Research on: Crypto

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• Understanding Crypto Fundamentals: Value Investing in Cryptoassets and Management of Underlying Risks, Thomas Jeegers 2023, ISBN 978-1484293096
• The Book of Crypto: The Complete Guide to Understanding Bitcoin, Cryptocurrencies and Digital Assets, Henri Arslanian 2023, ISBN 978-3030979515
• Crypto Decrypted: Debunking Myths, Understanding Breakthroughs, and Building Foundations for Digital Asset Investing, Jake Ryan and James Diorio 2023, ISBN 978-1394178537

Money Is About Trust

• It is common among crypto books to dedicate the first chapter to talk about money
  • The definition of money (a unit of accounting, a store of value, a medium of exchange)
  • A history of money and how it evolves in different civilisations
  • The problem of inflation
  • And how bitcoin, the first crypto product, can be seen as a form of money
  • Traditional currencies are based on trust in a central authority (the government)
• And in later chapters of those books they will address how cryptocurrencies can potentially overcome certain challenges that traditional currencies face
  • As a decentralised system, cryptocurrencies can avoid inflation caused by a central authority printing excessive amount of money (this can be regulated in the source code)
  • No single party can manipulate the decentralised ledger in theory, so there is no need to worry that a central authority may seize your money
• While the authors’ theories sound compelling, the real-world truth is that money’s value hinges entirely on public trust and the expectation of stable purchasing power over time
  • If everyone lose faith in the US dollar and stop accepting it as payment, the dollar will lose its value overnight, and that has nothing to do with the flaws of the paper fiat currency not being a cryptocurrency
  • One may argue that the dollar runs the risk of losing value precisely because of a central authority managing the dollars, and the central authority may mess up
  • But cryptocurrencies do not run the same risk (secured on blockchain, decentralised, regulated by open source code)
  • While that may be true, it doesn’t mitigate the risk of people simply losing faith in a cryptocurrency (look at all the pump-and-dump of meme coins)
• In fact having a central authority that does a good job can make people trust the currency more
  • The government can use their political or even military power to secure the use of the currency they issue. Ultimately, power grows out of the barrel of a gun. Will the use of cryptocurrencies liberalise a closed-off country and benefit the people in those countries? Likely not.
• Let’s have a thought experiment: imagine a popular MMORPG with in-game currency
  • Just assume, by some techno-magic, the currency is secure, immutable, and the game is scalable, resilient, 100% reliability
  • Then this in-game currency is as good a candidate as any cryptocurrencies to be used as money for real life transactions
  • So the only advantage that cryptocurrencies bring is decentralisation
  • Decentralisation eliminates certain risks, but does not guarantee the longevity of the currency. It is ultimately based on trust.

Technical Details

• It is probably better to read up on the various papers published regarding blockchains and consensus mechanism

[!todo] Bitcoin whitepaper Ethereum whitepaper Various consensus mechanism DAO DeFi apps Privacy coins

Investments

• I think it only makes sense to view cryptocurrencies as a hedge and to only allocate a small portion of your diversified portfolio to it
• Potential investment vehicles
  • Directly purchasing cryptocurrencies and holding them in your own wallet
  • Staking cryptocurrencies in mining pools to obtain a yield (yield could be provided by the design of the blockchain as reward for proof-of-stake mining)
  • Staking cryptocurrencies in liquidity pools for DeFi applications (commission or transaction fee from transactions happening on the apps)
  • Buying cryptocurrencies ETF from stock exchanges or fund managers (only bitcoin for now)
  • Buying shares of publicly traded companies that operates cryptocurrencies (like Circle Internet) or holds a large reserve of cryptocurrencies (like Microstrategy)
  • Backing new crypto projects by buying their tokens or coins (highest risk)

Non-Financial Risks

• 51% Attack Risk
  • When a malicious party has control over a sufficient majority of miners/validators of the blockchain to manipulate the transactions in their favour. Having a majority control can ensure that the malicious party always mine every block in the chain.
  • But such attacks can only be short term, as the market will reach equilibrium quickly and the cryptocurrency will lose its value once people are aware of the attack
  • For bitcoin or blockchains that have reach a global scale, this attack is unrealistic as there is no single malicious attacker that can gather sufficient computing power, not even if all big tech companies collude and combine their computing power.
• Miner Concentration or Ownership Concentration
  • If a single party owns most of the miner, there is a risk that the party can control the mining
  • The same applies for proof-of-stake blockchains, if a single party owns most of the cryptocurrencies on the chain and can control the mining
• Quantum Computing
  • Advances in this field can potentially break existing cryptographic schemes.
  • Blockchains can adopt quantum resistant cryptographic algorithms
  • Wallets can also choose to only expose a public hash of the public key as wallet address, and to never use the same key twice for transactions
  • For example, after receiving funds in an address, forward it to a brand new wallet address that has never exposed its public key for longer term storage
• Regulatory Risk
  • This may shutdown your access to the crytocurrencies depending on your government
• Developer and Community Risk
  • The protocol of the blockchain may introduce new bugs in a new patch, even if it is open source, this can happen
  • The developers of smaller products may also be malicious or act against the interest of everyone else buying their products (platform risk or custody risk)
  • The community that owns the product may also disagree with the product direction, which can kill adoption
  • Client and platform applications that allows you to transact cryptocurrencies may not be securely implemented even though the underlying blockchain is secure
• Oracle Risk
  • Similar to the above risk, the oracles may not be securely implemented and they may be unavailable or provide wrong information, which may cause smart contracts to execute on inaccurate outcomes
• DDOS Attack
  • Like any applications available on the internet, it can be made unavailable by overwhelming bad requests sent into the network
• Scams and Market Manipulation
  • Pump-and-dump schemes
  • Financial fraud by the platform providers

Some DeFi products offer insurance against some of the risks mentioned above and is worth considering, since the paying out of benefits is automated using smart contracts

Financial Risk

• Credit Risk
  • When counterparty could not meet their debt obligations. This can happen to a centralised platform that you use.
• Liquidity Risk
  • There is insufficient sellers or buyers in the market to match your transactions.
• Market Risk
  • Changing market conditions like interest rates can cause a change in the value of your investment
• Value at Risk
  • Is an estimate, the P probability of losing at most D dollars over a T time period
  • Analytical VaR method uses statistics and a probability distribution to estimate the risk (but this is built based on assumptions of probability of certain events)
  • Historical VaR method uses historical values to estimate future values
  • Monte Carlo VaR uses the Monte Carlo simulation method to simulate changes in multiple variables and estimate the overall risk
  • Roy’s Safety-First Criterion: to manage portfolio by maximising return under the constraint that probability of loss of a certain amount does not exceed a certain desired limit
• Shortfall Risk
  • Similar to Roy’s criterion. This is the risk of a portfolio failing to achieve a desired level of returns
  • The level of returns may be a critical objective of the investor (e.g. to maintain a certain retirement lifestyle)
• Expected Shortfall
  • Estimates the expected loss on a portfolio over a specific time horizon beyond a specific percentile of the probability distribution (e.g. worst 10% scenarios)
• Backtesting
  • Can be used to check the portfolio performance against historical data
  • But historical events is never 100% representative of future returns
• Stress Testing
  • Similar to Monte Carlo method
  • Assumes certain scenarios and estimate how the portfolio would perform
  • Scenarios can include non-financial risks mentioned above

Valuation Assessment

Some factors to consider when valuing a crypto product

• Problem space
  • What problem is the product trying to solve (usefulness)
  • How important is the problem (scale and impact)
  • How does the product solve the problem (effectiveness, efficiency, scalability)
  • Best candidate solution (competitors, barriers to entry, unique value proposition)
• Product team
  • Is the team reliable (credentials, track records, incentives, transparency)
  • Local regulatory environment (red tapes, blockers)
• Tokenomics (the economic aspects of the crypto product as implemented by the code)
  • Token distribution schedule (who, when, and how tokens are given)
  • Token governance (how are decisions made)
  • Token supply design (inflationary or deflationary)
  • Consensus mechanism
  • Interoperability
  • Are incentives of all parties aligned with the interest promoted by the product

Value Investing Analysis

• Net Present Value (NPV) analysis
  • Commonly used to analyse traditional company stocks
  • Estimate the NPV considering future cashflow
  • NPV becomes a common metrics to compare different companies
• Valuations based on Multiples
  • Multiples like Price-to-Earning ratio, Price-to-Book ratio
  • These also provide common metrics to compare different companies
• Problems with the above two analysis approach
  • Companies in different industries have different multiples and different expectation of future earnings
  • Analysts often have to make adjustments to their analysis to consider the industry differences (which are subjective and based on their judgement)
• Alternative approach
  • Suggested by Benjamin Graham and David Dodd
  • Measure real net asset value
  • Measure earnings power
  • Measure value of growth (this is intangible and subjective)
  • Three separate analysis
• Applying the same analysis to crypto products
  • Net Asset Value can be approximated using Replacement cost (electricity cost of mining)
  • Earnings Power Value can be approximated using Staking yields (since proof-of-stake is much less intensive than proof-of-work, electricity costs will not be a good estimate)
  • Valuing Growth is subjective
    • Use high margin of error since the future in this space is highly uncertain
    • Prefer to be more conservative in all estimates
    • Consider number of nodes in the network
    • Consider activity on the network, like the number of transactions (easily manipulated) and total transaction costs (less incentive to be manipulated)
    • Consider Total Value Locked (TVL) which is a similar measure to Assets Under Management (AUM)
• Market Capitalisation is NOT a good measure for valuation
• Stock-to-Flow (S2F) ratio model (total quantity of the asset vs new supply of the asset)
• Using traditional commodities as a model to approximate the value of crypto products that behaves like commodities
• Network Value to Transaction (NVT) ratio can be used along side other metrics to check if a bubble is forming
• The Fulcrum Index, constructed based on the likelihood of credit default in G20 government currencies, can be used to approximate the value of crypto assets (assuming these assets are a hedge against government defaults)
• There are probably a lot more indicators and metrics out there that we can use to form our own valuation judgements