Our Thoughts on Libra

Last week we saw the biggest announcement in crypto since the Bitcoin Whitepaper. We are clearly not trying to downplay the enormity of this announcement - it is huge. A consortium of companies, led by Facebook, introduced the world to Libra - a cryptocurrency backed by a reserve of fiat currencies and government bonds.

As your trusted source on everything crypto, we have cut through the noise to distill the possible implications of the Libra announcement. While the project is not without concerns, we think it will be an enormous boost for crypto assets.

Let’s start with some of the positives.

Exposure

Slowly but surely, more and more people are coming into crypto. We regularly monitor metrics like transaction count and unique addresses, where increasing numbers suggest more people are using crypto assets. With Libra, this is set to accelerate, rapidly. The Libra Association includes companies like Uber, Stripe, Booking.com, Visa, Spotify and of course Facebook. The number of users connected to these members has been estimated at over 4 billion. In comparison, the number of blockchain wallets worldwide has been estimated at 35 million. Libra will serve as an on-ramp to crypto assets. Users might start with Libra and as they become familiar with wallets and crypto transactions, migrate to other crypto assets. We are not suggesting that every Facebook user will use Libra or migrate to other crypto assets, but when you compare 4 billion to 35 million, there only needs to be a tiny conversion rate to make a colossal impact.

Ambition

The Libra Association has enormous ambition. In practical terms, the goal is to send money as simply as we send a message - instantly and borderless. This will allow users to easily send, receive and store money - a “simple global currency and financial infrastructure that empowers billions of people.” The Whitepaper cites ambition to help the 1.7 billion people in the world that are still unbanked. Financial exclusion breeds poverty, which breeds civil unrest and in extreme cases, terrorism and war. Libra believes that “global, open, instant, and low-cost movement of money will create immense economic opportunity and more commerce across the world.”

How is Libra better placed to achieve this than existing crypto assets, including Bitcoin?

There are a few reasons why Bitcoin has been slow to be adopted as a Medium of Exchange. First, it is volatile. Second, user adoption has been slow - it is hard to use Bitcoin if your friends and network do not use Bitcoin. Lastly, there is a lack of infrastructure that allows users to pay with and merchants to accept crypto payments. Merchants need additional infrastructure to receive Bitcoin payments and to convert receipts into fiat currency. While there are a number of companies trying to solve this problem, they are all middlemen charging middleman rates, up to 3% either to the customer or the merchant. Why pay with crypto if the fees are higher than existing options like Mastercard or Visa?

The members of the Libra Association can attract the adoption necessary to build the infrastructure. It is a problem of economies of scale. The Libra Association is raising funds to tackle this infrastructure problem and in our view, will be much more likely to succeed than any existing crypto asset or middleman.

Credibility

JP Morgan, Fidelity, Yale, Harvard, New York Stock Exchange, Goldman Sachs and now Facebook, Uber, Mastercard, Visa and Vodafone. These are just some of the names that are now actively involved in crypto assets. The addition of the Libra Association founding members adds more credibility to crypto. This is having a direct effect on investors We are seeing this first hand as we talk to potential investors that take comfort from their involvement.

If you still think crypto is nothing more than magical internet money, it’s time to wake up.

User Experience

The user experience associated with many crypto assets is still poor. Facebook, Uber and eBay all know a thing or two about user experience. They also know that user experience can be the difference in creating and distributing a successful product. Libra will be seamless, beautiful, easy to use. Our grandparents will be able to use, send, store and receive crypto assets as easily as they can receive a text message.

Collaboration with Regulators

The Libra Association is actively talking with regulators. As regulators develop a better understanding of crypto assets, we see this as a step forward in the push for widespread crypto regulation.


___

While there are a number of positives about Libra, there are a few concerns.

Privacy

Facebook and privacy. Two words that by themselves evoke mixed responses. When put together, the response is uniformly negative. Facebook has a terrible track record when it comes to privacy. Facebook already has control of vast amounts of our personal data, allowing it to provide a wonderful service to marketers around the world. It is unclear whether it is using Libra to go after our financial data. The cynicists argue that Libra is an attempt to capture our financial data and use this data to Facebook’s advantage. By combining our personal and financial data, Facebook will make even more money from marketers looking to target their advertising. The optimists focus on Facebook’s global inclusionary mission, described above. The Libra Whitepaper is short on detail. It proclaims it will “evaluate new techniques that enhance privacy in the blockchain while considering concerns of practicality, scalability, and regulatory impact.” We retain a healthy skepticism and put the burden of proof on Libra to convince us that transactions and financial data will remain private.

Centralisation

Libra is centralised, not decentralised. Decentralisation is a fundamental property of valuable crypto assets. The most valuable crypto assets are decentralised. While it is an improvement over fiat currency that Libra is not centralised in one actor’s hands, it is not the same as being truly decentralised. Libra will start as a permissioned blockchain and start transferring to a permissionless, decentralised blockchain within five years. We won’t hold our breath.

When there’s someone in charge, an interested party – a policymaker, a banker, a regulator, a shareholder – can lean on them to make changes.

Michael J Casey, CoinDesk

Reserve

Libra will be backed by a reserve of fiat currencies and short-term treasury bonds. “The assets behind Libra are the major difference between it and many existing cryptocurrencies that lack such intrinsic value.” While we see it as an improvement that Libra is not backed by one fiat currency, rather a basket, let’s not pretend they have intrinsic value. A major reason for the introduction and development of crypto assets was in retaliation to the devaluing of fiat currencies globally, which still persists today. An appreciation for crypto assets often starts by realising that fiat currencies do not have any intrinsic value. The claim that the Libra has intrinsic value is nothing more than marketing spiel.

Marketing Speak

In addition to the intrinsic value claim mentioned above, there is clearly a degree of marketing freedom within the Libra Whitepaper. Another example is the promise of pseudonymous transactions and anti-money laundering compliance. These are intrinsically opposed. The Libra Association is trying to appease regulators who require AML compliance and crypto purists who value privacy. The presence of marketing speak, like these examples, makes us question the veracity of other claims in the paper.

The Lord of the Coins

Will this be the “One Coin to Rule them All?”

A potential negative is Libra could squash a wide range of other crypto assets. Will Bitcoin lose its appeal as users take a preference to Libra?

We have previously discussed how we divide crypto assets into key verticals - money, privacy, smart contracts, decentralised finance, Web 3.0. It is impossible to optimise crypto, including Libra, across all of these verticals.

Libra poses the greatest threat to the money vertical, specifically as a Medium of Exchange and stablecoins. We do not think Bitcoin will be challenged as “digital gold,” a decentralised, censorship resistant, deflationary, store of value. We do think the Medium of Exchange crypto assets (eg: Litecoin, Bitcoin SV) will be challenged. We think users will prefer Libra over alternatives as it is likely to be accepted more widely and easier to use. Libra will also challenge stablecoins. Tether, USDC, Pax Coin, Gemini, DAI all stand to be tested as Libra enters the market as an alternative stablecoin.

__

From a humble whitepaper released to a small mailing list in 2008, to one of the largest technology companies in the world releasing its own version, it is clear crypto assets have come a long way in the last ten years.

We at Apollo Capital are very excited to see the developments over the next ten years.


Volatility, Opportunity & Position Sizing

Our edge at Apollo Capital is our experience in both traditional financial markets and crypto markets. On a daily basis, Henrik and I draw upon our experience from traditional markets to construct a portfolio of crypto assets. Combined with our knowledge of crypto assets, we are the best in the country, if not further afield, at managing a crypto portfolio.

While I don’t pretend to know as much about crypto or financial markets as Henrik, my experience* is different and has undoubtedly shaped the way I approach crypto funds management.  I thought it timely to share a few thoughts on investing in crypto, in particular volatility, opportunity & position sizing.

(*for more information on my background, please feel free to visit my LinkedIn page.)

1. Volatility

A number of traditional financial ratios and models use volatility as a measure of risk. Modern Portfolio Theory (MPT), developed by Harry Markowitz in 1952, is used to optimise portfolios based on their expected returns and observed risk. The standard deviation of an asset’s returns is used as standardised measure of risk. MPT, CAPM, Sharpe Ratio, Sortino Ratios, nearly every ratio I have come across uses volatility as a unit of risk.

The general theory is that the more volatile the asset, the higher the standard deviation of returns, the riskier the asset. The words volatile and risky have almost become interchangeable in financial markets.

If we put crypto through these models, I suspect the models would spontaneously combust. Crypto is extremely volatile. I usually check crypto prices a couple of times a day and it is common to see 24hr price swings of greater than 10%. Imagine if that were the case in equity markets! Throughout the 16 months since inception, the Apollo Capital Fund has already delivered monthly returns ranging from +45% to -34%.

In Berkshire Hathaway's 2007 annual meeting, Warren Buffett said the following about volatility and risk:

“It's nice, it's mathematical, and wrong. Volatility is not risk. Those who have written about risk don't know how to measure risk. Past volatility does not measure risk. When farm prices crashed, [farm price] volatility went up, but a farm priced at $600 per acre that was formerly $2,000 per acre isn't riskier because it's more volatile.”

Instead, Buffett prefers the dictionary definition of risk: “risk is the possibility of loss or injury.”

Why is crypto risky?

It is clear that investing in crypto is risky: there is a possibility of loss (hopefully not injury!) and that possibility exists because crypto is young and the future is uncertain. Any groundbreaking technology is going to be met by opposing camps of skepticism and fervour. Crypto is a complex topic and it’s future is anything but clear. It is easy to forget, but many people thought the same about internet stocks in the mid 90s - they were risky investments.

Why is crypto volatile?

Crypto is volatile for two reasons: it is risky and prices are retail driven.

Crypto prices are predominantly retail driven. Retail investors are more easily caught up in the waves of greed and fear that drive financial markets, especially crypto markets. While the equities that represented the internet hysteria were certainly volatile, they were not as retail driven as crypto markets. Crypto assets are more accessible to the world’s population than equities on listed stock exchanges and equity markets are largely driven by institutional capital.

The distinction between risk and volatility is important:

“Crypto is not risky because it is volatile. Crypto is volatile because it is risky”

Once we accept this important distinction, the solution to deal with the risk is clear: position sizing.

Position sizing refers to allocation of capital to a particular investment in the context of the overall portfolio. For us as managers of the Fund, we discuss the size of positions such as Bitcoin and Ethereum. Do we invest 10%, 20% or 40% of the portfolio in Bitcoin? For the individual investor, position sizing refers to the amount of capital allocated to crypto relative to the overall portfolio.

Although we do not provide advice to investors in the Fund, we certainly do not advocate investing 50% of a portfolio in crypto, it’s too risky. The possibility of loss is too great and the consequences of any loss too severe. Many of the greatest thinkers in crypto suggest allocating an amount of capital that the investor is prepared to lose. Studies of institutional investors in crypto suggest starting allocations of 0.2% to 0.3%. Crypto is risky and for any investment in crypto there is a possibility of loss of capital.

2. Opportunity

I used to work at a funds management company that managed more than $500m of client funds in Australian equities. My former boss, a veteran investor with more than 30 years experience across a range of markets, taught me a number of lessons about investing. One of the key lessons that stuck with me is “the best returns often come from the ones you feel uneasy about.” I didn’t realise it at the time, but I now understand why.

“Risk creates opportunity”

When a company’s future is uncertain, when the risk feels high, other investors often reach similar conclusions, many choosing to avoid that risk by either selling or not investing. Risk can create opportunities to buy assets that are cheap. It is the job of the investor to discern from risky opportunities that are worth investing in, compared to those that are doomed to fail.

I see similar circumstances to crypto assets. There are numerous reasons why crypto assets may not succeed. Investing in crypto is risky. This creates opportunity. One of the main reasons for this uncertainty is a lack of understanding. The vast majority of people have not or will not spend a little time trying to understand crypto. This is a missed opportunity to learn about a technology with enormous disruptive and innovative potential.

This creates opportunity for those that have a keener understanding of crypto. It is interesting at this point to stop and consider, “how much do I need to understand to make an investment in crypto?” An investor doesn’t need a comprehensive understanding of the intricacies of crypto assets to make an investment. Just as we don’t need to understand the code behind Google’s search algorithms, we don’t need to understand the of code that powers the Bitcoin network. A more relevant understanding is the power of Google’s search algorithms to its users, the power of the Bitcoin network to its users and why both are better than the alternatives.

“Investors need to understand the three forces driving crypto innovation.”

First, it is a groundbreaking technology. We have written at length how crypto removes the need for trusted intermediaries and the resulting waves of disruptive innovation. Second, it has attracted huge amounts of capital. Third, the world’s best computer software engineers are flocking to work on challenging crypto projects. Understanding the power of innovation that is likely to come from these forces is more important than knowing the details of the Ethereum code.

For those that see the potential, for those that read Apollo Capital’s weekly newsletter and understand why crypto shows promise, investing a small amount in crypto is obvious. Investors realise the inherent risks in these investments, but they accept these risks and in doing so, give themselves a chance of capturing the upside.

Again, we come back to position sizing. The future of crypto is uncertain and accordingly, it makes most sense to only invest a small percentage of the portfolio in crypto assets. Despite working in crypto and understanding crypto assets better than most, I only have a small percentage of my net worth in crypto. I have a far, far greater percentage in my house, despite having greater conviction in crypto than the property market in Australia.


--

An unfounded fear of volatility and a lack of understanding is causing the majority of investors to miss out on the crypto opportunity. Many are waiting to understand crypto in full, or for there to be greater understanding from their peers and the media. They are missing the point. By the time this happens, the market capitalisation of crypto assets will be in the trillions.

Once crypto becomes mainstream and well understood, the opportunity will be long gone, leaving many investors to regret the omission of a small allocation in their portfolio.

**please note this article does not constitute financial advice. My thoughts are my own.


Investment Thesis Refresh

In a fast moving field like crypto assets we believe in the merit of having an investment thesis that is not set in stone but is updated as the market evolves. Crypto assets are based on a breakthrough technology. Far from all applications have been explored yet and some known applications have unknown market potential.

Irrespective of our final destination, Apollo Capital’s mission is clear:

1_4l3Gh5eB-IPL6GD9TXCPXA.png

Let’s unpack this sentence. We are:

1. “Investing in the crypto assets that are powering the next generation of computing infrastructure”

This is a new generation of computing. Specifically this new type of computing is replacing trusted third-parties with software. We can now do ownership and transfer of value (money, collectibles), participation and execution of smart contracts solely based on open source software not associated with a company or organisation. Software is both replacing rent seeking middlemen and enabling completely new use cases.

2. “Investing in the crypto assets that are powering the next generation of computing infrastructure

We think it makes sense as investors to focus on infrastructure investments when the potential applications are not yet clear. By investing in infrastructure we are exposed to any possible application being built on top of that ecosystem’s critical infrastructure. 

Not only do we believe infrastructure is a good starting point at the beginning of a new paradigm, our thesis is that most of the value will be captured in the lower parts of this new technology stack, specifically in what is known as base layer 1 Blockchains and Middleware:

Source: Apollo Capital

Source: Apollo Capital

Base layer 1 blockchains are their own chains like Bitcoin or Ethereum while middleware typically are smart contract protocols being built on top of one or multiple blockchains. 

Our portfolio is balanced between layer 1 and middleware.

3. “Investing in the crypto assets that are powering the next generation of computing infrastructure”

Our investment thesis is that Blockchains and certain Middleware are enabled by crypto assets, these are critical for this new software system. These crypto assets are where the majority of value is captured in this new paradigm. Another way of putting it — crypto assets are the fuel for this new type of software.

Verticals 

We believe that there are two broad categories of applications for open blockchains: financial applications and non-financial applications. As we map out the Potential Value Capture vs. the Maturity of certain applications we end up with this picture:

Source: Apollo Capital

Source: Apollo Capital

We are convinced that the biggest potential value capture by crypto assets on open blockchains are related to financial applications. One reason why this is the case is that blockchains are only able to secure native blockchain assets and smart contracts related to those assets. Non-native blockchain assets like identity will be hard to secure using open blockchains. Furthermore, anchoring non-native blockchain assets like identity doesn’t necessary capture a lot of value in crypto assets. In many cases non financial use cases end up anchoring information (e.g. through a hash) to a secure blockchain like Bitcoin. This can be done relatively cheaply using only a nominal amount of bitcoin.

For these reasons, financial related verticals and the crypto assets underpinning these verticals are our investment focus at Apollo Capital, specifically:

  • Store of Value

  • Privacy Coins

  • Stablecoins

  • Open Financial System

These financial verticals will create an infrastructure layer for financial primitives that are:

1. Permissionless — accessible to anyone. Just like the Internet made the world’s information accessible to everyone with a smartphone, open blockchains will make financial infrastructure available to everyone with a smartphone and an Internet connection. And just like the Internet broke down the barrier for publishing information on the Internet, anyone will be able to create financial instruments by interacting with smart contracts.

2. Trustless — not dependent on a third-party but on auditable software. Just like the information on Wikipedia is not dependent on one third-party actor but a network of contributors, the financial infrastructure of the future will not be dependent on a single vulnerable actor like a bank, state or financial institution. 

3. Censorship resistant — financial freedom. The Internet is hard to censor, in the future our financial system will be hard to censor as the Open Financial System is borderless in nature and not tethered to geographical jurisdictions. 

Once the basic layer is built, composability of these building blocks will lead to more advanced financial primitives to emerge and finally to user interfaces through web and mobile applications.

Store of Value

Bitcoin as a potential store of value and unseizable asset not relying on a government is material. Gold and offshore accounts today account for tens of trillions in value. Properties of crypto assets such as Bitcoin are on many accounts better than our current versions. In addition crypto assets are programmable which opens up new avenues for innovation not possible with a physical commodity such as gold. Store of value doesn’t exclude other use cases such as payments, but in our view volatility needs to decrease before a store of value enters the real competition for other properties of money such as medium of exchange and unit of account.

Medium of Exchange

In this category we mainly have stablecoins and privacy coins. Stablecoins suffer from a trilemma trying to optimise on scalability, stability and decentralisation. This is a hard problem to solve but where we see a lot of innovation. There is massive potential in the coming decade for stablecoins that can get this equation right. It is likely that in the very long term stablecoins will find competition from more pure crypto assets not tied to a peg once the volatility of those assets starts declining.

Privacy coins enable private transactions to take place and is an interesting and fast evolving vertical besides cryptocurrencies running an open transaction graph. As privacy coins tend to be innovative using newly developed cryptography, there is generally a higher technology risk in this vertical versus non privacy enabled coins.

Open Financial System

This is a general term referring to a new financial system being built on top of open blockchains. The first financial primitives being built include:

  • Lending — being able to earn an interest rate on assets that you already hold.

  • Credit markets — borrow against assets that you hold in your portfolio.

  • Prediction and oracles — create a trustless source of truth for events outside blockchains.

  • Derivatives — a leverage bet on an underlying asset.

  • Decentralised exchanges —blockchain based trading without giving up custody of your assets.

  • Synthetic assets — blockchain assets that can trustlessly replicate non-blockchain assets.

While many of the above primitives are still experimental in nature, it is easy to see them in the future vastly outcompete traditional solutions at least in certain categories and circumstances. As an example, taking out a loan on a blockchain can be as easy as a few clicks on a web 3 enabled browser.

Running financial services on software instead of relying on trusted financial institutions not only opens up access but could lead to substantial gains in productivity as the financial sector in many countries makes up a very substantial part of the GDP. 

Core to our thesis is that the financial infrastructure being built on open blockchains will become a common utility not unlike the Internet itself.


Henrik Andersson is the Chief Investment Officer at Apollo Capital . Based in Melbourne, Australia Apollo Capital invests in the crypto assets that are powering the next generation of computing infrastructure. For more information, please see apollocap.io.

Crypto Convexity

A Hydra is anti-fragile.

A Hydra is anti-fragile.

Convexity is an interesting concept that explains why investors should pay attention to crypto as an asset class.

I believe there are actually two ways that crypto has convexity. The first one is more technical and the second one more broadly related to individual crypto assets and portfolio allocation:

  1. Crypto has deeply rooted technical convexity 

As a former options trader, I learned that convexity is the concept of positive gamma. Gamma is the rate of change of the price sensitivity to the underlying price. If you’re ‘long gamma’ you will become more sensitive to price changes as the price goes up. Long gamma is a nice situation to be in, as the price goes up you will make more and more money (Short gamma on the other hand should be avoided like the plague.)

A short gamma trader on Bitmex gets liquidated.

A short gamma trader on Bitmex gets liquidated.

Why is crypto be ‘long gamma’? On a high level, base layer protocols like Bitcoin and Ethereum are creating an immutable ledger where value and contracts can be exchanged between any two parties. That network only has value if the security is strong enough, i.e. the network is only trustless if we don’t have to worry about a rollback of previous transactions. 

Since Bitcoin and Ethereum’s miners are paid in bitcoin and ether, the trustlessness of these crypto networks is a direct function of the price of those assets. Put another way, the value of the network as a secure ledger goes up as the price increases. This reflexivity means that 1. the network effect in crypto networks is strong 2. the immutability and thus the value proposition of the network increases with price — this self reinforcing effect is a form of positive gamma!

2. Crypto has convexity both in the micro and macro

On the micro scale, there is a lot of experimentation and competition going on in crypto markets. If you have exposure to a diversified portfolio of crypto assets you are more likely to capture the returns from breakout crypto assets. This is the reason why we are building a portfolio aligned to our investment thesis that is diversified between different verticals and technologies . In option parlance we’re said to be ‘long volatility’. We can view the portfolio as a collection of call options. 

Here it makes sense to mention another Greek letter, namely Theta. A call option has a negative theta, meaning that as time passes the value of the call option will decline as optionality decreases. If crypto assets are call options, I’d argue that the theta of a crypto asset is positive. This is due to the Lindy effect, which says the future life expectancy of a non-perishable thing like technology increases with time. Unlike call options that expire at a given time, crypto assets don’t expire. Instead, they prove themselves over time and become more trustworthy as time passes. If Lindy is valid for crypto assets, then they just have to survive to be successful — that’s a convex bet in time.

Secondly, on the macro side of things. By having 5% of crypto assets in your portfolio you are exposed to an asset class with limited downside (all of crypto is only US$150bn, a fraction of one company like Facebook) and with limitless upside. This has the added advantage that you can take much less risk with the rest of the portfolio. Instead of cultivating a portfolio of securities with average risk and average return expectations you can instead construct a portfolio where 90 or 95% of the portfolio has very little risk, maybe just enough to cover inflation while the rest of the portfolio has unlimited upside. Prof. in risk and philosopher Nassim N. Taleb describes this Barbell Strategy this way:

“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 hyper-conservative and hyper-aggressive as you can be, instead of being mildly aggressive or conservative.”

We believe this very asymmetric return profile coupled with the uncorrelated nature of crypto assets makes this a very unusual and attractive asset class. On the contrary if you’re short, you have limited upside (100%) and unlimited downside. 

The above reasons summarise why I like to say:

‘Crypto is Convexity for your Portfolio’.


Henrik Andersson is the Chief Investment Officer at Apollo Capital . Based in Melbourne, Australia Apollo Capital invests in the crypto assets that are powering the next generation of computing infrastructure. For more information, please see apollocap.io.

A New Crypto Valuation Framework

Crypto valuation is still a nascent and evolving subject. With something radically new like crypto it is easy to fall into the trap of trying to fit it into the framework of something familiar. Instead we believe crypto assets are be a diverse set of different type of assets, with different valuation frameworks. Most crypto assets won’t fit squarely into one bucket but will have properties that span across multiple different types of assets.

Over the past 12 months our understanding of the subject has evolved primarily when it comes to the token type that is becoming known as ‘Work Tokens’. This is how we currently map out the space on a high level:

Source: Apollo Capital

Source: Apollo Capital

Note that the above table doesn’t include Security Tokens. These are a traditional asset class represented by a crypto token, thus fall into the left column even though they are represented by a crypto token.

Crypto-commodities, Bitcoin

Bitcoin can be thought of as a digital gold. It shares many properties with gold such as being scarce while Bitcoin’s properties are superior (easily divisible, transportable, stored, secured etc). It is probably no coincident that a similar system to Bitcoin proposed by Nick Szabo but not implemented was called Bit Gold.

It is not clear how to value a store of value like Gold, but it clearly has value as a hedge against inflation and currency devaluation. This is also the reason why practically all central banks have gold in their reserves.

In a way, Bitcoin is closing the circle as all gold is again becoming a global currency like it used to, but this time a new, digital gold.

Source: Apollo Capital Information Memorandum, Nick Szabo

Source: Apollo Capital Information Memorandum, Nick Szabo

One way to assess the value of Bitcoin under this framework is to estimate how much of gold’s value will be transferred to Bitcoin in the coming decades. The total value of all gold that have been mined is in the order of $10 trillion. We know there will not be more than 21 million bitcoin minted (less, since a portion of all bitcoin has been lost). Thus if Bitcoin captures 20% of gold’s value, the value per bitcoin would be roughly $100,000.

Work Tokens

Sometimes I’ve referred to Work Tokens as Blockchain Native Security Tokens. I don’t mean that they are securities from a legal standpoint, but they do exhibit some traits founds in Equities and Bonds, namely some kind of cash flow is involved. Note that I’m using cash flow generously here, in some cases crypto is distributed, in other cases there is a burn or you risk losing crypto if you don’t participate in a certain activity. Work Tokens is a good name as the payment is made in exchange for work. The kind of work the tokens encourage varies a lot:

Securing the blockchain

Bitcoin miners are paid newly minted bitcoin and transaction fees for securing the ledger. For them Bitcoin is a Work Token.

Validating blocks

In proof-of-stake systems new coin inflation is paid to the validators as a reward. By locking up coins, the validators risks being slashed in exchange for a possible reward.

Governance

Some projects such as 0X (in the case of 0X no cash flow per se is going to the token holders, its token economics is currently in flux) and MakerDAO have a token for coordinating decentralised governance.

Reporting outcomes

Augur is a predicting market where holders of the REP token can participate in reporting market outcomes. In V2 of Augur as a token holder you risk being slashed if you don’t participate during certain market related circumstances.

Predicting outcomes

Erasure is building a protocol where the token NMR is used as a stake in relation to ones confidence about your prediction.

The above is just some examples of possible work that Work Tokens can encourage, this is still an area of much innovation.

Note that just because there is a crypto-related ‘cash flow’ doesn’t mean the asset has a yield in the traditional sense. Ethereum moving to Proof-of-Stake doesn’t mean that Ethereum becomes a yield paying asset. The reason for this is that the reward is paid in the same currency as the token. It is a bit like a stock doing a stock split, it doesn’t make it more valuable. It does mean however that if you don’t participate in validating blocks, you’re leaving money on the table. The value comes from having a demand side and a supply side that work in sync. Take the case with the MakerDAO network. MakerDAO is a protocol for lending on top of Ethereum. There is a demand for Maker tokens from borrowers as they need to pay interest with the Maker token. Maker tokens that are used are burnt in the process. Thus it is relatively straightforward, at least in theory, to calculate a net present value of Maker using a discounted cash flow model.

Work tokens are often built on top of blockchains such as Ethereum and thus classified as Middleware assets. As such they can be blockchain agnostic and potentially capture value across blockchains. Decentralised work tokens is quickly emerging as one of the most exciting places for crypto investors to place capital and participate in the network. 

Utility Tokens

Utility tokens are also known as Payment Tokens, they focus on the medium of exchange use case of crypto assets. Sometimes they are restricted to a certain payment or a product or service within a network, other times they try to be a general payment token. One of the most clear types of utility tokens are stablecoins. They are typically pegged to a national currency like the USD or the AUD.

For utility tokens we have a valuation framework in the Equation of Exchange:

MV=PQ

Here M is the monetary base, V is the velocity, P is the price and Q is the quantity.

Bitcoin’s use case for remittances is an example of it being used as a utility. Say $1bn is sent through a particular remittances payment corridor per year. In our case P times Q equals 1bn. Assuming a velocity of 5, the monetary base needs to be 1bn/5 = $200M. This hypotethical example would be additive to any other use case for Bitcoin.

As we have seen with Bitcoin, a crypto asset can span two or three of the categories above. 

In summary we are getting a clearer picture as how to look at crypto assets from a valuation standpoint. This is a fascinating subject that is evolving rapidly and that I’m sure we will come back to many times in the future.


Henrik Andersson is the Chief Investment Officer at Apollo Capital . Based in Melbourne, Australia Apollo Capital invests in the crypto assets that are powering the next generation of computing infrastructure. For more information, please see apollocap.io.

The Unwritten Rule of Crypto

The game Satoshi’s Treasure — if you find the key, the bitcoin is yours.

The game Satoshi’s Treasure — if you find the key, the bitcoin is yours.

This article was inspired by an article in Wired titled “A ‘Blockchain Bandit’ is Guessing Private Keys and Scoring Millions”. It’s a fascinating story of how a security consultant uncovered how millions of ether has been transferred out of Ethereum wallets over the years.

An Ethereum private key is a random 78-digit string. That’s an impossibly large number to guess. My favourite analogy relates to the number of grains of sand on earth. Now imagine each grain is another earth with as many grains as ours. That’s on the order of magnitude the number of different combinations that’s possible in the public key cryptography that is used by cryptocurrencies. 

A weak key could be generated if there is a fault in the random number generation algorithm and since computers are deterministic, random number generation is a really hard (and interesting!) problem. Another way to generate a weak private key is to use a so called brain wallet. Let me explain, brain wallets are based on a user defined passphrase. The idea here is that with a passphrase that you can remember, you will always have access to your crypto. The passphrase generates the private key in a deterministic way, so instead of the 78 digit randomness, the private key possible combination space has now collapsed down to the length of your passphrase. Humans are not very good at picking a strong passphrase, and if you need to remember the passphrase, which is point with a brain wallet — it gets so much harder to choose a strong passphrase.

In the early days of crypto, bitaddress.org was a popular web site to generate your private keys, your paper wallets and it also provided an easy way to generate a brain wallet. The site is still up and running today:

1_lOwYnhR1CMpmoJyY9xopqw.png

However looking at the Brain Wallet section there is a now a warning: 

“Choosing a strong passphrase is important to avoid brute force attempts to guess your passphrase and steal your bitcoins.”

They also enforce long passphrases, probably a very good idea. 

Let’s try a passphrase that’s easy to guess: ‘satoshinakamoto’:

1_HokSy7oL2ayx2cuRHwAeGA.png

Then plug in the address in our favourite block explorer. Turns out this address has been involved in 8 transactions, this was the first one:

1_s2CDftTClLhTpDiwpdZpOg.png

It currently contains no bitcoin — no treasure for us to claim!

The scenario here is that someone has created a very weak, guessable private key (‘satoshinakamoto’), to store bitcoin. A vigilant person or programmed bot has detected the incoming transaction, easily worked out the private key and then sent the bitcoin to their wallet. All this is easily programmed to happen automatically.

This shows the importance of protecting your private keys and generate them in a secure way. There is an army of people and bots out there that will jump at the chance of redeeming your private key, a point the Wired article drives home.

But I think there is broader lesson and understanding here — and that’s what I call the Unwritten Rule of Crypto.

The unwritten rule of crypto is that if you have the private key, you’re the owner. Another popular way to put it is:

Not your keys, not your crypto.

The key in crypto gives the holder the right to change the ledger — that’s the software enforced rule of blockchains.

There is a clear analogy to the DAO hack. The DAO was a very popular decentralised application on Ethereum during its early days. The smart contract code of the DAO contained a vulnerability which meant that funds from the DAO could be moved out. 

The software code (or rule) of the DAO said those funds could be moved. Just like having access to a private key gives you the right to update the ledger, the DAO ‘hacker’ had the right to move those funds.

This led the Ethereum community to roll back transactions like they never took place. That decision created a fork of Ethereum and we now have the original blockchain without the rollback, Ethereum Classic and the forked chain, where the ‘bail out’ took place, Ethereum.

Just like transactions are immutable, are exploits in smart contracts fair game? Supporters of Ethereum Classic would say ‘yes it is’ while some elements of the Ethereum community would disagree.

For many of us, ‘code is law’ is our motto. With the help of crypto we can create something that is as trustless as possible. We ask ourselves what’s the point of blockchain if not for being trustless. We are building a new future based on code. That code is the law of the blockchain.


Henrik Andersson is the Chief Investment Officer at Apollo Capital . Based in Melbourne, Australia Apollo Capital invests in the crypto assets that are powering the next generation of computing infrastructure. For more information, please see apollocap.io.