Posts from crypto

The Hinman Test

For most companies and projects in the crypto sector, a big issue has been how to design their token and how to get it in the hands of users, validators/miners, and investors. As Joel explained in this post, you need all three stakeholders to create a well functioning crypto-token.

There is the Bitcoin approach, which is to allow anyone to mine the protocol and earn tokens.

There is the Ethereum approach, which is to do a pre-sale.

And there are many other approaches. The last time I looked there were over 2,000 crypto-tokens that are trading on various exchanges around the world and many more that are not yet trading.

There are plenty of considerations when you design a crypto-token but certainly one of them is figuring out how to avoid having it deemed to be a security in the US. Securities are highly regulated in the US, can only be traded on regulated exchanges, come with significant disclosure requirements (many of which make no sense for an open source project), and there are limits to whom you can sell them to and how.

Most token projects and companies look at Bitcoin and Ethereum and say “we want to be like them.”

So when William Hinman, director of the SEC’s Division of Corporation Finance gave a speech at the Yahoo Finance All Markets Summit on June 14, 2018 suggesting that Bitcoin and Ethereum were not securities and laid out an argument that they were sufficiently decentralized, it got a lot of people’s attention in the crypto sector.

The basic reasoning behind the decentralization framework is that if a project is truly decentralized and there is no central actor or actors, then there really is no “issuer” and there is no possibility that the central actor(s) can act on insider information or otherwise have information asymmetry.

The crypto industry has been pressing the SEC to codify this logic in a set of rules that projects and companies can follow. But the SEC has to date been unwilling to do so.

So the Blockchain Association has stepped in and taken a stab at codifying the Hinman Test. In a post they published today, they have laid out the basic arguments of Hinman’s Framework and then outlined how one could determine if a token project was sufficiently decentralized.

This is not as helpful as an SEC published set of guidelines, but until we get that (soon I hope), this will have to suffice.

Stakeholders In A Cryptonetwork

Joel Monegro, who is one of the Partners at Placeholder and a former USV analyst, has written an important post that outlines the relationships between the three primary stakeholders in a cryptonetwork; users, miners/validators, and investors.

Joel calls it the Cryptoeconomic Circle, although it sure looks like a triangle to me 🙂

The most important “aha” that this post generated for me was the role of capital/investors in a cryptonetwork.

Maybe because I come from the world of venture capital, where the role of capital is to fund the cost of developing the technology and business, I had always seen the role of capital in a cryptonetwork similarly.

But as Joel points out in his post, that is one of two roles of capital in a cryptonetwork. The other role is to support and sustain the network by supplying financial capital to the validators who do the work in the system.

As Joel explains in his post:

There are short-term investors (traders), and long term investors (holders). Traders create liquidity for the token so miners can cover operational costs, while holders capitalize the network for growth by supporting token prices. The former is a direct form of value transfer where miners sell earned tokens in the open market to cover their costs and reinvest profits, and the latter is an indirect transfer of value that shows up in miners’ balance sheets rather than their income statements.

Like Joel’s post on Fat Protocols two and a half years ago, I think this will be an important post in helping people understand how these networks actually operate and exchange/capture value. As Joel says at the end of the post:

it helped me see cryptonetworks as systems for exchanging labor for capital (vs. currency), the fundamental concepts of network capital, and what the different roles are for investors like us in the development of these new economies

What Is Going To Happen In 2019

Hi Everyone. Happy 2019.

Today, as is my custom on the first day of the new year, I am going to take a stab at what the year ahead will bring. I find it useful to think about what we are in for. It helps me invest and advise the companies we are invested in. Like our investing, I will get some of these right, and some wrong. But having a point of view, a foundation, is very helpful when operating in a world that is full of uncertainty.

I believe and have been telling those around me that I think 2019 will be a “doozy.” I think we will see major dislocations in the leadership of the United States, a bear market in stocks, a weakening economy, a number of issues with the global economy including a messy Brexit and a sluggish China. All of this will lead to a more cautious stance by investors in the startup economy. And crypto will not be a safe haven for any of this although there will be signs of life in crypto land in 2019.

Let’s take each of those in the order that I mentioned them.

I believe that we will have a different President of the United States by the end of 2019. The catalyst for this change will be a devastating report issued by Robert Mueller that outlines a history of illegal activities by our President going back decades, including in his campaign for President.

The House will react to Mueller’s report by voting to impeach the President. Which will set up a trial in the Senate. That trial will go so badly for the President that he will, like Nixon before him, negotiate a resignation that will lead to him and those close to him being pardoned for all actions, and Mike Pence will become the President of the United States sometime in 2019.

I believe this drama will play out through most of 2019. I expect the Mueller report to be issued sometime in the late winter/early spring and I expect an impeachment vote by the House before the summer, leading to a trial in the Senate in the second half of the year.

The drama in Washington will have serious impacts to the economy in the United States starting with our capital markets.

The US equity capital markets enter 2019 on shaky ground. Though the last week of the year brought us a relief rally, the markets are dealing with higher rates, some early indications of a weaker economy in 2019 (possibly due to higher rates), and, of course, the potential for the drama in Washington that we’ve already discussed. Here is a chart of the S&P 500 over the last five years:

I expect the S&P 500 to visit 2,000 sometime in 2019 and then bounce around that bottom for much of the year. This would represent a decrease in the S&P’s trailing PE multiple to around 15x which feels like a bottom to me given the recent history of the equity markets in the US:

S&P PE Multiple (source http://www.multpl.com/)

Interest rates have been rising gradually in the US for the last three years. The Fed has taken its Fed Funds rate from essentially zero three years ago to almost 2.5% today:

Source: https://www.macrotrends.net/2015/fed-funds-rate-historical-chart

The rates that are available to consumers and businesses have followed and I expect that to continue in 2019. Here is a chart of the interest rates on the three most popular mortgage products in the US:

Source: https://www.amerisave.com/graphs/

When it gets more expensive to borrow, marginal projects don’t get funded. And what happens at the margin has a much larger impact on the economy than most people understand. No wonder the President wants to fire the Fed Chairman.

I expect the combination of higher rates, uncertainty in Washington, and storm clouds globally (which we will get to soon) will cause business leaders in the US to become more cautious on hiring and investment. Consumers will make essentially the same calculations. And that will lead to a weaker economy in the US in 2019.

The global picture is not much better. The eurozone is about to go through the most significant change in decades with some sort of departure of the UK from the EU (Brexit). It remains unclear exactly how this will happen, which in and of itself is creating a lot of uncertainty on the Continent. I don’t expect most businesses in Europe to do anything but play defense in 2019.

Probably the biggest unknown for the global economy is the resolution of the ongoing trade tensions between China and the US. It seems inevitable that China will make some concessions to the US to resolve these trade tensions. But, of course, what happens in Washington (first issue) may impact all of that. In the meantime, the uncertainty around trade and exports hangs over the Chinese economy. China’s GDP has been slowing in recent years as it achieved relative parity with the US and the Eurozone:

Source: https://tradingeconomics.com/china/gdp

Any significant trade concessions from China could impact its growth prospects in 2019 and beyond, which will take the most powerful engine of global growth off the table this year.

So all of that is a pessimistic take on the broader macro environment in 2019. How will all of this impact the startup/tech economy?

The startup/tech economy is somewhat immune to macro trends. Many startups and big tech companies were able to grow and expand their businesses during the last financial downturn in 2008 and 2009. Some very important tech companies were even started in those years.

The tech/startup economy is driven first and foremost by technical and creative (ie business model) innovation. And that is not impacted by the macro environment.

So I expect that we will continue to see big tech invest and grow their businesses and do well in 2019. I expect we will see IPOs from big names like Uber/Lyft/Slack, although I also expect those deals will get priced well below the lofty expectations they have in mind right now. Some of that will be because of weak equity markets in the US, but it is also true that most of the IPOs in 2018 also priced below the lofty “going in” expectations of founders, managers, boards, and their bankers. The public markets have been much more sanguine about value than the late stage private markets for a long time now.

However, I do think a difficult macro business and political environment in the US will lead investors to take a more cautious stance in 2019. It would not surprise me to see total venture capital investments in 2019 decline from 2018. And I think we will see financings take longer, diligence on new investments actually occur, and valuations to come under pressure for even the most attractive opportunities.

But all of that is going to happen at the margin. I expect 2019 to be another solid year for the tech/startup sector as we are in a possibly century-long conversion from an industrial economy to an information economy and the tailwinds for tech/startup vs the rest of the economy remain in place and strong.

Any set of predictions for 2019 from me on this blog would not be complete without some thoughts on crypto. So here is where my head is at on that topic.

I think we are in the process of finding the bottom on the large, liquid, and lasting crypto-tokens. But I think that process could take much of 2019 to play out. I expect we will see some bullish runs, followed by selling pressures taking us back to retest the lows. I think this bottoming out process will end sometime in 2019 and we will slowly enter a new bullish phase in crypto.

I think the catalyst for the next bullish phase will come as the result of some of the many promises made in 2017 coming to fruition in 2019. Specifically, I think we will see some big name projects ship, like the Filecoin project from our portfolio company Protocol Labs, and the Algorand project from our portfolio company Algorand. I think we will see a number of “next gen” smart contract platforms ship and challenge Ethereum for leadership in this super important area of the crypto sector. I also expect the Ethereum open source community to ship a number of important improvements to its system in 2019 and defend their leadership in the smart contract space.

Other areas of crypto where I expect to see meaningful progress and consumer adoption happen in 2019 are stablecoins, NFT/cryptoassets/cryptogaming, and earn/spending opportunities, particularly in the developing world.

There will also be pressure on the crypto sector in 2019. The area I am most concerned about are actions brought by misguided regulators who will take aim at high quality projects and harm them. And we will continue to see all sorts of failures, from scams, hacks, failed projects, and losing investments be a drag on the sector. But that is always the case with a new emerging technology that allows anyone to set up shop and get going. Permissionless innovation produces the greatest gains over time but also comes with the inevitable bad actors and actions.

So that’s where my head is at on 2019. Do I sound pessimistic? I suspect I do, but I am not. I am incredibly optimistic, like my partner Albert and can’t wait to get going and make things happen in this new year. It is going to be a doozy.

A Conversation With Tushar Jain

USV is an investor in Multicoin Capital, one of the leading token funds. In late October I attended their Multicoin Summit and spent about 45mins on stage with Tushar Jain, one of the two managing partners at Multicoin.

It’s a pretty good wide ranging conversation about how we think about investing in crypto right now (although it is a couple months old now).

When Markets Overcorrect

When capital markets change direction, to the upside or to the downside, they often go too far before finding the right balance. When they overshoot to the downside, you can find some real values.

Back in the financial crisis of 2008, I was blogging about that as it related to the big tech stocks (Apple, Amazon, Google). The market hated everything and you could buy the big three tech franchises at crazy low prices as it related to their fundamentals (revenues, profits, cash flow, etc). And so I did and a lot of other people did too. And when the market came back in 2009 and beyond, those who bought at those bargain prices were rewarded.

So, it may be time to start thinking this way in crypto land. The reason I say “may” instead of “is” has to do with the fact that really bad bear markets take a while to find their footing and start moving up again. I worry that it will take crypto a while before it can make a move upward again. I wrote about that in this post a few weeks ago.

But nevertheless, I think it is time to at least start looking for fundamental value in crypto land. Ethereum is trading below $10bn. There are some traditional businesses in the crypto sector that are valued at almost that level. And if you believe in the fat protocols thesis, as I do, that gets my attention.

But there are more rigorous ways to think about fundamental value in crypto and one of the best known fundamental value thinkers in crypto is Chris Burniske, a partner in Placeholder, a crypto venture firm that USV is an investor in and I am an investor in too.

Chris posted a bunch of charts and analysis yesterday comparing Bitcoin and Ethereum to a bunch of measures of the fundamental value of their networks.

This chart from that post is the most telling in my view:

The green line is the use of gas to pay for smart contract execution on the Ethereum network. The blue line is the market cap of Ethereum. The growing gap between the green and blue lines represents, to me, the sign of market overshooting itself.

There remain some important fundamental questions about Ethereum so it is not like Apple, Google, and Amazon back in 2008. There is still existential risk in Ethereum. It could fail as a protocol and go to zero. So there are many reasons not to go all in on Ethereum right now.

But if you view Ethereum as a call option on the possibility that it will retain its role as the leading decentralized smart contract execution platform, then I think it is starting to look pretty compelling. And analysis like the work that Chris is doing is really helpful in determining things like that.

Centralization vs Decentralization

Decentralization is one of, if not the most, discussed features of the crypto tech stack. In a decentralized system, no single body controls the system. We have most certainly not reached the era fully decentralized systems, but that is what most of the world-class technologists working in the crypto sector are focused on getting us to and I believe we will get there in the not too distant future.

If you are a student of tech history, you will not be surprised that decentralization is also the right technology arriving at the right time to solve some of the most challenging policy problems facing the tech sector right now.

Before I elaborate on that, I want to show you a slide from my colleague Nick‘s deck on crypto that he uses to talk to policymakers and elected officials. I believe he borrowed it from our friends at Placeholder and they are credited at the bottom of this slide.

Here is my quick explanation of that slide.

IBM had a near monopoly on computing by virtue of their domination of the mainframe, mini-computer, and, it seemed, the PC computing platforms.

But the open PC hardware standard allowed Microsoft to develop an operating system that could run on any computer built to the PC hardware spec and they eventually unseated IBM, only to become a near monopoly themselves.

But just as we were wringing our hands about what to do about Microsoft’s monopoly, an open source operating system (Linux), the internet protocols, and the free distribution of the world wide web undid that monopoly and we got Google, Facebook, Amazon, and other big tech platforms.

And now we are wringing our hands about these near monopolies and their market power and the ability of bad actors to manipulate them. And around the same time, the technology to architect and scale a completely decentralized system emerges.

The other thing that is true of these moments of hand wringing is that just as the technology is emerging to unseat the near monopolies, regulators and elected officials try to put the genie back in the bottle using traditional regulatory techniques that often end up more deeply entrenching these near monopolies.

To give you an example of how this might happen, I am going to suggest you all go read my partner Albert’s post from yesterday on Twitter and how one might approach addressing some of the vexing problems that platform is dealing with right now.

Albert points out that:

On the minus side the calls to treat Twitter as a traditional publisher are growing.

That is how elected officials and regulators often think. They look backwards to find a model of regulation that has worked in the past and try to apply it to a new thing. But as Albert explains:

The idea that there could or should be a single central institution, let alone a commercial company, which as a benevolent dictator resolves all of these issues to everyone’s satisfaction is a complete non-starter.

Instead he proposes a few ideas that are steeped in decentralization:

my preferred go to answer is to shift more power to the network participants by requiring Twitter (and other scaled services) to have an API. That would allow endusers to programmatically create the best version of Twitter and would also make it easier to simultaneously use Twitter and new decentralized alternatives.

And

Twitter should significantly expand the features that let individuals and groups manage the visibility for tweets for themselves. There are already useful features such as muting a conversation or blocking an individual. These could be expanded in ways that allow for delegation. For instance, users should be able to say that they want to subscribe to mute and block lists from other individuals, groups or organizations they trust. One example of this might be that I could choose to automatically block anyone who is blocked by more than x% of the people I follow (where I can choose x). Ideally these features could be implemented at the tweet/conversation level and not just the account level.

So you can see that by decentralizing the power to the edges of the network INSTEAD of further concentrating it by requiring the network owner to further centralize power is the right answer, both from a technology perspective and a regulatory/policy perspective.

Sadly, I think we are in a race with ourselves in this centralization vs decentralization debate. We need the decentralized tech stack to evolve more quickly and show the world how decentralized technology works in a mainstream way at scale before policy makers and regulators force the tech sector to go the wrong way.

And, most disturbingly, the regulators and elected officials are taking actions, well intended of course, to slow the decentralized sector down, not speed it up.

Which is why we at USV have been spending a lot of time with public servants of all kinds, educating them, imploring them, and desperately trying to get them to understand where we are, why it is an important moment, and why we need to this new technology to succeed.

Video Of The Week: The Sorkin-Clayton Interview

One of the big issues facing the crypto sector is the regulatory question, both in the US, where it looms largest, and elsewhere around the world. In the last few weeks we have seen the SEC reach settlements with several crypto projects and decentralized exchanges, all of which were the subject of enforcement actions or threatened enforcement actions. As I alluded to in this post last week, I fully expect to see the SEC continue to look hard at the crypto sector in an effort to rein in what it sees as violations of its rules on the offering and sale and trading of securities.

In the wake of all that, The New York Times hosted an event last week in which Andrew Ross Sorkin interviewed SEC Chairman Jay Clayton. 

This is a recording of that interview. The conversation is about an hour long. You can/should fast forward to 11 1/2 minutes in to bypass all the introductions.

What Bear Markets Look Like

It’s hard to look at the price charts of the big crypto assets and not cringe. 

But it helps to look back to an earlier time, when a new sector was emerging, and understand what can happen.

Amazon peaked in the Internet bubble in late 1999 at around $90/share.

Almost two years later, at the trough, you could briefly buy Amazon at $6/share.

And then it took until late 2007 for Amazon to trade above the highs it reached in 1999.

But of course, all of this is ancient history and if you look at Amazon’s chart today, all of that turbulence is hardly even visible.

But for those of us who were investing in tech and tech startups back in 1999-2002, that time will forever be etched in our minds. It was a brutal period during which our belief in the Internet and its potential was sorely tested. Many friends and colleagues left the sector and never returned.

So while crypto asset prices are down 80-95% in USD terms over the last year, they could and probably will go lower. Amazon was down 80% a year into the post-bubble bear market and it got cut in half again before it made a bottom almost two years after it peaked.

What we have yet to see in crypto land is when they kick you when you are down. And that is certainly coming. Regulators came after the Internet sector in a big way post the bubble and that seems likely to happen in the crypto sector too.

And most everyone in big companies wrote the Internet sector off, cancelling their Internet efforts as a fool’s errand. That seems likely to happen in crypto too.

And many talented people left the sector. That seems likely to happen in crypto as well.

But those who stayed were rewarded, although it took a long time for that to happen. We didn’t see meaningful paydays in the Internet sector until the 2007-2008 period and the big paydays didn’t start coming until 2010 and beyond.

The thing to look for in the downturn is signs of life. There were little projects that turned into big ones. Blogger was started in late 1999, almost shut down many times in the next few years, and was picked up by Google in 2003. Myspace, LinkedIn, and Facebook all emerged in the 2002-2004 period, as the Internet was finally coming to life again.

So that is my framework for thinking about where we are with crypto and where we are going.

I think some crypto asset (and possibly a number of crypto assets) will have a price chart like Amazon’s current one in 18 years. But we will have to do what Amazon did, hunker down and build value and survive, for quite a while to get there. And I think things will get worse before they get better.

Bleeding

The Nasdaq is down almost 15% from its labor day highs.

Apple is down almost 25% in the last two months.

Facebook is down about 40% since July.

Bitcoin is down about 80% from its highs last December.

Ethereum is down about 90% from its highs in January.

All of those are examples of bleeding, if you happen to own any of them.

So what do you do?

Close out your position?

Buy the dip?

Sit on your hands?

It all depends on your fundamental views on these various investments.

Here are mine.

Apple is the easiest one for me. They aren’t going anywhere, although growth is slowing as they are close to saturating the high end of the mobile phone market. It will be a value stock at $120/share. If it gets there, load up on it.

Facebook is harder. They own some incredible assets like Instagram but the outlook there is cloudier given likely regulation and it won’t be a value stock for another $100 of losses. 

The Nasdaq is even harder. Are we in a bear market now? Or just a painful correction? A bull market that is almost ten years old feels long in the tooth and I can see the arguments for a bear market more clearly than a correction.

Bitcoin will form a bottom at some point and is a buy when it does. But where is that bottom? Probably not $4500.

Ethereum feels like the easiest one to make a bull case for right now. It is hated. Everyone has lost their shirt on it by now. Nobody other than developers want to know about it. It feels like time to start nibbling on it but not loading up on it.

But the thing to understand more broadly about what is going on right now is that big sophisticated investors are reducing their risk exposure across all asset classes and have been doing that for some time. The pace of the “risk off” trade is accelerating. Which means a flight to safety is going on. And when that is happening, you really need conviction to be buying.