Pantera Capital: Three Emerging Catalysts in Crypto
Original title: Emerging Catalysts in Crypto
Original author: Cosmo Jiang, Erik Lowe, Matt Stephenson
Original source: panteracapital
Original compilation: Kate, Marsbit
This article is written by three authors and discusses three aspects: the light at the end of the Bitcoin-ETF tunnel, the maturity of the crypto industry and stocks, and digital property rights and scarcity.
Light at the end of the “Bitcoin-ETF” tunnel
By Cosmo Jiang, Portfolio Manager and Erik Lowe, Head of Content
Over the past few months, there have been some positive developments in the crypto regulatory environment in the United States. In our previous blockchain letter, we wrote about the three-year-old lawsuit between the U.S. Securities and Exchange Commission (SEC) and Ripple Labs, in which the District Court for the Southern District of New York ruled that XRP was not a security. We call it a “positive black swan” and almost no one expected it.
Cryptocurrencies recently scored another unexpected victory. On August 29, a U.S. appeals court ruled in favor of Grayscale in its lawsuit against the U.S. Securities and Exchange Commission after its application for a spot Bitcoin ETF was rejected last year. We believe this significantly increases the chances of Bitcoin ETF applications from BlackRock, Fidelity and others being approved.
While the United States appears to be lagging behind much of the world in embracing digital assets, many countries have taken equally or even tougher measures against cryptocurrencies. But the saving grace of the United States is that it has a court system committed to procedural due process, ensuring there is a path to redress when boundaries are exceeded.
Rejection of Grayscales motion is arbitrary and capricious because the Commission fails to explain its disparate treatment of similar products. Accordingly, we grant Grayscales request and vacate the injunction. - Court by Circuit Judge RAO Submitted comments
We have been emphasizing the need for trustless systems. In our industry, this means that users can rely on blockchain-based architectures to perform fairly and as designed. Our ability to rely on the U.S. court system to do the same may help shape a promising regulatory environment for cryptocurrencies in the future, allowing further innovation to occur within the United States.
We’ve been discussing the possibility of a spot Bitcoin ETF, but now we see some light at the end of the tunnel.
Grayscale vs SEC Key Takeaways
Ruling: The D.C. Court of Appeals ordered that the SEC’s order denying the conversion of Grayscale’s Bitcoin ETF be vacated.
- The rejection of Grayscale’s proposal to convert to an ETF was “arbitrary and capricious” because the SEC failed to explain its disparate treatment of similar products (approval of a Bitcoin futures ETP vs. rejection of a Bitcoin spot ETP).
- It was a unanimous 3-0 decision by the three-judge panel, a resounding verdict rather than the split decision expected.
- NOTE: Federal Circuit courts rarely find that an agency violated the Administrative Procedure Act.
The heart of the argument:
- Grayscale believes that the CME’s regulatory arrangements for Bitcoin futures ETFs should also satisfy Grayscale’s spot ETFs, as both products rely on Bitcoin’s underlying price.
- However, the SEC concluded that Grayscale lacked data to determine whether CMEs futures regulatory protocols could also detect potential manipulation in the spot market.
The court summarized its argument and its decision in two points:
- The SEC itself stated that while approving a Bitcoin futures ETP, fraud in the spot or futures market could be detected through the supervision of the CME futures market.
- The SEC’s denial based on a “significant market test” lacked a reasonable and coherent explanation.
- The court held that the correlation between futures prices and spot prices is as high as 99.9%, so fraud in the spot market will be reflected in the futures market.
Timeline: Both sides have 45 days to appeal the ruling, and the SEC could still find other avenues to reject the Bitcoin spot ETF application.
- The SEC could appeal to the full bench of the U.S. District Court, or to the Supreme Court, but this is unlikely because the case is not that important from a legal perspective (even if it was for this particular industry Very important).
- Grayscale has previously announced that it intends to seek an ETF conversion following its court victory, which is likely to proceed beyond the appeal period.
- The mid-October appeal timing also coincides with the SEC’s deadline to respond to all other Bitcoin spot ETF applications.
you canits hereRead the courts decision.
Crypto Industry Similar to Stocks Maturity
By Cosmo Jiang, Portfolio Manager
Today, the maturity of the digital asset space may resemble an inflection point in the maturity of the stock industry.
Tokens are a new form of capital formation, and they may replace equity in an entire generation of businesses. That means many companies shares may never be listed on the New York Stock Exchange. Instead, they will only own one token. This is how businesses align incentives with management teams, employees, token holders and (unique digital assets) potentially other stakeholders such as customers.
There are approximately 300 publicly traded liquid tokens with a market cap of over $100 million. This investable universe is expected to expand over time as the industry expands. There are a growing number of protocols with product use cases, revenue models and strong foundations. Just two or three years ago, apps like Lido or GMX didnt exist. It seems to us that a significant source of alpha generation may come from filtering ideas out of this vast universe, because just like in stocks not all stocks are created equal, not all tokens are created equal.
Pantera focuses on finding agreements with product-market fit, a strong management team and a path to attractive and defensible unit economics, and believes this is a generally overlooked strategy. We believe we are at an inflection point in this asset class – where traditional, more fundamental frameworks will be applied to digital asset investments.
In many ways, this is similar to major turns in the evolution of stock markets over time. For example, fundamental value investing is taken for granted today, but it didnt become popular until the 1960s when Warren Buffett launched his first hedge fund. He was an early pioneer and practitioner in applying the lessons of Benjamin Graham, who created the long/short stock hedge fund industry as we know it today.
Cryptocurrency investing is also similar to emerging market investing in the 2000s. It faced much of the same criticism as the Chinese stock market at the time, when there were concerns that many companies were small in an irrational stock market driven by retail investors. You dont know if the management team is misleading investors or misappropriating funds. While there is some truth to all of this, there are also many high-quality companies with strong long-term growth prospects that make excellent investment opportunities. If you are a discerning, fundamentals-driven investor who is willing to venture overseas, take risks and work hard to find those good ideas, you can achieve incredible investing success.
The main point of our paper is that digital asset prices will increasingly be traded on fundamentals. We believe that the same rules that apply to traditional finance apply here. There are now many protocols with real revenue and product-market fit that attract loyal customers. Now, more and more investors are starting from fundamentals and using traditional valuation frameworks to price these assets.
Even data service providers are starting to look a lot like the traditional financial industry. But instead of Bloomberg and M-Science, they are Etherscan, Dune, Token Terminal and Artemis. In fact, their purpose is the same: to track the companys key performance indicators, income statements, management team actions and changes, etc.
We believe that as the industry matures, the next trillion dollars entering this space will come from institutional asset allocators trained in these fundamental valuation techniques. By investing within these frameworks, we believe we are already ahead of this long-term trend.
Fundamentals-Based Investment Process
The process of investing in digital assets based on fundamentals is similar to that of investing in traditional stocks. For investors in traditional asset classes, this may come as a surprise and an important misconception.
The first step is to do basic due diligence—answering the same questions we ask when analyzing a public stock. Does the product meet market demand? What is the total addressable market (TAM)? What is the market structure? Who are the competitors and what differentiates them?
Second is business quality. Does this business have a competitive moat? Does it have pricing power? Who are their customers? Are they sticky or do they drain quickly?
Unit economics and value capture are also very important. While we are growth investors with a long-term investment horizon, ultimately cash is king and we want to invest in sustainable businesses that can ultimately return capital to their token holders. This requires sustainable profitable unit economics and value capture.
The next level in our due diligence process is to examine the management team. We care about the management team’s background, track record, incentives, and what their strategy and product roadmap is. What is their plan to go public? What strategic partnerships do they have? What is their distribution strategy?
The first step is to gather all basic due diligence information for each investable opportunity. Ultimately, we built financial models and investment memos for all core positions.
The second step is to translate this information into asset selection and portfolio construction. For many of our positions, we have a multi-year three-statement model with capital structure and forecasts. The models we create and the memos we write are at the core of our process-driven investment framework, which allows us to have the knowledge and foresight to select investment opportunities and adjust position sizing based on event path catalysts, risk/reward and valuation.
After making an investment decision, the third step is to continuously monitor our investments. We have a systematic process of collecting and analyzing data to track key performance indicators. For example, for Uniswap, the decentralized exchange we invest in, we actively extract on-chain data from our data warehouse to monitor trading volumes on Uniswap and its competitors.
In addition to monitoring these KPIs, we also strive to maintain a dialogue with the management teams of these protocols. We find it important to conduct on-the-ground research with management teams, their customers, and various competitors. As an established investor in this space, we are also able to leverage Panteras wider network and connections to the community. We see ourselves as a partner and are committed to adding value where we can help management teams and contribute to the development of these protocols, particularly in areas such as reporting, capital allocation or management best practices.
Fundamentals-Based Investment Practice: ARBITRUM
The main criticism of Ethereum is that transactions on the base layer can be slow and expensive during periods of high activity. While the roadmap for creating scalable platforms has been controversial, Layer 2 like Arbitrum is becoming a viable solution.
Arbitrum’s key value proposition is simple: transactions are faster and cheaper. It delivers transactions 40 times faster and 20 times cheaper than Ethereum, while being able to deploy the same applications and with the same security as Ethereum transactions. As a result, Arbitrum has found product market fit and is showing strong growth, both on an absolute basis and relative to its peers.
For an investor focused on fundamentals, looking for evidence of growth in a protocol with fundamental traction, Arbitrum would be near the top. It is one of the fastest growing Layer 2s on Ethereum and has captured a sizeable share of the trading market over the past year.
To delve deeper into that last point, Arbitrum is one of the few blockchains to see volume growth so far throughout the bear market, while overall usage has been weak throughout this period. In fact, when you break down the data, you find that within Ethereum and all other layer 2s, Arbitrum actually contributed to 100% of the incremental growth of the Ethereum ecosystem this year. Arbitrum is a huge share taker in the Ethereum ecosystem, and Ethereum itself is a huge share taker in all of crypto.
Arbitrum’s cyber flywheel is turning. Based on our fieldwork, it’s clear that developers are attracted to Arbitrum’s growing usage and user base. This is a positive web flywheel: more users means more developers interested in creating new applications on Arbitrum, which in turn attracts more users. But as fundamental value investors, we have to ask ourselves, do these activities matter unless there is a way to monetize them?
Answering this question is why we think this is a good fundamental investment opportunity - Arbitrum is a profitable protocol with multiple potential catalysts.
Many casual investors in this space may not be aware that there are some protocols that can actually generate profits. Arbitrum generates revenue by charging transaction fees on its network, batching those transactions, and then paying a fee to the Ethereum base layer to publish this large merged transaction. Arbitrum collects this fee when a user spends 20 cents on a transaction. They then bundle these transactions in large chunks and publish them to Ethereum Layer 1, paying a fee of about 10 cents per transaction. This simple math means that Arbitrums gross profit per trade is about 10 cents.
Weve identified a protocol that has found product market fit and has reasonable unit economics, which ultimately leads us to believe the valuation is reasonable.
Key operating indicators achieved growth
The following diagrams illustrate some basic principles.
Since launch, active users have grown quarter-over-quarter, with nearly 90 million transactions per quarter. Second-quarter revenue was $23 million and gross profit was nearly $5 million, or $20 million annualized. These are some of the key KPIs we can track and verify on a daily basis on the blockchain to monitor whether Arbitrum is consistent with our investment thesis and financial forecasts.
Today, there are an average of 2.5 million users per month, each making an average of 11 transactions per month, and approximately 350 million transactions per year. According to these figures, Arbitrum has annual revenue of nearly $100 million and normalized gross profits of about $50 million. All of a sudden, it became a very interesting thing.
A key part of our research process is following the entire Ethereum technology roadmap in terms of catalysts and what makes it a timely investment. The next big step is the upgrade to EIP-4844, which will effectively reduce the transaction costs of rollups like Arbitrum. Arbitrums main cost, which is transaction costs of 10 cents per trade, could be reduced by 90% to 1 cent per trade. At that point, Arbitrum will have two options. They can give the savings to users to further accelerate user adoption, or they can use the savings as profit, or a combination of both. Either way, we expect this to be a material catalyst for increased adoption and profitability of Arbitrum.
Valuation awareness is an important component of fundamental investing. Arbitrum currently has a market capitalization of $5 billion in shares outstanding. In our opinion, this is quite attractive relative to some other Layer 1 and Layer 2 protocols trading at similar market caps, but its usage, revenue and profits are only a fraction of Arbitrums.
From a growth perspective, we believe Arbitrum will surpass 1 billion trades next year, with profits of 10 cents per trade. That equates to earnings of about $100 million, meaning that, at a market cap of $5 billion, the company is valued at roughly 50 times expected earnings. That looks expensive in absolute terms, but in our view its reasonable for an asset thats still growing at triple digits. Compared to real-world business valuations, if you look at well-known software companies with double-digit revenue growth, like Shopify, ServiceNow, or CrowdStrike, their average P/E multiples are around 50 times, and theyre growing at the same rate Much lower than Arbitrum.
Arbitrum is a protocol that has product-market fit, is growing very quickly (on an absolute basis and relative to the industry), is demonstrably profitable, and has a strong position relative to its own growth, other crypto assets, and other assets in traditional finance. The transaction valuation is reasonable. We will continue to pay close attention to these fundamentals and hope that our paper will make a difference.
Macrocatalyst
There are some macro catalysts on the horizon that could have a meaningful impact on digital asset markets.
While institutional investor interest has waned over the past year, we are keeping a close eye on future events that could spark renewed investor interest. Most notably, a Bitcoin spot ETF could be approved. In particular, BlackRocks IPO is significant for two reasons. First, as the worlds largest asset manager, BlackRock is subject to intense scrutiny and makes decisions only after careful consideration. Even amid regulatory fog and the current market environment, BlackRock has chosen to double down on its investment in the digital asset industry. We believe this is a signal to investors that cryptocurrencies are a legitimate asset class with a durable future. Second, we believe ETFs will increase access to and demand for the asset class faster than most expect. It was recently reported that the U.S. Court of Appeals ruled in favor of Grayscale in last year’s lawsuit against the U.S. Securities and Exchange Commission’s rejection of Grayscale’s spot Bitcoin ETF application. We believe this significantly increases the chances of Bitcoin ETF applications from BlackRock, Fidelity and others being approved, possibly as early as mid-October.
While the regulatory environment is starting to become clearer, it may still be the biggest factor holding back the market, especially for the prices of long-tail tokens. In some respects, the tide appears to be turning against the SEC as courts begin to push back against the SEC’s “enforcement regulatory” actions. In addition to the news about the Grayscale spot Bitcoin ETF, the court sided with Ripple in its case against the SEC, which is positive for the interpretation of the digital asset as not being a security. This is a big deal because it shows that regulation around digital assets can and should be more nuanced. Regulatory clarity is important, not only to protect consumers, but also for entrepreneurs who need the right framework and guidance to feel confident creating new applications and unlocking innovation.
Finally, cryptocurrencies are in what we call their “dial-up broadband moment.” In previous letters, we mentioned that cryptocurrencies are in some ways very similar to the internet of 20 years ago. Scaling solutions for Ethereum such as Arbitrum or Optimism are making huge progress and we are seeing transaction speeds increase at lower costs and the functionality that goes with them increases. Just like we couldnt imagine the breadth of internet business that would be created when internet speeds accelerated from dial-up to broadband, we think the same thing will happen with cryptocurrencies. In our view, we have yet to see the proliferation of new use cases enabled by the dramatic improvements in blockchain infrastructure and speed.
Digital property rights and scarcity
Author: Matt Stephenson, Head of Cryptoeconomics
Digital scarcity is a powerful force. Facebook initially exploded by requiring users to sign up with an email address of Harvard.edu, Amazon uses digital rights management technology to sell e-books, and the iPhone dominates Gen Z because theres a stigma associated with using green text messages.
But this scarcity is essentially false: Apple can choose any color it wants for the text. Harvard may issue any number of email addresses. And Amazon’s e-books can’t be sold out.
True internet-native scarcity seems to have emerged with the advent of Bitcoin. Unlike the endless copying machine of the open Internet, and unlike the centralized strategic decision-making of Kindle e-book pricing, Bitcoin’s supply is closer to natural scarcity. This is a fact about the world, written into mutually shared code, and difficult to undo.
Create minimum feasible scarcity
In mathematical logic, there’s a phrase (one that’s sure to make you a hit at the dinner party) that describes the way blockchain creates digital scarcity: “entity abstraction.” Entity abstraction refers to the process of generating abstract properties from processes. For example, the way keratin moves coherently through space is thought to be like a woolen scarf.
The great strategist Thomas Schelling noted that enforcement and mutual perception can produce this process of abstraction. In the scarf example, physics provides us with execution, while our shared visual system manages mutual perception. But Schelling provides numerous examples, the most striking of which concern national borders. These borders are created through enforcement and mutual perception (via maps), and often seem real enough that its not surprising for people to do things like travel to the Four Corners, where the borders of four U.S. states intersect at right angles places so they could stand in four different states at the same time. These boundaries are enforced and mutually perceived, which makes them actually real.
Perhaps it’s not surprising that blockchains use these same mutual perception and execution properties to create scarcity. The scarcity of your cryptocurrency is mutually perceived on an open digital ledger, and the rules governing its use are reliably enforced by the protocol. Therefore, scarcity is real.
Digital scarcity gives rise to digital property rights
How blockchain creates mutual awareness is intuitive enough: there is an open digital ledger. This is similar to Schellings map example. Blockchain also promises enforcement, but note that this is often a special kind of enforcement: enforcement of property rights.
The two pillars of property rights are exclusivity and transferability. That is, you can exclude others from the cryptocurrency you own, and you can alienate yourself by selling, transferring, or burning it. These two aspects of property rights loom out above other conferred property rights. Note also that in economics these are not legal concepts per se - they may just as well arise out of cooperative action.
In a blockchain environment, these “cooperative behaviors” are non-legal agreement rules. These rules are largely maintained because they require large-scale coordinated efforts (such as 51% attacks) to change.
The reversal of the Web2 business model
Blockchains enforcement of scarcity is trustworthy because the cost of violating protocol rules is very high in a blockchain environment. This is a large-scale coordination problem, essentially the same large-scale coordination problem that Web2 uses against us. But as Vitalik Buterin describes the goal of cryptoeconomics, it is to create and maintain “the security and vitality of complex systems of coordination and collaboration.”
That is, the Web2 business model uses network defenses to trick users, while encryption uses it to solidify ideal rules. Web2 users who wanted to log out of the Web2 social media platform faced a huge coordination problem because they had to get all their friends to log out as well, preferably at the same time. Web3 users can simply fork the protocol because we have enabled this forking capability.
The utopians of the early internet believed that ignoring scarcity could create abundance. In the vacuum they left, predatory Web2 business models emerged that sought to trick users, herding them into a loop and making them watch ads. But it has been exploiting scarcity to create abundance. For the first time in the digital realm, we have it.
