taleb

Crypto fits very comfortably into the barbell investment thesis. Crypto assets remain a small asset class that still shows very high volatility. Because crypto has the potential to reengineer large swathes of the economy, we believe an investor has high potential upside.

Screen Shot 2018-08-03 at 9.17.35 am.png

All the while, by keeping an investors position small, to between 2–10%, the downward risk is minimised while remaining sufficiently exposed. 

Conclusion

This analysis has demonstrated that including a small portion of crypto assets in a diversified, Australian portfolio of stocks and bonds has greatly benefited investors. This is not only from a capital growth perspective but also from a risk/reward perspective. 

Even when the downside is limited (2% of a diversified portfolio), the upside has been shown to be very substantial (responsible for almost 50% of total returns). As large international investors are waking up to the opportunity of crypto assets, we believe now its time to pay attention.
 

Apollo Capital is Australia’s premier crypto fund, allowing sophisticated wholesale investors to gain access to investment opportunities within the crypto asset market. This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions. Past performance not indicative of future returns.

Published: Friday, July 27, 2018

[This article was originally published in Switzer]

 

A View to a Kill(er app)

 San Fransisco, home to many crypto projects, featured in the 1985 Roger Moore classic ‘A View to a Kill’. That’s where the similarities end. 

San Fransisco, home to many crypto projects, featured in the 1985 Roger Moore classic ‘A View to a Kill’. That’s where the similarities end. 

To the Bond fans out there, I have to apologise for brutalising the title of the 1985 Roger Moore classic. The subject of this article isn’t as immediately exciting as Bond — no ski chase in Siberia here — but it is important:

What do crypto-assets actually do?

Oftentimes people say that bitcoin isn’t money because it’s volatile, and Ethereum is just a platform for digital cats.

We believe this is underplaying one of the biggest breakthroughs of our time. 

Let’s step back for a moment. To understand crypto use-cases, we need to know what it means. At Apollo Capital, we think that crypto brought in two major innovations:

  1. Digital Ownership
  2. Digital Organisation

Bitcoinwas the first digitally scarce,censorship resistant (i.e. unseizable) asset that you could ownon the internet. To make this happen, Bitcoin brought in a new form of decentralised coordination or organisational structure. It established a new way to organise people in a way that was not centrally coordinated but rather coordinated by incentives baked into the design of its protocol, namely a scarce game theoretic token called bitcoin.

Crypto is digital ownership as well as a new way to organise humans without the need of central coordination.

The possible implications of digital ownership and decentralised organisation are immense. At Apollo Capital, as we see it, there are currently three major areas in which crypto use-cases fall:

  1. Digital Assets
  2. Digital Agreements
  3. Tokenisation of Traditional Assets
Screen Shot 2018-07-12 at 11.50.03 am.png

Digital Assets

We can break down the digital assets part of crypto into three categories: Money, Personal Data, and Digital Goods. 

Money

So far, the killer app of crypto is currently the ability to create government independent money. Until recently, circulating new and government independent currencies was very difficult. This is because the money needed to be centralised, and that centralised actor widely trusted. 

Trust comes into the equation because most monetary systems are centralised for mediation purposes.

There usually needs to be a trusted party to ensure that economic value transfer between two parties is legitimate. Bitcoin enabled truely peer-to-peer economic transfer over the internet for the first time. Now there are over 1600 crypto assets. In decentralised, trustless, and permissionless crypto networks (the type Apollo Capital are interested in), the token is the money to that economy. It is that critical. 

Screen Shot 2018-07-13 at 10.18.11 am.png

 

The proliferation of distributed ledger technology, notably blockchain, has made creating, distributing, and using new money trivially simple (on the condition that others also use that same money). 

Personal Data

“Digital Slavery” is the state that artist Jennifer Lyn Moronethinks most Americans currently live in. In order to get access to free online services, she laments, people hand over intimate information to technology firms. “Personal data is much more valuable than you think,” she says. 

In March, it was revealed that Cambridge Analytica, a now defunct political consultancy, acquired data on 87 million Facebook users in underhand ways. 

The collection and exploitation of personal data is the major business model of the current internet, often called Web 2.0.

This practice is dominated by large tech firms, namely Google, Facebook, and Amazon.

Crypto and blockchain technology allows ownership in the digital arena. This extends to the currently under compensated and increasingly important economic resource of personal data. People are thinking about this: Angela Merkel, Germany’s Chancellor, recently called for a price on personal data.

The next iteration of the internet well imbed personal data ownership at the protocol layer. Fred Wilson of the the New York based Venture Capital firm wrote yesterdaythat:

Web 3 is the next generation of the web in which decentralized apps (dApps) operate on top of a shared data layer and users have control of their data and the ability to move between dApps with little to no switching costs.

In the Web 3.0 world, users will be able to be ‘sovereign’ on the internet. This means that individuals will be able to own their identity, provision it at will, and perhaps even profit from doing so. This makes sense, as the process of creating data can be thought of as a form of labourthat powers artificial intelligence, at least accordingtothe University of Chicago Law Professor, Eric Posner. Incumbents are waking up to this future:

 Seen last week on Gertrude Street, Melbourne. Facebook is trying to counter the brand damage following the Cambridge Analytica fiasco, reports of fake news, and people waking up to economic and social costs of social media.

Seen last week on Gertrude Street, Melbourne. Facebook is trying to counter the brand damage following the Cambridge Analytica fiasco, reports of fake news, and people waking up to economic and social costs of social media.

Other areas where personal data could be personally owned using crypto-assets is in the fields of medical data — a project called Shivom is making a genomic data-hub where contributors own their genomic data, control the right to access it, and receive rewards if they choose to share it. People may also be able to own and control the data they contribute to more traditional online activities such as on decentralised version LinkedIn or Twitter. 

Digital Goods

Digital Goods are unique digital objects that are enabled by blockchain technology. We are seeing glimpses of this world in games, where on Crypto Kitties and CryptoStrikersyou are able to buy digitally scarce cats and playing cards respectively. It the Web 3 decentralised application world, this could mean moving your pet cat, say, from one computer game to another, seamlessly. 

This is also the beginning of digitally native artwork. Gendry Morales, a friend of Apollo Capital, developed Crypto Cats early last year, before the launch of the more well-known Crypto Kitties. These may be looked at in future generations like hand prints in primitive caves:
 

Screen Shot 2018-07-13 at 10.18.27 am.png

Smart Contracts

A smart contractis intended to digitally facilitate, verify, and/or enforce the negotiation or performance of a contract. Smart contracts allow the performance of transactions without third parties. These transactions are trackable and irreversible. 

Smart contracts are digital agreements that are enforced without the need of a third party between people who may not know or trust each other

Financial Contracts

The inventor of smart contracts Nick Szabo once wrote that, “In a few years teenagers in Indiana will be swapping over-the-blockchain derivatives with grandmas in India without asking New York City”.

Apollo Capital has long thought of financial contracts as being low-hanging fruit for smart contract technology. 

Derivatives, like smart contracts, are agreements that are built on systems with clear rules and quantifiable terms of agreement.

dYdXis an exciting project that is about to make crypto-derivates a reality. We spoke with Zhouxun Yin from dYdx a few months ago. This project is a glimpse at the $1.2 quadrillion global derivative market entering this industry. It is also great for those who own crypto-assets as derivatives can be a way to manage risk in a portfolio, improve market efficiency, and improve price discovery.

MakerDaois another example of a financial product being developed on the smart contract platform Ethereum. MakerDao collateralises ETH (the native currency of Ethereum) in a smart contract and then draws credit in the form of their stablecoin, Dai. This is a platform that I use. Below is a screenshot of one of my CDPs (Collateralised Debt Positions):

 Drawing credit out against yourself without any financial institution in-between

Drawing credit out against yourself without any financial institution in-between

This is a classic example of the disintermediation of financial projects that this technology enables. Instead of going through a bank to collateralise, the MakerDao platform allows consumers to bypass banking institutions in a way that could spell significant consequences of the structure of the global economy. The platform currently is fairly primitive, relatively difficult to use, and you can only collateralise ETH (well, technically wrapped ETH). However, these are not insurmountable challenges. The fact remains that smart contracts enable people to draw out money from exisiting assets at an interest rate of only 0.05%. That’s a big deal.

Finally, debt markets are enabled with smart contracts. The very same Dai that I created on the MakerDao platform was then lent out on a new peer-to-peer debt marketplace called Dhama. Below is a screenshot of when I loaned on their DharmaPlex platform: 

 DharmaPlex. Now you can borrow and lend peer-to-peer

DharmaPlex. Now you can borrow and lend peer-to-peer

Capital Formation

ICOs, also known as token sales, involve the sale of newly minted crypto coins based on Ethereum or another smart contract platform. The ICO hype of recent months has led to an immense amount of capital raised.

In 2018, ICOs have so far raised a staggering $6,028,714,036, according to ICOdata.

 The most significant ICO of this quarter of EOS, which concluded on June 1, and ultimately raised over US$4 billion, or 7.12 million ETH. This ICO was conducted over a year, from June 26 2017 to June 1 2018. Basis, the ‘algorithmic central bank’ raised $133 million from Bain CapitalLightspeed Venture Partners, and others. Aside from these, there were approximately 600 other ICOs that took place in Q2 2018.

This is all possible due to the technology of smart contracts:

 Smart Contracts have enabled a new form of token-based fund-raising for startups

Smart Contracts have enabled a new form of token-based fund-raising for startups

Decentralised Autonomous Organisations, a new business model

 Smart Contracts could re-invent the firm

Smart Contracts could re-invent the firm

A DAO is a vision of a community that can function without traditional hierarchical management or centralisation. It is a form of organisation structure where its rules, agreements, and other principles could be hard-coded from the beginning and software could facilitate transactions and transfers of property between participants. The rules in a DAO are enforced digitally (usually via a smart contract).

A Decentralized Autonomous Organization is a radically new way for humans to organise their activity 

By relying on smart contracts, DAOs establish a set of rules at inception which govern agreements and relationships between participants in a network. For example, digital agreements can be set to see funds paid out at certain dates, refunds occur if certain conditions are not met, and so on. 

In some ways Bitcoin is a primitive example of a DAO. There is no “Bitcoin Corp.” that pays miners to authenticate transactions on behalf of the community; there is no central organisation that promotes or builds the bitcoin ecosystem. 

Satoshi Nakamoto created bitcoin, set it up sufficiently, then promptly and purposefully disappeared. 

Because if its hard-wired incentives, humans came and contributed without the need of central coordination. Through its code, bitcoin is thus decentralised, autonomous, and a form of human organisation. It is a DAO. Much more complex DAOs will be built at a later date. These will have their own values, governance structures, and incentive regimes. 

Traditional Assets

Tokenised Securities & Real Estate

We sometimes think of crypto-assets as a distinct asset class, separate from traditional equity, debt, and derivate markets, but what if blockchain-based tokenisation could be used in traditional markets to improve the way society records ownership and trade assets, and thus re-engineer large swathes of today’s financial plumbing. This is the grand hope of security tokenisation, which hopes to increase the settlement speed, liquidity, and increase fractional ownership. 

What security tokenisation doesis imbed the security with its compliance requirements into smart contracts so that its tokens can be traded on secondary blockchain-based exchanges anywhere in the world. 

A security token may thus be less an invention than an innovation — it could improve traditional financial products, removing middle men from transactions, reducing cost, and linking more buyers with sellers. 

The massive challenge to overcome in this field is the robust tethering of real-world assets to blockchains. Real world assets, like stocks and real estate, are regulated by the jurisdiction it happens to be in. This means the security is connected with something in addition to the smart contract created. Because of this, possession in a smart contract doesn’t necessarily mean possession in the real world. 

With real world asset tokenisation, possession in a smart contract doesn’t necessarily mean possession in the real world. This is the greatest hurdle to overcome. 

It’ll be interesting to see whether the world of crypto will be able to connect real world ownership to decentralised and global trading through smart contracts; I’m very uncertain about it, although we hope that further work will go into bolstering security, oracles, and the legal enforceability of smart contracts across jurisdictions.

Conclusion

The [Web 3] time will come. I am more sure about that than anything else right now. The last few years of Web 2 have shown us what is wrong with the current architecture of the web and what we need to do to fix it. 
— Fred Wilson

The use-cases for crypto will no doubt evolve. This is Apollo Capital’s punt at where we see things going. 

Please get in touch if you have any ideas on this subject, at james@apollocap.io

 

 

Value Creation in Crypto Assets

There two big, emerging areas of value creation in the crypto space. These are centred around what we call ‘Money-ness’and ‘Governance’.

Money-ness

We added the suffix ‘- ness’ after money to emphasise the breadth of this category. Money-ness encompass everything from a global store of value to a currency specific to a crypto-economy or use-case.

The categorisation of crypto assets is oftentimes not clearcut (actually, almost never clearcut!). Take Bitcoin as an example. It’s deflationary and limited in supply, global, and not issued by a central authority. These qualities make it look very similar to gold. On the other hand, however, bitcoin derives value from being used as a currency to pay for goods and services. This is because it is easy and cheap to transfer globally and highly divisible. Settlement in Bitcoin has occurred globally on average every 10 minutes for almost a decade; Bitcoin’s smallest unit, a Satoshi, is one hundred millionth of a single bitcoin or 0.00000001 BTC. In this sense, it acts as both a digital gold equivalent and as an M1 (or cash) equivalent. With the introduction of the Lightening Network, the dual-character of bitcoin becomes even more pronounced. 

On the other end of the money-ness spectrum you have pure utility tokens. Utility tokens are used to pay for a good or service in a particular crypto-economy, much like a laundry token is used in the physical world.

The category of money-ness is thus very broad but the defining question should always be "can this token act like money?".

Not all tokens in this the money-ness category are created equally for value accrual purposes. In our opinion, in the long run store of value forms of money-ness will accrue value while utility tokens won't. This is because of the relative velocity, or turn over, of these forms of money-ness.

An example of a utility token is Binance Coin (BNB). BNB is used to pay transaction fees on the Binance crypto exchange. The major issue with the explosion of utility tokens is that if every good or service had its own token, we would all be driven mad trying to keep up with such a variety of currencies. No one would want to hold onto hundreds of utility coins that pay for hundreds of separate goods or services. The implication from all this is that the velocity for many if these coins is likely to be very high, and therefore the value of utility tokens will be low. 

Why? Because rather than holding 100s of currencies, we are much more likely to hold just one store of value, then seamlessly swap in and out of utility tokens as we need them. Most people will not even realise that they are using distinct utility tokens as this process will be automated. In this version of the future, the velocity of utility tokens would be very high as people are not incentivised to hold the tokens for any length of time. Currently people are holding onto utility tokens for speculative reasons, but that incentive will recede when tokens begin to be used for their stated purpose. People won't need to hold onto (or 'HODL' in crypto-speak) utility tokens but will instead buy and sell them on-demand. This increases in the velocity of the token, and according to the value exchange equation, the network value tends towards zero with increased velocity:

MV=PQ

Where:

M = Money Supply
V = Velocity of Money Supply (i.e. the amount of times the money supplies turns over)
P = Price Level
Q = Index of new real expenditures

Because of this velocity problem, teams behind ICOs, developers and investors have attempted to artificially lower velocity as they all have an interest in increased network value over time. This have lead to discussions over clever ways to create ‘velocity sinks’ in order to increase the token value. However, we perceive this as not a viable way to create value.

 Don't even try creating artificial value where none exists.

Don't even try creating artificial value where none exists.

A common example of where a utility token may be needed is for a decentralised markets in the sharing economy. Mike Novogratz, founder of crypto merchant bank Galaxy Digital Management, likes to highlight the example of a decentralised model for ride-sharing. It's also a good example of why utility tokens won't accrue value.

Uber is the highest valued private tech company in the world with a market capitalisation of $69.9bn. In a Decentralised-Uber (dUber) equivalent little value would likely accrue in the dUber token itself. We can think of that difference in value between Uber and dUber being mainly due to the radical reduction in the 25%+ cut that Uber captures in fees. This fee would by definition be almost eliminated in a dUber world. As a user, the application layer would automatically trade bitcoin, for example, into dUber tokens in real time so the user never actually holds onto it for a substantial period. You may not even realise there was a token in the middle, and potentially only see you BTC balance change following the ride. 

Lastly, utility tokens may not accrue value due a lack of network effects because of, funnily enough, utility. Existent crypto assets like Bitcoin or Ethereum can often be used in place of a utility token like the Binance Coin. A concerning number of the projects that come across our desk at Apollo Capital do not need their own native token, and simply staple one of for fundraising purposes. 

 This is what institutional investors think of your payment ICO

This is what institutional investors think of your payment ICO

In summary:

  • Pure utility tokens might not capture much value at all, because the velocity will likely be high.
  • Many projects might not need their own token. The value of an artificial token used for fundraising is highly questionable.
  • On the investment side, we see value accruing in the store of value that incentivise HODLing, rather than in utility tokens that incentivise high velocity trading. 

Again, many tokens are not pure cut, and crypto-assets used to fuel smart contract platforms like Ethereum’s ETH can be in part store of value, in part currency, and in part utility for paying gas on the Ethereum platform. There are clearly different degrees of ‘Money-ness’, but these principles should help in deciphering which token will likely have long term value, and which will not.

Governance

The other big value creator in crypto is governance. We’re in a phase where projects experiment with how governance is distributed and architectured within crypto networks.

Bitcoin’s governance is distributed between different stakeholders like miners, developers, users, wallets, and exchanges. In Decred, the coin holders have a much larger say in how the network is developed through their hybrid proof-of work/stake system. Other systems like Tezos are inventing new forms of on-chain governance. The 0x project was thought of as a utility token, but is turning into more of a pure governance token. The relayers in the 0x eco-system do not actually need to use the 0x token for payments, and are using it rather to vote on governance. The team behind 0x realises that as velocity goes to infinity, the payment aspect of 0x is not actually where the value lies.

Governance in itself is valuable. If you want to control the future of the protocol you’re investing in or building an app on top of, the governance is very valuable. Do you think Apple considers it's ability to determine what apps can and cannot go on their App Store as valuable? Of course they do. And the app developers would also find it valuable if there was a way for them to contribute to the App Stores governance. At the moment, app developers on iOS have no say on the governance of the Apple app store. Open crypto networks enable community-led governance, or, in classic crypto jargon, decentralised governance.  

Crypto assets represent new methods to organise society based on merit and free markets. Governance is a critical factor in these networks. This is an excellent article about network governance by Mike Maple, Jr. 

How these values are captured are critical issues to think about for developers as well as for investors in this space. 

In our emerging decentralised world of crypto assets, Money-ness and Governance are two of the leading value creators. This is where Apollo focuses investment. 

Crypto-Assets: a Compelling Alternative Investment

Investing in crypto-assets before 2017 was a very niche activity, largely limited to technologists, libertarians, and some speculative investors. This is changing. Goldman Sachs, perhaps the most storied name in finance, has confirmed their intention to trade bitcoin. Closer to home, the ASX announced that by 2020, they will switch to a blockchain-based distributed ledger that will clear and settle the $2 trillion Australian equity market.

Crypto assets are tokens that are needed to run decentralised blockchains. Blockchains are fundamentally a new way of organising our society based on decentralisation. Instead of having big corporations, like Facebook and Google, owning our digital data, blockchain technology enables individuals to take ownership of digital goods directly. Bitcoin was the first crypto asset, the first asset that enabled outright digital ownership. The Bitcoin blockchain is used to transfer value over the internet while disintermediating financial institutions. Today, blockchains are being built not just around money, but other private data, like identity, medical records, supply chains, and much more. Blockchains also have the ability to support a new kind of decentralised application; Ethereum is an example of a blockchain enabling that. Blockchains have three core characteristics that set them apart from other digital assets: they are censorship resistant (built on open source code), trustless (we don't have to trust a third party) and their are permissionless (anyone can join these open networks).

While crypto-assets are now started being accepted by an increasing part of the investment community, the asset class remains nascent and extremely volatile. Even if the proportion of individuals and institutions with investments in crypto-assets increase, crypto is likely to remain a minority of their overall portfolio in the short to medium term. There’s therefore a pressing need to understand how these assets perform when placed within a diversified portfolio of traditional assets, and not just as an independent asset-class. This article attempts to shed light on some of these dynamics. 

Bitcoin, the oldest and most famous crypto-asset, is studied here as a proxy to the broader market. Our analysis uncovers that bitcoin is a very compelling alternative investment given its high potential for capital growth, low correlation to traditional assets (diversification benefits) and highly liquid nature.

Capital Growth & Volatility

From a capital growth perspective, bitcoin has performed extraordinarily well: US$1000 invested in bitcoin on May 3 2013 would now (May 3 2018) be worth ~US$104,000.

Bitcoin Price Chart (July 2013 - Present Day)

 Source, www.coinmarketcap.com

Source, www.coinmarketcap.com

Bitcoin’s extraordinary growth trajectory, however, has not been linear. Relative to other assets such as stocks, bonds or commodities, bitcoin’s standard deviation of returns (‘volatility’) has been materially higher. The following graph shows the 30-day rolling daily volatility for bitcoin compared to other assets on an annualised basis:

 Source: Apollo Capital

Source: Apollo Capital

Crypto’s extreme volatility is driven by numerous factors. Crypto remains relatively unregulated and speculative. It has also been driven by retail investors. A retail investment market, with little institutional or regulatory input, is likely to be more volatile than one where institutional money has a stake. We are now seeing institutional money enter the market, and with it more market confidence and certainty. Regulatory bodies around the world are rapidly adjusting to the crypto paradigm. For example, the USA’s SEC recently deemed that Ethereum is not a security, and in February Switzerland’s Financial Regulator, FINMA, released their ICO guidelines. 

The emergent crypto-asset valuation techniques are also a likely cause for volatility. A widely accepted behavioural finance paper by Barker and Wurgler (2006) argues that market-wide sentiment should exert stronger impacts on stocks that are difficult to value. The broader issue here is that crypto-assets are digital and new, meaning their fundamental value is harder to comprehend. We may expect a decrease in volatility as crypto markets mature, and investors gain deeper knowledge and conviction about valuation techniques.

Correlation with Traditional Assets & Diversification Benefits
Alternative investments are frequently used for diversification and hedging reasons. The below table is a summary of bitcoin’s correlations with more traditional assets, namely the S&P 500, Global Equities, and US Bonds. Gold is also included as a comparative alternative investment. The data is based on weekly returns from July 2016 to September 2017. Both gold and bitcoin experienced low correlations to other assets during this period (see table below). Bitcoin correlated even less than gold to most asset classes, especially when compared to US Bonds. 

 Source: Apollo Capital 

Source: Apollo Capital 

How do these metrics, namely capital growth, volatility, and non-correlation, play out when placed in diversified portfolio of traditional assets? According to the below analysis, including crypto in a portfolio could result in diversification benefits for the investor. 

The below graph illustrates a global diversified portfolio with 60% global equities and 40% US bonds compared with a portfolio with 59% global equities and 39% US bonds and 2% Bitcoin, with both portfolios rebalancing weekly. The data was based on weekly returns from July 2016 to September 2017.

 Source: Apollo Capital

Source: Apollo Capital

We’ve seen that Bitcoin is independently highly volatile, but interestingly when added to a this diversified portfolio it actually decreased overall volatility, while increasing overall returns. This was due to the non-correlative nature of the asset and its high historical capital growth. 

Liquidity of Bitcoin

Alternative investments typically demonstrate lower liquidity when compared to more traditional assets such as stocks or bonds. For example, it is more difficult to find a buyer for a $100,000 bottle of wine than, say, the equivalent amount in Apple stock. This is not true of crypto-assets. In fact, crypto-assets are traded on exchanges that are accessible anywhere in the world (with an internet connection and/or a VPN) and are open 24/7. Today’s (June 25 2018) 24 hour volume of bitcoin was more than US$4.5 billion; over the same period, volume for the crypto-asset market was almost US$17 billion. There are certainly threats to bitcoin and crypto-asset liquidly, such as exchange closure, hostile regulation, and acceptance, but these do not seem to be affecting the markets currently. 

Crypto as an asset class

Bitcoin is only one of over 1500 crypto-assets, each of which have different characteristics and uses. For simplicity, we have limited analysis to bitcoin. However, it is critical to think of crypto as more than bitcoin: the applications of these assets go far beyond the vertical of money. The universe of crypto is expanding and the diversity of assets will require further studies into their performance as part of a diversified portfolio. The dynamics of non-correlation and diversification have been shown exist when the alternative investment is extended to a diversified portfolio of crypto-assets. Academics David Lee, Li Guo, and Yu Wang writing in the Journal of Alternative Investments in 2018, concluded that concluded that

‘…cryptocurrencies can be a good option to help diversify portfolio risks because the correlations between cryptocurrencies and traditional assets are consistently low and the average daily return of most cryptocurrencies is higher than that of traditional investments’.

Apollo Capital believes firmly that a diversified and actively managed portfolio of high potential crypto assets is the best way to achieve diversification and non-correlative results over the long run. We will soon publish another piece on this subject with recent data. 

Conclusion  

Crypto-assets present a compelling alternative investment opportunity, but it is clearly not the faint hearted. Bitcoin’s extreme high volatility may indicate that placing all one’s wealth in it may be foolish. However, including an amount in a diversified portfolio of traditional assets has been shown to increase returns and lower overall volatility, while the alternative investment remains very liquid. Time will tell if these relationships hold. But with institutional money about to enter the space, and mass market psychology close to a nadir, this might be the moment to take a closer look. 

Apollo Capital is Australia’s Premier Crypto-Asset Fund. We professionally manage a diversified portfolio of crypto assets, offering investors exposure to the fast growing crypto market.