Author: 0xArthur
Translation: Dr.Hash research
In recent years, no other frontier market has become more interesting for investors than cryptocurrencies.
Given the nascent nature of this asset class, there is no universally accepted valuation framework for investors to use. In this market, prices are often driven by speculation and hype, with little regard for fundamentals. This is evidenced by the fact that “Meme coins” with zero utility value have reached multi-billion dollar market caps in a short period of time. Unlike traditional markets, early seed or Series A startups/protocols often list their tokens on the open market. This is also facilitated by the ease of providing liquidity for newly created cryptocurrencies on decentralized exchanges, allowing them to quickly introduce liquidity from the outset. All of these factors combine to make the cryptocurrency market one of the most dynamic and challenging investment markets today.
Unbalanced capital inflows have led to a distorted cryptocurrency market structure.
Currently, there are four broad categories of participants in the crypto space: retail investors, crypto trading firms/hedge funds, large enterprises (such as Tesla, Tether, and MicroStrategy, etc.), and venture capitalists (VCs).
Many retail investors do not conduct serious research and analysis when investing in cryptocurrencies. This is why we see “meme coins” and cryptocurrencies that have not lived up to expectations still trading in the top 10 by market cap.
Crypto hedge funds/trading firms are often focused on trading short-term market volatility and tend to amplify that momentum. Large players have yet to get involved outside of Bitcoin, and even there, their involvement has been sporadic.
Finally, there are VCs. In recent years, most institutional capital has entered the crypto field through VCs, which can be proved by the number of super financings completed by native digital currencies and traditional VCs. Between 2021 and 2022, VCs have invested $37.7 billion and $31 billion in crypto startups, far higher than the total amount of previous years.
Source: The Block Research
In contrast, there are very few structural buyers in the cryptocurrency market, as long-term institutional capital has largely flowed to venture capital. This problem is not limited to cryptocurrencies. The long-term participation of market participants from other sectors fluctuates with market conditions.
While some VCs have some flexibility to invest directly in liquid cryptocurrencies, they typically focus on primary market transactions in startups due to their expertise and the structure of their VC funds. Even when they do invest in liquid cryptocurrencies, they typically do so on a case-by-case basis and rarely actively manage matters related to the latest fundamentals. They also rarely increase their investment in invested projects, even though the price may be lower than their purchase price and product-market fit is further verified.
Distorted market structure provides huge opportunities
For investors who are willing and know how to navigate the liquid cryptocurrency markets, this dislocation in market structure is a huge opportunity to create outperforming risk-adjusted returns. Although this concept has been succinctly explained 6 years ago by Kyle and Tushar of Multicoin Capital, it still holds true today. Most cryptocurrencies are now essentially liquid venture investments, and with the exception of Bitcoin, due to the early stages of the space, most cryptocurrencies are young, less than five years old, and have the same characteristics of high potential returns and fat-tailed distributions.
For the most capital constrained investors, investing in cryptocurrencies now using a liquidity VC approach will generate the best risk-adjusted returns given the dynamic nature of the space. This approach allows investors to earn venture-like returns while being able to manage the investment as an asset with public market liquidity. There are many examples where the majority of returns for these cryptocurrencies came from liquid markets following a token generation event (TGE). This is important because cryptocurrency networks also exhibit characteristics of power-law distributions, where market leaders can continue to lead and dominate, as shown by the large technology companies’ share of total U.S. stock market capitalization.
Source: CoinGecko, ICODrops as of March 27, 2023
As liquidity venture capital cryptocurrency investors, they are able to adjust position size and manage investment risk based on real-time changes in fundamentals, so they do not need to "randomly sweep" hundreds of bets, hoping that a few of them will achieve 50x to 100x returns to make up for the underperforming parts of the portfolio. Instead, they can focus their investments on 10 to 20 more likely and confident targets, thereby generating superior risk-adjusted returns.
This strategy also allows investors to better manage their investment risk, as they can wait for the protocol/product associated with a particular cryptocurrency to gain more market validation before increasing their investment, or reduce their investment if the cryptocurrency fails to live up to initial expectations. This approach allows investors to adjust their investment in a particular cryptocurrency based on the degree of market validation, thereby better managing risk.
Kai Wu of Sparkline Capital put it best:
Investing in early-stage innovations has very high implied volatility. Due to power-law distributions, the range of outcomes for start-ups is very wide. Crypto tokens allow us to directly observe this volatility, with annualized volatility often reaching 100%.
Therefore, investing in innovation should place particular emphasis on liquidity. Technological trends can shift suddenly, and the best startup today may not be the best tomorrow. Liquidity allows investors to make course corrections in a rapidly changing environment. ”
Efficient and liquid crypto markets require active fundamental investors
For the wider crypto ecosystem, liquidity VC investors can play a key role in building a strong co-ownership culture for Web3, where token economics and governance align the incentives of product users, startups, and investors. For example, the funding and liquidity support provided by investors can help solve the cold start problem of DeFi protocols and put them on the path to product adoption. These investors can also play a substantive role in protocol development, such as actively participating in governance and providing input and suggestions on the strategic direction of the protocol/product. They can actively contribute to the development and maturity of the entire ecosystem.
Finally, the increase in fundamentally focused liquid venture capital investors will help improve market efficiency in the cryptocurrency public market, help cryptocurrencies achieve their fair value, and become a balancing force to offset the excess supply brought about by private round venture capital unlocking. This will help reduce market uncertainty and drive the cryptocurrency market towards a healthier and more mature direction.
Inspiration:
https://multicoin.capital/2017/08/15/venture-capital-economics-with-public-market-liquidity/
https://every.to/napkin-math/venture-capital-is-ripe-for-disruption
https://www.sparklinecapital.com/post/liquid-venture-capital
IMPORTANT NOTICE: This document is for informational purposes only. The views expressed in this document should not be considered investment advice or recommendations. Persons receiving this document should conduct their own due diligence before investing, taking into account their specific financial situation, investment objectives and risk tolerance (which are not considered in this document). This document does not constitute an offer or solicitation for any of the assets mentioned.
