DeFi Decoded: Crypto Investing

Podcast between crypto and tradfi investors.

Alex Tapscott and I discuss the crypto investing world on his podcast DeFi Decoded. Alex is Managing Director of Ninepoint Digital Asset Group. He’s the author of the 2016 book The Blockchain Revolution, which sold over half a million copies worldwide. His Tedx Talk Blockchain is Eating Wall Street has over 800,000 views. 

He’s a crypto OG…with a financial markets background. 

We had lots to talk about. 

Are there fundamental metrics in crypto? Do they lend themselves to valuing protocols? Are fundamentals even important? What’s the difference between hedge fund and crypto investing? 

Enjoy the engaging discussion.

Listen on Spotify, Apple or watch on YouTube. 

Throughout our discussion we reference my article Ethereum Q4'22: State of the Network. It serves as a lens into tangible metrics to assess blockchains…like revenue, costs and even profit! The article also highlights observable trends in metrics, like declining usage, that we discuss in the podcast. 

We touched on a number of subjects. What follows in this article are additional, bonus if you will, thoughts to accompany our conversation. 

Crypto thesis

I alluded to my crypto thesis as one of the reasons why I pivoted full time into crypto. We didn’t get into it in the pod…so what’s my thesis?

It’s simple. 

Crypto will accelerate commerce. 

There have been four disruptive technological innovations in the past 200 years. The railway and steam engine in the 19th century. Electricity in the late 19th and early 20th century. Oil and mass transportation in the early 20th century. Telecommunications, internet and mobile in the late 20th century and early 21st. These disruptive innovations all have one thing in common. They accelerated commerce. The volume and frequency of goods and services exchanged increased. The acceleration of commerce drives economic expansion. Economic expansion is a good thing. It leads to job creation, opportunities and wealth creation. 

Crypto’s global accessible interface, trustless architecture and low cost instantaneous settlements will power an acceleration of commerce. 

Crypto investing dynamics

We tackled the dynamics of crypto investing. They’re truly unique. 

Technology aside, there are two unique things in crypto markets that don’t exist in any other asset class. 

Crypto is an inefficient market. Yet it’s also liquid. 

No other asset class in the world has both of those attributes. It’s one or the other. 

That dynamic alone makes for a fertile investment ground. 

The importance of blockchain profitability 

Alex and I discussed Ethereum’s recent profitability. The revenue Ethereum generates in fees charged to network users is greater than the cost of maintaining the network. The “profit” is used to “buyback” tokens in traditional finance speak. What is actually happening is the excess revenue is “burned” in crypto speak. It means the excess revenue (what is left over after costs) is used to reduce the number of Ethereum tokens outstanding. The smaller the number of tokens outstanding, all else being equal, the higher the value of each individual token. 

What’s more is that Ethereum, in traditional finance speak, has “high operating leverage.” It means that as revenue grows, costs don’t really grow; so profits grow…a lot. In crypto speak, that means a lot of Ethereum tokens will be burned. When companies grow, they usually incur a lot of costs to do so. That won’t be the case with Ethereum. Eth tokens will benefit from two compounding effects: revenue growth and declining number of tokens outstanding. 

Ethereum’s operating leverage is widely misunderstood. People in crypto aren’t familiar with operating leverage. People outside of crypto aren’t familiar with Ethereum.

We talked about how Ethereum’s profitability ensures the network’s security. That’s valid for any chain. I’ll elaborate on that point and suggest two other reasons why profitability is such a big deal. 

1. Security 

Validators are paid to process transactions and secure blockchains. Security is tantamount to existence for blockchains. Validators are paid in new token issuance. Validators will stop validating if they are paid in tokens that continually decline in value. They will no longer have an economic incentive to validate. The security of the blockchain will be compromised. Users will stop using it. It will quickly unravel. 

Profitability ensures the economic incentive for validators to secure the blockchain is preserved. As a result, Ethereum’s security and ultimately its sustainability is cemented. 

Profits are necessary for the long term viability of a blockchain. 

2. Attracts outsiders

The more economically attractive a blockchain is, the more capital, developers and interest it will attract. The more stuff gets built on it. The more it gets used. 

3. Flywheel effects

Points 1. and 2 power a flywheel. They exacerbate one another. Combined they enshrine network effects. 

Metrics and value

We then pivoted our conversation to tackle what metrics to look at. Alex rightly pointed out there is a ton of on chain data to look at. There is more detailed real time usage data accessible in crypto than a stock analyst has access to. 

Pioneering funds like Electric Capital produce the Developer Report. The Developer Report tracks all blockchain developer activity. How many people are building, on what blockchains, how often are they committing code. It’s truly remarkable. It provides tangible early indication of which projects are gaining traction. 

Once a protocol is running, we can track usage with incredible granularity. Etherscan publishes Ethereum usage data. Many similar websites provide data on other blockchains. Open source analysts at Dune create customized dashboards to track key metrics across nearly everything in crypto. 

At later stages, we track revenue and costs, in real time. 

Alex pointedly asked:

“with all these metrics, how is it the market was so wrong valuing some protocols?” Referring to the massive drawdown crypto has experienced. 

In the podcast we used Uniswap as an example. I’ll elaborate here:

1. Value accrual

The value created by the protocol does not necessarily accrue to token holders. Wait…what?

If I own stock in a company then I am an owner of the company. The value the company creates manifests itself in profits. Those profits accrue to its owners; me. That’s not the case in crypto. At least not always. 

Many tokens in crypto are “governance” tokens. Governance tokens allow its holders to vote on how the protocol should operate. They do not grant token holders the right to the value or profit the protocol creates. 

You may be correctly asking yourself…so what’s the point in owning said token?

There isn’t one. At least not one backed by economics. 

These governance type tokens are a way to bet on the direction of where the market is going. There is a high correlation between token price and protocol usage. Not surprisingly, in an up only market like 2020 and 2021 as usage increased so did price. Then in 2022 as usage collapsed so did price. 

When crypto traders think usage will increase, they buy the token. But in a wipeout scenario, like 2022, there is no economic value to fall back on. There is no economics supporting the value of the governance token. It’s not like the market cap of Acme Co falling 80% in value to $50 million, but knowing it owns $30 million in property, has $10 million in cash on the balance sheet and generates $20 million in profit. I can rest assured there will be a bottom price for Acme Co at which someone (for example me) will buy it. That doesn’t exist for governance tokens, so panic selling ensues.      

Buying a governance token is no different than me thinking a certain horse is going to win a race so I bet on the horse. But if the horse wins the race, I don’t get part of the winnings the jockey gets. 

2. Public goods and securities law

So why aren’t profits distributed? 

There are two main reasons. 

There are no profits. But hear me out…that is not such a bad thing.

Some applications, like Uniswap, are highly valuable. But they’re public goods. Some of the breakthrough technology allows users to exchange an asset (or thing if you prefer), record the transaction publicly, settle it nearly instantaneously and do it all for pennies. You can also get a loan secured by digital assets. Again for almost free and instantaneously. 

These transactions occur peer-to-peer via smart contracts. These applications have no cost to operate. In a simplified way, they offer a similar product a stock exchange and a bank; but at no cost. And since nobody owns them, they don’t have shareholders to remunerate. So they don’t charge users fees. That’s often why there are no profits. 

So these things are very valuable. They’re just not good investments. 

The other reason that profits are not distributed is…well if they did they could be breaking the law. There are all sorts of complicated legalese which entangle some tokens. The gist is, if an entity distributes profit it could be construed as a security. If the token is viewed as a security and didn’t register as such and provide the necessary disclosures, it’s in breach of securities law. That’s a no no.   

3. Tokenomics 

One more big issue that the market largely missed: tokenomics (crypto speak for the economics of your token economy).  

Quick background on tokens. A token can be used to bootstrap a network. The thinking is, in the early days of building a network, the network doesn’t have much utility value. So, you incentivize people to use the network by giving them a token. Once the network has lots of users and utility value, the token will be worth a lot. Early users are economically rewarded for bootstrapping the network. For simplicity, let’s ignore what I just wrote about value accrual, and assume this token does actually represent the value of the network. 

Token inflation refers to how many new tokens are issued (in crypto speak “minted”). These new tokens power the continuous incentive mechanism to get more people on the network. 

It brings about two problems. 

One, are people joining because you’ve built the best network since Facebook? Or, are they joining because you’re paying them a magic token to join? In both cases, usage metrics look great. But the health of the network is easily misdiagnosed. 

Second, token inflation. Projects issued enormous amounts of new tokens as incentives. The token incentive worked to get people on the network. But the second order effect is that it massively dilutes the value of the existing tokens. Token price needs to appreciate at a faster rate than new tokens are being issued in order for the token to maintain its price. The price collapses if that’s not the case. The third order effect is the earliest adopters, the best customers, get screwed. They took a risk. They helped build the network. And got paid in a token that was massively diluted by new tokens issued to later adopters. They get pissed and leave the network in frustration. The network is then left with a bunch of mercenary users there to collect and flip the magic token. 

4. Usage drivers

DeFi usage collapsed. It’s down 70%. 

One of the reasons is because rates increased. When I earn 0% in my savings account I’m willing to go further out on the risk spectrum to get a return. When my savings account pays me 4% to park my cash there, I am less likely to degen into some random protocol for an 5% yield paid in a magic token. 

I think the market missed just how levered DeFi was to rates. Higher rates lower the value of Apple because its future cash flows are discounted back to today at a higher rate. But people don’t stop using their Apple products in high rate environments. Like Apple, the value of DeFi protocols are lower because whatever that future value could be is now discounted at a higher rate. But unlike Apple, people actually stopped (or at least greatly reduced) using DeFi products. What’s the point in earning 5% yield in a random coin when my savings account pays me 4%?

There are exceptions

I’ve made generalizations for the sake of simplicity. The challenges of value accrual, tokenomics, securities law and usage apply most directly to DeFi tokens. 

Crypto is a big market. There are areas of value accrual ripe with good investments. 

The most interesting are infrastructure. By that I mean, layer 1 blockchains. 

Value accrues to token holders. Massive token dilution is less of a problem. In the case of Ethereum, the number of tokens outstanding is declining. Securities law is less of a hot button issue. Their tokens are viewed more as a commodity than security. Their usage is driven by more than degen token trading. 

Plus if you want to build an app to trade magic coins with leverage on a blockchain - great! Users of the app still need to pay gas fees, which accrue to blockchain token holders. 

Infrastructure is where I spend most of my time. It’s the most promising sector of crypto with tangible economics and real use cases. 

Stay curious. 

Alex has a great weekly email outlining market moves, news and his astute insights. Subscribe here. 

Follow me on Twitter @samuelmandrew for my latest thoughts.