Blockchain Early Opportunities Fund — September 2020 Client Newsletter

‘Know what you own and why you own it’ Peter Lynch — President fo stock picks Fidelity Investments ( 1977–1990)

I am often asked what type of assets we hold in our fund, are they just cryptocurrencies or are they something else. This newsletter is my best attempt to answer this question.

I start by considering the characteristics and nature of traditional assets. I look at the commoditization of assets and the way in which assets have become more liquid through corporatization, unitization and securitization and how markets have grown up around these assets. I then consider how our key assets fit within our understanding of assets and how value will accrue to these assets.

Understanding the Nature of Our Assets

I want to briefly recap here what we understand of the nature of traditional assets and asset markets as this will set the scene for understanding the digital assets we own in our portfolio.

‘What is an Asset Class Anyway’

This was the question addressed by Robert J. Greer in his 1997 seminal article for The Journal of Portfolio Management. Over 23 years later his paper is still the most important reference to the definition of an ‘investable asset class’.

In summary, Robert set out three ‘superclasses’ of assets :

• Capital assets
• Consumable assets
• Store of Value assets

Each of these superclasses can then be divided into sectors.

Capital Assets provide a yield and include equities, bonds and income producing property. The valuation of such assets is tied to future earnings, a discounted cash flow model is the most common method of valuation.

An example of a Consumable/Transformable Asset is Oil. Oil is consumed to produce energy and once consumed it ceases to exist. The valuation for consumable assets is determined purely on a supply and demand basis.

Store of Value assets cannot be consumed and they cannot be valued using discounted cash flow models. Assets such as rare art, classic cars or currency itself are Store of Value assets and they are valued based on supply and demand, but with scarcity of supply being the main driver of demand.

For the past 20–30 years many portfolio managers have made asset allocation decisions based around these concepts. In some cases, portfolio managers have a mandate to allocate certain percentages of their portfolios based on these different asset classes.

Bucketing assets into classes has helped portfolio managers achieve more balanced diversification and better understand the risks in their portfolios.

Understanding Asset Markets

Specific marketplaces have been built around these asset classes. These markets are typically siloed by geography and asset class, they are not interoperable and there is no fluidity between the markets. It is difficult to swap a security for a commodity or bond and each market typically has their own set of regulations and regulators.

Commoditization

The commoditization of assets has facilitated the growth of commodity market places as it removes the individual, unique characteristics and brand identity so that the product becomes interchangeable with other products of the same type. Making commodities interchangeable (fungible) allows competition on the basis of price only and not on different characteristics.

Consider rice as an example. There are over 90,000 samples of cultivated rice and wild species stored at the International Rice Gene Bank, yet there are only 4 major types of rice produced globally. The Chicago Mercantile Exchange offers just one type of Rice futures contract, ‘Rough Rice’. Commoditization technology and practices have given rise to massive markets and efficiencies that would not have otherwise been possible. Imagine trying to grow and market 90,000 types of rice in a way that would feed the world’s people efficiently.

However, commoditization does have its drawbacks. Local rice farmers in India complain that they are now dependent on global commodity traders for the seeds they need to grow rice, and they have no choice about the type of rice they can grow. The rice producers have no autonomy or market power. They are at the bottom of the supply chain with their source of production (seeds) being sold to them by the same company that buys their end product.

As I explain below, the next generation of trading infrastructure, which is being built ‘as we speak’ will allow for the de-commoditization assets where there are economic incentives to do so and it allows for the creation of completely new assets and markets to grow around those assets.

Corporatization, unitization, securitization and tokenization

Liquidity is typically brought to asset markets by breaking larger assets into smaller parts.

The world’s stock markets have been created around the concept of the joint stock company, which was first developed in 1601. The joint stock company provides liquidity and helps investors to spread risk across a number of ventures.

Another example of market creation is the unitization of assets which brought liquidity to large capital assets such as property and infrastructure projects.

More recently we have seen securitization markets develop where smaller assets are bundled together to be sold as marketable sized parcels. Mortgage backed securities being an example.

The tokenization of assets, which I explain below, will herald in a cambrian explosion of newly tradable assets and dramatically increase liquidity of existing assets.

Conclusion

We have looked at traditional assets through the lens of asset ‘superclasses’. We considered how the commoditization of assets and the creation of liquidity structures have helped create global marketplaces for these assets that are worth trillions.

Add to this an understanding that underpinning all asset markets are the books and records of who owns which assets. These records are typically maintained on centralised ledgers. The maintenance of these ledgers is one of the pillars supporting our civilisation, without a secure and trusted record of asset ownership there can be no free markets.

Cryptoasset Markets

Blockchain technology is simply ledger technology. The technology piece of it is the distributed/decentralized nature of the ledger. The name Distributed Ledger Technology is a far better descriptive for the technology (but not as cool!).

So what is the big deal of being a distributed vs centralised ledger and how will this change the nature of assets, asset markets and the ledger based infrastructure of our societal and economical systems?

‘Every asset can have a unique identifier…’

This quote from tech venture capitalist Bill Tai comes from a 2 minute explainer video about asset ownership and transfer and the transformational aspects of blockchain technology (see here). Even Bill’s great explanation does not fully capture the big deal with this technology. The big deal is that every asset in the world (take for example a motor vehicle) can have a unique identifier and that the ownership can be transferred directly from one person to another without any third party being involved. And this can be done in seconds using a smartphone. The record of transfer being maintained simultaneously on thousands of computers around the world.

Think about how this will change the structure of not only existing asset markets, but also government departments and others whose main purpose in life is maintaining a centralised ledger. For example, the central Govt. department, which records vehicle ownership, can be replaced by a decentralised ledger maintained by thousands of anonymous computers around the world. With this new technology the marketplace for cars (or any other asset) is now truly global, I can buy a car from an owner in Germany in the morning and sell it in the afternoon to a New Yorker, all the while the car is stored in a warehouse in Canada. There is already an existing project which does just this, it allows for fractional (or whole) ownership of rare and classic cars, see here.

The assets we own are at the centre of this new operating model for asset ownership and transfer.

So what is the nature of our assets?

One of the first investment firms in the world to identify the emergence of Bitcoin as a new asset class (in 2016) is ARK Invest. There is a long podcast here with ARK Invest CEO Cathy Wood for those interested.

The person doing the research for ARK Invest at that time was Chris Burniske (and Adam White). Chris’ paper, subsequent book and writings have brought traditional asset analysis techniques to these new assets. Most recently Chris has developed a thesis about Ethereum where he puts forward the proposition that Ether is a ‘triple point asset’, that is to say that Ether has characteristics of Capital Assets, Consumer Assets and Store of Value Assets (You can listen to a podcast with Chris here).

Ether as a Capital Asset

I have mentioned in previous newsletters that Ethereum will soon move to a Proof of Stake (PoS) consensus model. Under PoS holders of Ether (the native asset of the Ethereum blockchain) can stake their assets and earn a return, a yield. This is very much like a Capital Asset.

Ether as a Consumable Asset

In order to conduct transactions on the Ethereum blockchain participants need to pay a fee, that fee (called Gas) is payable in Ether at the time of the transaction. These fees are paid to those who operate a node (validate transactions) and these fees ultimately pay the staking returns mentioned above. Gas, as the name suggests, is the oil for the Ethereum network, with no oil the network ceases to operate. The more transactions on the blockchain the more valuable it becomes. This is why people are interested in statistics such as transaction volumes and Gas fees.

Once spent on Gas the Ether has been consumed (although it still exists) so in this way it has characteristics of a Consumable Asset.

Ether as a Store of Value Asset

The fundamental basis of valuation for Store of Value Assets is scarcity. That is why things like gold, fine art, rare cars and Bitcoin are considered Store of Value Assets.

Ethereum also has limited supply. Although there is no cap, the issuance rate of Ether is built into the code. The rate of issuance is designed to keep inflation in the system to below 2% (the cryptoeconomics of the Ethereum blockchain is a study in itself. Obviously if the incentives for running a node and staking Ether are not sufficient, the system will not work).

The limited supply aspect of Ethereum gives Ether some characteristics of a Store of Value Asset.

How does value accrue to Ether?

In a word ‘utilization’.

We can think of Ethereum as a public utility, like a power station. There is value in owning a power station, the bigger the network of the station the more valuable it becomes. The Ethereum blockchain is a virtual machine for processing transactions and keeping records of asset ownership (it is referred to as the Ethereum Virtual Machine). It is not possible to own a part value of the machine, it is not possible to own equity in Ethereum (there is no equity) but it is possible to own the oil which runs the machine, that oil (Gas as it is called) is Ether and it is in Ether that the value accrues. Simply put the more the machine is used the more demand there is for Ether and the greater the value of Ether. But it is not just demand for usage as a Consumable Asset, there will be demand to hold it as a Capital Asset and as a Store of Value.

I do not believe there is a comparable ‘triple point asset’ in the traditional world. Yes there is oil, but it is not a Store of Value or a Capital Asset. Yes there are bank shares, but they are not a Consumable Asset. Yes there are rare works of art, but they are not Capital Assets or Consumable Assets.

Ethereum and some other cryptoassets (Hedera Hashgraph) fit within all three asset ‘superclasses’. This is one reason why Ethereum is considered a new type of asset, an asset type that we have not seen before.

Status of Utilization/Adoption of blockchain tech

Not only is Ethereum in of itself a new type of asset but the technology has facilitated the creation of a number developments, these developments will drive adoption. Some are :

1. The tokenization of assets.

Tokenization of traditional assets will create liquidity in the same way that corporatization, unitization and securitization has done. However, a tokenized asset on a blockchain is easily transferable peer to peer. So for example, the Perth Mint has a tokenized gold, they have a token called Perth Mint Gold, one PMG token equals 1 ounce of gold. The ownership of these tokens is recorded on the Ethereum blockchain.

There is a project to tokenize the tallest building in the world (the Burj Khalifa based in the UAE) which will be tokenized using the Hedera Hashgraph DLT.

The tokenization of assets is the next logical step in the asset ‘…izations’ mentioned earlier. It will bring liquidity and fluidity to all the World’s assets in ways that were never possible before.

This will allow for the de-commoditization of some assets where it makes sense and the commoditization of others.

2. Creation of Unique Digital Assets

We have never had unique digital assets (also called non-fungible tokens). This is a new type of asset. They are in their infancy but will become a large and very common part of our lives.

One early example where unique digital assets are being created is in the sport and gaming industries. Sporting franchises are already creating digital collectibles of their franchise assets. Think of baseball cards and the value that can accrue to rare cards, autographed footballs and the like. Well it is now possible to create unique digital collectibles with scarcity. The Formula 1 franchise for example, have created a digital form of Formula one, it is called F1DeltaTime. The first digital car in this game was sold for USD 113,000 (paid with Ether). Soon all sporting franchises will create digital assets. I can imagine the Australian Football League and teams selling non-fungible tokens to fans for trading and collecting and the AFL taking a nano-fee each time a token is traded ( they should build this business now to partly fill the COVID-19 revenue hole!).

Even individual player contracts can be tokenized. The first sportsperson to do this was NBA player Spencer Dinwiddie. He tokenised his three-year, USD 34.4 million contract with the Nets into an investment vehicle called Dream Fan Shares, via which he will sell 90 SD8 tokens or Professional Athlete Investment Tokens (PAInTs). The benefit to Dinwiddie of doing this is he receives cash up front. The benefit to fans is that they feel closer to their favorite player and they get paid when he would actually be paid under the terms of his contract.

The other early area for NFT’s is gaming.

Many games have what is known as ‘in game purchases’ which allow players to purchase certain objects for use in the game, like an iron sword or shield. These items stay in the game and cannot be re-sold. If instead the items are a NFT, it is possible to re-sell the item, use it in another game, or collect it as a rare item. There are already marketplaces where NFT’s can be bought and sold see here.

3. Central Bank Digital Currency

I wrote about the global arms race to develop a Central Bank Digital Currency (CBDC) in November 2019, see here. Since then the arms race has been moving at great pace. There is not a central bank in the world that is not experimenting with blockchain technology generally. Some are using Ethereum, some are using Hedera Hashgraph and some are developing their own.

CBDC will be a significant theme for the next couple of years. Think of the ease with which Governments could have delivered stimulus ‘cheques’ if they had a CBDC…and the ease with which it could be stopped. The adoption of CBDC will act as an on ramp for other cryptoassets as individuals and institutions become comfortable with the technology, user interfaces improve and the number and type of digital assets grow.

4. Enterprise Adoption

I would be surprised if there is a Fortune 500 company that has not by now, at the very least, set-up a blockchain research project. The indications are that most have gone a lot further.

The FANG tech companies in particular have big plans, Facebook have of course announced their plan for Libra coin, a plan that will introduce 1.6 billion daily users to crypto.

In September 2020 JP Morgan announced that they have sold their Ethereum based blockchain project to Consensus and then invested an undisclosed sum into Consensus. The Founder of Consensus, Joseph Lubin (a co-founder of Ethereum) commented that this is a ‘doubling down’ by JP Morgan on their commitment to the Ethereum technology.

Even more significant was the announcement by NASDAQ listed MicroStrategy that they are using Bitcoin as their treasury asset going forward. They essentially traded their USD 450 million in surplus USD for Bitcoin and they will use Bitcoin going forward as their main treasury holding. In commenting on this the CEO advised that they felt they were sitting on a melting iceberg of dollars and they wanted a more certain future for their savings, so they switched to Bitcoin. There is an excellent interview by the CEO here. Now all eyes are on Jack Dorsey and the USD 10 billion sitting on Twitter’s balance sheet. Jack is a fan of Bitcoin, will Twitter be the next public company to switch from USD to Bitcoin?

For Hedera Hashgraph the enterprise adoption story grows every month. The Governing council are all, as part of their obligations as council members, adopting Hedera Hashgraph within their systems and processes. In addition to the council members we have several significant projects using HH consensus service.

One such project is EFTPOS, the Australian payment network. EFTPOS announced that they will be using Hedera Hashgraph to develop a micropayments proof-of-concept in hopes it could be used as an alternative payment to monthly subscriptions or paywalls. They advised that :

‘By working with Hedera, we are leveraging next generation payments infrastructure technology that can support Australian dollar-based micropayments and open up entirely new ways of conducting business online,’

‘The Hedera network will enable us to get speed to market and offers us the technology to process fast, secure, and affordable micropayment transactions for all Australian merchants and consumers.’

The above is just a snapshot of what is happening relative to mainstream adoption of our main assets.

Conclusion

So, to answer the question of what type of assets do we have in the fund?…it is complicated.

At the moment we hold mainly ‘triple point assets’ which fit into all the ‘superclasses’ of assets (Ethereum and Hedera Hashgraph). Our thesis is that these assets will become among the most valuable assets in the world. The current value of Ethereum, USD 26bn is a fraction of its full value when fully operational with widespread adoption.

We hold some Store of Value assets (Bitcoin) and in the balance of smaller assets we have a mixture of both. We do not yet hold any tokenized assets or non-fungible tokens.

At this stage real world adoption of these technologies is very limited. However, Ethereum is only just 5 years old and Hedera Hashgraph is just over a year old (from the date of open access). It is inevitable that this technology will achieve widespread adoption, based on history, I expect adoption rates from here on will be quicker than what we experienced with the internet.