Being Digital
Finance is a Global Digital Closed Loop
“Being Digital,” the groundbreaking book by Nicholas Negroponte written in the early 1990s described what happens to a global economy when all assets can be digitized. Presciently predicting the impact on music, film, retailing, and commerce in general, Negroponte intuitively understood the disruption and the creative/destruction that would be unleashed when a globalized infrastructure could deliver all products and services, including assets and intellectual property, instantly via a worldwide digital infrastructure and network.
The same “digital” effect is impacting global finance today. Now, all financial assets are “being digitized” and can be delivered instantly on a global infrastructure, fundamentally upsetting the world’s largest industry with unprecedented creativity and destruction.
Crypto. Asset or Fraud?
Crypto assets are the manifestation of that digital form. While there is debate about whether or not an asset can truly be “digital,” the market has spoken. While there will be continued volatility, speculation, creation, and destruction, a digital platform for financial transactions ranging from the simple transfer of funds to complex financial transactions, investment, and lending are here, disrupting a multiple trillion-dollar industry.
Cryptocurrency is an Asset – Sometimes
Bitcoin closed recently at about $35,000 and estimates as to where the price will go range from $500,000 in a few years (because of its store of value and pervasiveness on a global digital network) to zero (simply because there is no “there there”). In the meantime, other skeptics include global central bankers warning investors that bitcoin is speculative and will never be used for transactions or to buy any actual things, and will therefore be worthless. Thoughtful perspectives could not be more divergent. So, what will happen?
Cryptocurrency prices are extremely volatile, impacted by news about regulatory crackdowns, environmental concerns, and heightened tax scrutiny. But it is also gaining acceptance among credible investors and financial institutions as new crypto offerings are launched. Given all this, can crypto assets be considered an institutional asset class? If so, financial securities markets may be forever changed.
A critical mass of credible investors and institutions is now engaging with crypto assets. That alone may cement crypto as an official asset class. Despite price volatility, institutional interest in bitcoin is increasing. One of the drivers establishing this new asset class is an uncertain and volatile political and economic environment requiring a convenient, secure, and easily transferred value, and crypto meets these requirements.
Institutional investors are more and more accepting that digital assets are real, and are assuming a value based on the very assumptions on which a currency like bitcoin was established: Bitcoin has a finite quantity, and since it is verifiably finite, it is seen as a way to hedge against inflation and currency debasement, and to diversify portfolios in the pursuit of higher risk-adjusted returns. Even though crypto assets have behaved as anything but a diversifier over the past year with wild volatility and significant drops in value, the rebound in 2020 reassured investors about crypto’s resiliency as an asset class. Satoshi Nakamoto would be proud.
A Store of Value?
But what makes crypto like bitcoin – which has no income, no practical uses, and high volatility – a good store of value? For one, markets are increasingly believing in it. “Inherent value” is a meaningless concept because value is given to every asset by a market. That is, all assets are inherently valued on some basis. That asset may generate cash flow, and that cash flow may be discounted at a certain interest rate, and therefore a value is ascribed. But that cash flow must be projected, and interest rates must be estimated and discount rates must be assumed. All these factors could change dramatically changing whatever was thought of as an inherent value.”
Scarcity value may also create a predictable store of value. The scarcity and desirability of an asset – essentially supply versus demand – creates a current value that may or may not be sustainable. After all, will a Picasso be worth $100 million in the future, as it is today? There is a belief that the uniqueness of this asset will retain and even increase its value because the supply is obviously limited, but demand continues to be stable or growing.
However, if suddenly, the market decided that a company was about to be outdone by a competitor (think Blockbuster) or that a Picasso is worthless (perhaps the specific painting was a fraud more was a sudden dramatic change in art lovers’ taste), there is no floor to the value. Will this happen? We can probably generally agree that it won’t in most cases, but it does happen. So, there is no white line separating absolute store of value from something tenuous and at great risk of collapse.
Will it happen for crypto assets? Today the answer is no, but will the market suddenly change its mind and determine that digital assets, like a fraudulent Picasso or outmaneuvered Blockbuster, really have no value? This is the debate, but it seems increasingly unlikely as demand is spread among institutional investors. Digital assets have the potential for widespread social adoption given security, privacy, transferability, and digital form. Institutional investors are treating crypto assets as a macro asset, similar to gold.
Wait a Minute
The idea that something with no income, utility, or any direct relationship with economic fundamentals can be considered a store of value, or an asset at all, still seems absurd on the face of it. Despite the recent crypto-mania, will most institutions really expose themselves to cryptos’ volatility and risks, which the recent volatile price action serves as a stark reminder.
For an asset to add value to a portfolio, it has to have either an attractive risk adjusted return or low correlations with other macro assets, and preferably both. On that basis, a small allocation to crypto in a standard portfolio since 2014 would have delivered strong outperformance over the S&P 500 while giving diversification benefits from relatively low correlations between crypto and other assets. But crypto’s short and volatile history make it too soon to conclude how much value it adds to a balanced portfolio.
So Then What Do We Do?
Be Digital.
The real opportunity is in the broader crypto ecosystem. The three biggest developments in the crypto ecosystem – payments, decentralized finance (DeFi), and nonfungible tokens (NFTs)—mostly being built on the Ethereum network, potentially provide substantial upside for crypto and various DeFi applications. Blockchain technology will prove revolutionary if the technology can resolve the question of trust. No small feat.
But the trend seems overwhelmingly favorable, and blockchain is forming the foundation of a fundamental disruption to global finance. Demand is growing among asset managers diversifying portfolios, to individuals and businesses looking for broader exposure, and to hedge funds playing the volatility.
Global Transformation in Investment
The crypto ecosystem is positioned to fundamentally change finance and its impact on the way we live and work globally. From an investment perspective, opportunities range from owning and trading digital coins, to venture capital, to digital assets including institutional and commercial finance, as well as entertainment (film, music, and gaming studios), and non-fungible token (NFT) projects. Essentially, an investor today participating in this ecosystem is at the frontier of a fundamental and disruptive change in one of the most important global industries, and will participate in the creation of the next generation of financial services companies.
Signal versus Noise
Of course, this requires exceptional fortitude in the face of excesses, knuckleheaded Twitter comments, cheerleading, and tribalism that we are seeing in the market. This is noise. The fundamental signal is that digital assets are transforming from stores of value to decentralized finance to stable coins in payment systems. Critically, crypto infrastructure, including security and institutional engagement has increased, including at money center banks, PayPal and Square.
While volatility continues, crypto is established well enough to believe it is not going away. Digital asset infrastructure enables financial markets to be more transparent, egalitarian, and independent of questionable central government decisions regarding budgets, finance, and the potential debasement of central bank currency.
One example is the money transfer business. A very high margin business for legacy financial institutions, but is under threat from new payment systems that are faster, cheaper, and more transparent. Fundamentally, stable coins (digital coins backed by independent verifiable assets) will be the driving force here. This is an important distinction from bitcoin. Bitcoin cannot scale to process thousands of transactions per second. Dollar-based stable coins will enable money transfers that will be essentially free. The crypto ecosystem – payments with stable coins, decentralized finance, and NFT’s – are being built on the Ethereum network, whose foundation is secure blockchain technology. This is here to stay and scales to meet enormous potential demand.
About That Store of Value
Digital assets, despite volatility, are becoming an effective store of value. For example, Bitcoin is a global uniform store of value. It’s the most widely distributed asset outside of the Dollar and Euro. 140 million people own bitcoin, and it’s easily stored and transported (unlike gold).
Stores of value are social constructs—they have value because we believe they do. The myth of “inherent value” distorts reality. There is a belief in the value, which can evaporate, but, in the case of bitcoin, there has never been a more successful creation in such a short period of time. It’s a little more than 10 years old, and it is now worth approximately $1 trillion. The world believes bitcoin is a store of value, therefore it is. While there are still arguments against it, since global financial institutions are all adopting it, it appears highly unlikely belief in this asset will disappear.
Momentum and Long-term Viability
Markets are momentum investors. All great fortunes have been created by capturing new trends. While often labeled as “disruption,” value is created through a closed loop which is a virtuous cycle of adoption, knowledge, improvement, and growth, whether that is from Amazon, Apple, Microsoft, Google etc. Macro factors converge to create a long-term profitable trend competitively sustainable. Digital assets are building that momentum, and the ecosystem has the potential to create this virtuous closed-loop cycle with digital assets and financial transactions, potentially on a global scale creating substantial value.
Momentum is not a speculative surge. Dogecoin is an excellent example of a speculative surge with little prospect of long-term value. There is no institutional support, and, at some point, the Reddit and Twitter crowd will lose interest. Tribalism is real in the investment community (think of GameStop), and it is powered by trading apps like Robin Hood and social media platforms like Twitter. Some crypto assets, like Dogecoin, and some equities like GameStop, have short-term potential but no long-term viability.
What was that about a Currency?
Digital assets are not currencies. Currencies must have four qualities: they must be a unit of account, a means of payment, a stable store of value, and act as a a basic standard by which value is computed (a numeraire). Bitcoin and most other cryptocurrencies are not a unit of account; nothing is priced in bitcoin. It’s not a scalable means of payment; the bitcoin network can only complete seven transactions per second, versus the Visa network that can conduct 65,000. It’s not a stable store of value for goods and services, the price it is far too volatile. Finally, the crypto universe doesn’t offer a single numeraire in which the prices of different items can be denominated because there are thousands of tokens and thus limited price transparency.
But is it an Asset?
As we discussed earlier, there is an argument that an asset must have some cash flow or utility that can be used to determine their fundamental value. A stock provides earnings growth and dividends that can be discounted to arrive at a valuation. Bonds provide a coupon, loans provide interest, and real estate provides rent or housing services. Commodities like oil and copper can be used directly in different ways. Gold is used in industry, jewelry, and has historically been a stable store of value against a variety of tail risks, including inflation, currency debasement, financial crisis, and political and geopolitical risk.
The argument is that crypto assets have no income or utility, so there’s just no way to arrive at a fundamental value. A bubble occurs when the price of something is way above its fundamental value. But we can’t even determine the fundamental value of these crypto assets, and yet their prices have run up dramatically. In that sense, this looks like a bubble.
This misses a fundamental point about an asset value. While all these arguments have validity as to how one would value an equity or a bond, etc., there are still assumptions about business risk, interest rates, fiscal policy, tax policy, etc. that are all uncertainties. Essentially, there is an assumed value that the market accepts which determines the value of these assets. This is even more the case with gold. While it has been said to be a store of value protecting against inflation, etc., this is only the case because we have assumed there is a value to it. There is nothing inherent in gold that generates any value close to its price, whether it’s cash flow or applications for which the input can be objectively priced. It has its value because we have simply agreed that it has value.
This is the case with crypto assets in general, we have agreed that there is a value. However, there is much more “inherent value” generated from stablecoins linked to real assets via a decentralized finance platform. Crypto that exists in digital form but linked to a real asset, whether that is a dollar, equity shares in a business, or interest-bearing debt, has the same “inherent value” as the underlying currency, equity, or debt.
That’s the crypto revolution. These assets collectively can become the equivalent of the stock and bond market, as well as all public and private finance. That is hundreds of trillions of dollars.
Revolutionary and Inevitable
The next decade will see radical financial innovation across many dimensions, disrupting the traditional financial system. Driving this innovation will be a combination of a digital platform of smart contracts and digital assets enabling secure and verifiable connections among investors, lenders, borrowers, entrepreneurs, and businesses. This will combine with an additional revolution in fintech using AI, machine learning, and the Internet of Things (IoT) to collect data. Fintech is already transforming payment systems, lending, credit allocation, insurance, asset management, and parts of the capital markets. In the context of payment systems, billions of transactions are made every day using AliPay and WeChat Pay in China, M-Pesa in Kenya and most of Sub-Saharan Africa, and Venmo, PayPal, and Square in the United States. These are all great companies that are scalable, secure, and are disrupting financial services. More importantly, they are laying the infrastructure which will form the foundation upon which financial innovation will accelerate.
The Closed Loop
Closed loop businesses were discussed earlier and are the bottom line to a potential value creation engine beacuse once a combination of these and other platforms are based on decentralized finance (DeFi), and effectively utilize a blockchain platform, global markets will be disrupted by a virtuous “closed loop.” That is, more data combined with distributed services and direct contact between parties without central banks, central authorities, or high-priced intermediaries, will create more cost-effective services, better feedback, and more data to create more effective products and services. Thus, the virtuous “closed-loop” that will spiral into a global trend.
This trend will generate tremendous value as other closed-loop businesses have (e.g. online retailing, software services, consumer base subscriptions, etc.). Previous trends created the spectacular value of Amazon, Apple, Microsoft, and Netflix, to name a few. The closed loop in finance has the potential to create many more companies and opportunities with extraordinary value.
