Updated: Feb 10
The new asset class ‘digital assets’ that includes Bitcoin and Ethereum is one of the most exciting and fundamental developments in global financial markets since centralised electronic marketplaces. In fact, we will argue that they could be the greatest synergistic force in history, developed just in time to be ready for unprecedented monetary and fiscal interventions in the year 2020 and beyond.
As an asset class, digital assets began with Bitcoin, of which we cover here as an investment asset, discussing its investment characteristics. Bitcoin is the place to start for investors who are interested in this new asset class. In Bitcoin: A Revolutionary Investment we argue that understanding the philosophical underpinnings and the potential for a cultural impact is just as important as understanding the investment characteristics.
Readers who are familiar with Bitcoin will take the strength and power of the technology for granted. Bitcoin has been worth over $100 billion USD for a long time now, facing many adversaries who have challenged it technically, functionally and philosophically. Bitcoin has proven itself as anti-fragile, becoming stronger after each challenge.
The possibility of other digital assets had been suggested from as early as Bitcoins development. Smart contracts, found in Ethereum as well as other de-centralisation platforms such as Polkadot, Cardano and Algorand suggest an enormous universe of functionality, all of which is fascinating in its potential.
However it is in finance and financial markets functions that are most fascinating and promising for digital assets, especially in the current environment of moral hazard and hubris in official policy.
With Bitcoin forming the monetary value of this new asset class, a foundational layer of pure value, a new financial system is being built. A few years later, there are already de-centralised exchanges, loan books, asset lending, liquidity pools, insurance and bad-debt. In short, the concept has been proven, and it is now a matter of time for the full catalogue of technologies to catch up to the potential, as computing had eventually caught up to the papers by Alan Turing and John von Neumann.
(For more information on investing in Bitcoin, click here)
We don’t expect the development of this financial system to take as long as computing technology was developed previously. With the acceleration of technological development, the computing papers to personal computers took upto 40-50 years while the maturity of the internet took around 20 years. It was about 12 years between the NASDAQ bubble of 2000 and dominant global applications that early and late majority of technology adopters participate in. In digital assets we expect a 5-7 year maturity period for these new assets to change the face of finance, financial markets and global commerce forever.
So, what are the working parts of a digital asset portfolio?
The first asset to consider is Bitcoin, which contributes to the system in multiple ways.
First of all, Bitcoin contains the philosophical underpinnings of the digital asset space. This makes understanding the philosophical underpinnings of Bitcoin very important. Bitcoin is an intelligently designed digital money built on principles of de-centralisation and trust-less transactions. It achieves this through new technology and a new way of looking at systems.
As a system, Bitcoin attracts the resources it requires through the power of its protocol, its incentive structure pays the right actors the right amount, its cost structure makes challenging the system expensive in asymmetric ways to the point of futility, its game theory is open but solid and has proven itself in battle time and time again.
Bitcoins developmental events include being released on the same day (31 October) as Martin Luthers formal protest against the Catholic church was pinned to the door of castle Church. Bitcoins code also includes a reference ‘The Times 03/Jan/2009’ Chancellor on bring of second bailout for banks’ and in short it exists as a fundamental critique to the role of money in Western civilisations materialist paradigm.
This inherent critique is an ideological motivation in the development of both Bitcoin and the rest of the digital asset universe and it has empowered Bitcoin to a now USD $600+ billion market cap.
De-Centralised Computing Platform
After Bitcoin was established, a new protocol that allowed smart-contracts was the next major project, with the Ethereum white paper released in late 2013.
Ethereum is a platform on which digital contracts – smart contracts – could be created and the platform – de-centralised and owned by no single actor – would execute the smart contract, allowing de-centralised applications.
Although many have been developed with various use-cases, it wasn’t until 2020 that De-centralised finance began to validate itself, potentially in tandem with increasing regulation that emerged in 2019. As is often the case in an anti-fragile system, attempts to frustrate or control this phenomenon create opportunity for successful innovation.
In choosing a de-centralised computing platform investment, investors must consider the blockchain tri-lemma. It is between scalability, security and de-centralisation. A platform that is scalable (can handle large numbers of transactions) is not de-centralised. A centralised platform is not secure - and so on.
For example, current limitations mean that the Ethereum network may currently handle 30 transactions per second – enough to prove concepts but not enough to run full-scale applications.
There is, of course, a lot of work going into solving this trilemma, from improving the base technology, changing the original game theory (the Algorand chain requires 33% consensus of nodes in its system as opposed to the usual 51%), using second layer solutions (independent systems that write to the main blockchain at intervals). But in 2021 there is now a trillion dollar asset class with proof of concept of a new financial system developed by highly motivated, highly focused researches who are now also highly funded.
In short, de-centralised computing with smart contracts has enormous potential and as a combination with the fundamental value of money that Bitcoin represents, is an almost incalculable synergy. Adding de-centralised finance assets (including Oracles) is yet another synergy with exponential potential in the ecosystem.
Another interesting component of the digital asset ecosystem is the connection between the digital universe and the physical world. Smart contracts executed on de-centralised computing platforms require fast access to reputable data of the ‘real world’ for the clean performance of those contracts in the digital world. The mission of Oracles is to provide this data, and the most reputable project doing this so far is Sergey Nazarov’s Chainlink.
Notable de-centralised finance projects include Uniswap, a de-centralised asset exchange, Aave, an asset lending protocol with over $3 billion held in assets, Synthetix, a derivative liquidity protocol (to gain access to asset exposure), Maker, a de-centralised stablecoin management protocol for the Dai stablecoin (other stablecoins exist but are either asset backed, partially asset backed and do not solely exist within the digital asset universe.), yearn.finance a liquidity aggregator and SushiSwap a de-centralised exchange with liquidity pools.
There are also de-centralised derivative exchanges and insurance projects.
Some of the yields in de-centralised finance liquidity pools are upto (and over!) 300% annual yields, with USD stablecoins at the time of writing attracting 10-15% annual yield – significantly higher than the 0.25% USD rate via the federal reserve.
As we get further away from the foundational underpinnings of this space, there are other assets worth considering. This is by no means an exhaustive list, and there are other worthy projects that we can’t get into for the sake of simplicity and brevity.
Onto the portfolio construction!
The first question that an investor must ask themselves regarding digital asset portfolio construction is where it fits into their overall strategy. Is this their only type of asset? Are they using it to boost returns in a traditional strategy? What are their individual requirements and how should they look at digital assets?
Some of these questions can only be answered by the individual, however if an institutional investment portfolio is held, an allocation between 5 and 40% probably makes sense. For new investors without other assets, they may decide to invest 100% of their funds into this new asset class - given that they are not involved in protecting capital.
Within that allocation, a Bitcoin / De-Centralised Computing / DeFi allocation for low risk might be
40-60% Bitcoin, 30-50% De-centralised Computing Assets and 10-30% Decentralised Finance (and other)
A high risk allocation might be
15-25% Bitcoin, 25-45% De-centralised Computing Assets and 30-60% Decentralised Finance (and other) assets.
Timeline and Volatility
Like all investments, the asset choice and allocation should be reviewed in intervals to check on the investments. Where investors may begin with 3 or 4 de-centralised computing protocols, it could be clear that one is more likely to perform over the others and they may wish to consolidate into the single asset.
In constructing the portfolio, investors should aim to leave their portfolio for as long as a year without major changes, with a medium term time-frame of 5 years.
There are also ways of securing yield(income) for investors, whether that is staking assets or providing them to liquidity pools. Some of these techniques require more information and we recommend doing this carefully if investors choose to pursue them.
Finally, investors should note that this is not generalised advice and is certainly not personalised advice. For more information you should get in touch with an expert. There are many exciting things going on in this space with great rewards and risk!
By Thomas Kuhn, CFA
Thomas is the author of 'Bitcoin: A Revolutionary Investment' and has previously written for the Asia-Pacific Research Institute of the Chartered Financial Analyst Institute, QuantumEconomics, Hackernoon and Medium.
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