There’s value in crypto, especially layer 1, even if regulators and politicians don’t see it |
April 5, 2023
Insights and analysis for the professional investor
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Welcome to Crypto Long & Short!
This week, Glenn Williams Jr. talks about the purpose of crypto, something politicians and regulators appear to be ignoring as they squeeze the industry.
Then, Sandy Kaul of Franklin Templeton discusses “experiential” tokens and how they can upend the historical relationship between companies and their customers.
Crypto Investors: Why You Need to Understand Layer 1 Protocols
As we discussed last week, the first quarter was a great time for cryptocurrency prices, but a terrible time for sentiment about the industry. I’d like to expound on the latter point, given that crypto is clearly in the crosshairs of regulators and politicians – including some who seem to not want this sector to exist at all.
But instead of critiquing the critics, I’d rather talk about what drew me into crypto, which is illustrative. My initial interest in 2018 was based on speculative interest, which may be dirty words to many. Why is speculation spoken of in the pejorative? I don’t know anyone who deploys capital with the expectation that it will decrease in value. If you are that person, feel free to just pass your asset on to me and I can hold onto it for you.
Intellectual curiosity, the desire to generate wealth and a goal to increase my knowledge of a nascent technology led me to bitcoin (BTC). In hindsight, though, it wasn’t just bitcoin. It was the concept of layer 1 blockchains, because ultimately that’s what we are accessing: space on a blockchain.
The value of a layer 1, or L1, network comes from people conducting peer-to-peer transactions with that blockchain. The native token of any given blockchain – BTC in the case of Bitcoin – acts as an incentive mechanism to get people to ensure that the data stored on the blockchain is secure and accurate.
The value is especially relevant in areas of the world where central bankers have caused local currencies to hyperinflate. One of the mistakes being made by U.S. lawmakers and regulators is looking at cryptocurrencies from a U.S.-centric perspective only.
It appears regulators don’t care about the functionality or reliability of blockchains, especially as some of the loudest opponents of crypto are in favor of central bank digital currencies – a type of digital currency issued by a central bank. The animosity feels more related to the decentralized nature of crypto – the ability to take fiat currency and exchange it for another asset of value, without the need for a central body (central banks, regulators, politicians, conventional banks, etc.).
Here are some of the larger layer 1 protocols and their recent performance:
(note: data for ALGO and SOL is from April of 2020. Data for AVAX is from 2021)
The performance runs the gamut from impressive to anything but, which is how it probably should be. On a technical level, BTC is correlated most to ether (ETH), the second-largest cryptocurrency after bitcoin, with its lowest correlation being to crypto exchange Binance’s BNB token.
What I find intriguing about layer 1s is the nuance that exists between them. As one L1 comes into existence, another attempts to improve upon it on the basis of speed, scalability, etc. For instance, I am admittedly anchored to Bitcoin. Its foundation as a peer-to-peer network gives it a first-mover advantage and the largest market share.
The ability to develop smart contracts on top of the Ethereum blockchain, where predetermined conditions are met and executed via code, is another facet that I find value in.
In many ways, crypto forces someone focused on assets and prices to level up on technology, while the tech-focused person is incentivized to get up to speed on market dynamics. The discipline of tech and the discipline of assets are pulled together, much in the way that code links tasks within a smart contract.
In my own experience, doing so caused me to uncover differences between blockchains. For example, Avalanche uses a “heterogeneous network of blockchains.” Rather than all applications occurring in one blockchain, Avalanche uses an Exchange (“X”) Chain, Platform (“P”) Chain and Contract (“C”) Chain. In doing so, the goal is to increase scalability and reduce fees, things the Ethereum blockchain has struggled with.
Asset ownership is important. It makes little to no sense to ignore a burgeoning technology, unless you want to be completely left behind. If people can engage in peer-to-peer transactions while having complete confidence in their accuracy, and not having to compensate a third party, they will do so.
L1s are at the base of the crypto economy and should be understood and be used as a base network for applications. And, yes, sometimes even used to generate a profit, as well.
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Institutional Outlook
Web3 Experiential Tokens and Asset Pricing
Web3 consumer engagement models are still developing and only just beginning to migrate into the real economy, but some hints of what the future of transaction and asset pricing may look like are beginning to emerge. To plot this trajectory, it is important to understand how Web3 consumer engagement will differ from the current Web2 world.
Today, exclusive access to transactional data is used to build and fuel network effects and is often also monetized through advertising. But Web3 lives on blockchains, where key transactional data is openly available. Incentivizing network effects in this realm may come down to encouraging the crowd to engage through strategies specifically designed to deliver emotional appeal.
Today, complex, multi-leg transactions require bespoke contracts and operational processes, people and systems to administer required activities. In Web3, smart contracts embed these contractual activities into a token and the terms self-execute when the right conditions are met. This is likely to reduce costs and enable more multi-leg transactions.
The ability to assign additional rights to a token-based transaction – such as the payout of royalties or community access or both – is likely to turn such transactions into “experiences” that have value beyond the initial purchase. “Experiential” tokens become assets that offer a dual purpose: They are both a key to access benefits and a financial instrument that can be valued in decentralized-finance transactions or in an investment portfolio.
Moreover, experiential tokens are transferrable. If the asset is sold, the rights and remaining value are reassigned to the new owner. Today, contracts would need to be renegotiated and redrawn to enable such a transfer. In Web3, the rights are reassigned as soon as the token moves from one to another wallet.
These attributes suggest the emergence of a new approach to valuation. As shown, we believe the value of an experiential token increases each time a more precise target audience is used to price the asset. Identification of the target audience can be done using blockchain transactional data.
(For illustrative purposes only. This chart represents Franklin Templeton’s view. There can be no assurance that these events or expectations will be realized. Actual results may be significantly different from that shown here.)
For example, in March 2022 two celebrity chefs dropped unique pizza-themed non-fungible tokens that offered digital art as well as access to a community connecting NFT owners with their favorite chefs through online Master classes and events – both virtual and in real life.The ongoing “value” of each NFT will be based on the perceived desirability and value of the art, community, classes and events that the token offers.
That value might look quite different if the token price were to be based on demand from the marketplace at large as compared to demand from a community of cooking enthusiasts, and potentially even higher if the audience valuing the token were specifically interested in the particular chefs.
Algorithms able to evaluate digital wallets and find addresses with a transaction history that aligns to desired attributes may be designed to advertise token sales and request bids and offers in an increasingly targeted manner. Valuations may be created through this type of solicitation process (request for quote) and perhaps even invitation-only auctions created to enable targeted exchange of NFTs.
Obtaining the highest potential valuation for a specific asset will be in the interest of institutional investors because this can help to increase the value of an institution’s broader set of related holdings. For example, the recent NFT sale of royalty rights to a famous singer’s song from 2015 raised slightly more than $60,000, but the success of the NFT drop may have helped to increase the value of the music catalog owned by the issuing platform.
While Web3 consumer engagement models are still in their infancy, we believe they have the potential to unlock incremental value and enable price discovery for creators and investors alike.
From CoinDesk’s Nick Baker, here’s some recent news worth reading:
THAT DOG: Sometimes crypto is about high-minded principles like breaking down barriers that keep many out of traditional banking or replacing obviously needlessly complex processes with more efficient smart contracts. And sometimes it’s about Elon Musk doing whatever he’s doing with dogecoin? That includes this week! Musk swapped out Twitter’s iconic bird logo for DOGE’s dog mascot, and DOGE’s price soared to a many-month high. This is not the kind of attention many in crypto want …
BITCOIN VIX: The VIX is well-known in traditional finance (TradFi) circles as a measure of the degree of fear in markets. In reality, it’s not exactly that; it simply reports what the implied volatility is for S&P 500 options. It doesn’t have to rise when worry is plentiful, though that is often what it does. There’s something resembling it in crypto: Deribit’s DVOL, which measures bitcoin’s implied volatility. It has soared this year while bitcoin has, too. Fear is not plentiful with BTC, and yet DVOL is up, flipping what’s expected of “fear gauges.” CoinDesk’s Omkar Godbole spoke with experts who think that’s made bitcoin call options more attractive than ever.
GETTING RICH: If you haven’t been paying attention to crypto prices but have been paying attention to what U.S. regulators are doing to the industry, you’d be forgiven for suspecting the prices of bitcoin and the rest of digital assets have been shooting straight toward zero. And yet they have not. Bitcoin has zoomed higher to start 2023, and the industry’s market capitalization has just hit a new high: $1.19 trillion, a level last seen in June. Markets can be weird.
AN EDITORIAL: CoinDesk generally doesn’t take a position on issues, preferring to cover the news straight and let readers decide what to think. We just made an exception, in an editorial written by Editor-in-Chief Kevin Reynolds. The U.S., he argues, is giving off vibes of being completely against crypto, which Reynolds argues risks sending a vital industry overseas without actually protecting investors.
To hear more analysis, click herefor CoinDesk’s “Markets Daily Crypto Roundup” podcast.
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