Aquanow Digital Dives: Navigating the open water of web3 — Vol. 3
Originally published on Feb. 11, 2022
I did my best to stay clear of anything resembling financial advice in the discussion below, but in case anyone gets confused, let me clarify — none of this should be interpreted as me telling you how to allocate capital. Let’s dive in…
Don’t go it alone — buddy up!
While solo scuba diving is growing in popularity, it’s more common to use a buddy system when exploring open waters. For more technical dives like exploring submerged cave systems, it’s especially recommended to have someone go along. When I feel like plunging into new and obscure concepts, I tend to go with someone I trust. Oddly enough, I’ve never met any of the “buddies” I dive with, but many podcasters and bloggers have opened my eyes to fantastic new worlds in the vast ocean of knowledge that is the internet.
Patrick O’Shaughnessy is someone I like to nerd-scuba with often. He curates a roster of fascinating guests and poses them thoughtful questions such that the conversation flows effortlessly, and the listener comes away a little wiser. A couple weeks ago, Patrick interviewed John Pfeffer. If you’ve got some free time this weekend, then I’d recommend giving this podcast a listen.
The discussion kicks off with the idea that an accelerating rate of scientific change is shifting how humans operate as communities. Back in the day, even though our ancestors were on an exponential growth path, the trajectory of development was so slow that survival of the fittest meant people who could conform and collaborate in groups. The risk/reward for striking out on your own wasn’t worth it. Today, we’re on a different part of that exponential curve, so innovations are frequent and fast. In such an environment, having an adaptive personality is an edge, while acquiescing means you’re left in the dust. Collaboration remains critical, which speaks to our nature as social beings.
John goes on to explain that technology investors, like him, are convexity seekers. This inherent optimism has motivated his family office’s significant allocation to Bitcoin. It also underpins a controversial thesis that alternative Layer 1 blockchains will generate staggering amounts of value, but that most of it will flow to users, limiting the profitability of holding tokens. “An (Institutional) Investor’s Take on Cryptoassets” details Mr. Pfeffer’s analysis. His approach adapts Moore’s Law and the quantification of economic output (GDP) to explain that while user growth is an important driver of network valuation, it doesn’t tell the whole story.
The open-source nature of many modern protocols means that innovations are easily borrowed or forked outright. Frictionless interoperability could result in markets trending towards perfect competition, a state where marginal revenues equal marginal costs and economic rents are nil. According to Mr. Pfeffer, BTC’s rising cost of network preservation through its security design and proof-of-work mechanism mitigates this scenario. Further, the asset’s status as a non-sovereign store of value combined with other optionality make it the most worthwhile investment in the digital asset space.
Pfeffer Capital has stated that they approach markets with an infinite time horizon, so they can wait for markets to calibrate. However, as you shrink an investor’s holding period, sentiment enters the equation. Clichés like “something is only worth what someone is willing to pay for it” and “the market can stay irrational longer than you can stay solvent” are opposing perspectives to the long term. But they have a point and to be clear, it’s not lost on John:
Using an alternative example, Purchasing Power Parity (PPP) is the economic tenet that a basket of goods in one country should cost the same in another country after considering the prevailing exchange rates. However, empirical evidence has shown that PPP is not observed in the short term and there is uncertainty over whether it applies in the long term as well. The theory sounds good, but there are nuances that limit its practicality.
Neat formulas do a poor job explaining markets because humans tend not to be the rational, self-serving actors assumed in most economic models. Mr. Pfeffer’s belief that there will likely be a single dominant digital store of value also relies on this premise. “Why would we need multiple cryptocurrencies serving as non-fiat monetary stores of value? What utility would that add?” But that’s the thing… Humans have shown a willingness to substitute among stores of value in the past, albeit infrequently. Gold has long served this role, but we believe its worth into existence. There’s very little practicality to storing your wealth in a metal that has marginal use cases. It’s fascinating — Mr. Pfeffer notes that: “we would estimate that the dominant store-of-value crypto could be worth 25–78% of total gold stocks at maturity”. Using gold as an underlying valuation premise makes appraising BTC a meme of a meme, and this isn’t unlike Dogecoin (worth $21B) or SHIB ($18B). It’s like Su Zhu of Three Arrows Capital says in this podcast — “Valuation is a meme”.
Let’s dive a bit deeper
In my quest to understand markets, I try not to make predictions, but I love learning from the methodologies that others use when making them and am thankful that Mr. Pfeffer spent the time to outline his thesis. A related discussion comes courtesy of a former a16z investment partner, Jesse Walden. Back in 2018, he wrote “4 Eras of Blockchain Computing: Degrees of Composability” which discussed a vision for how the crypto-based tech stack might evolve over time. His latest note elaborates on this further, but envisions a more continuous and interconnected progression rather than of a process of discrete phases. Here’s a summary:
· The Calculator: Bitcoin is a full-stack solution to solving the problem of internet money or digital gold. Besides the simple function of tracking balances and transfers, bitcoin offers a scripting language that can be adapted for advanced functionality. It is purpose-built and good at its task, but limited in scope
· The Mainframe: Ethereum offers a trust-less virtual machine that run software across a network of computers. A program running on the EVM can be viewed as a Lego block that can be adapted to create higher order applications. These portable chunks of code enable rapid compounding of innovations. Think of this as an accounting system that is relatively slow and expensive, but also decentralized and secure
· The Server: at the expense of decentralization, some blockchains can sacrifice composability for control, which can have profound impacts on the user experience and economics. Programs on this layer are limited to the resources allocated at a given time. However, security, storage and computation power can be scaled up to meet demand. Because they remain verifiable, open structures with programmable incentives, applications built here aren’t the closed systems of web2. The different chains can communicate with one another, but it requires some additional engineering
· The Cloud: a “promised land” of blockchains where developer creativity is the limit of what gets built. This is the domain of researchers who are exploring solutions for interoperable blockchains or a world of many mainframes. Perhaps we’ll even see the development of totally novel designs as well
Ash Thaker is another unknowing diving buddy of mine and I’m a subscriber to his Weekend Reads — a compilation of links like a Choose Your Own Adventure for geeks. One of his recent editions included an essay from a blog called Interfluidity. Steve Randy Waldman is the author and interested parties can check out this interview to learn more about his background. He’s a neat dude who passed all CFA exams to learn about finance, but never received the certification because his work experience as a computer programmer didn’t qualify.
In a blog post from July, Mr. Waldman outlined his thesis for why crypto will likely prove to be a “gray technology”. Such innovations start out as underdogs or antagonists to existing industry and regulatory regime. Their small size provides temporary cover from lawmakers so that well-executed pilot projects demonstrate sufficient value to spark a movement. He uses the example of Uber and Napster. Both skirted governing systems to open consumers’ eyes to a new service they didn’t yet know was desired. The result was that well-rooted incumbents had to adapt their business practices, but importantly, they did not disappear. We still have taxis and record companies, but there’s more choice regarding how we get around and listen to tunes. Here’s Walden’s view on how this relates to blockchains:
I try to keep an open mind while swimming in web3 concepts. Often, I will conceptualize the ideas in the context of an institutional investor because this has been my formation. Working on the sell-side required me to empathize with clients who approached capital allocation with different philosophies. Some were more Value oriented (purchasing equities at a discount to what they identified as intrinsic value), others spent less time trying to evaluate the present value of an issuers expected cash flows and instead focused on its potential Growth prospects. Both tended to employ a probabilistic approach to the various scenarios that they foresaw. Regardless of how they approached security analysis both camps were only ever partially right or wrong. Investment management is a humbling business.
No one knows what the future will hold and none of the authors linked above claim to have such foresight. Their theses have overlapping elements like exponential growth, disruptive technological change, and significant economic consequences, but with specific differences that will matter in time. Across all the scenarios outlined there is a benefit to being diversified and early. So often you hear that concentrated portfolios are the way to make money, but consider the power law and how in the equity market most stocks are duds. Holding a set of broad beliefs and allowing them to be updated might be inefficient relative to perfect knowledge, but absent omniscience, it seems to be a sensible approach for success in a rapidly changing environment.
What do you think, buddy?
If you want to contribute to the web3 movement, Aquanow is on the look for curious and motivated folks to join our team. Feel free to reach out directly or check out the current openings here.
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