The Snowball Crypto Thesis | (Part II) Down the crypto rabbit hole

Updated: Aug 1


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Key Points


  • There are multiple crypto use cases outside of Bitcoin aiming to solve different problems in various verticals


  • DeFi could serve as an alternative financial system for users to engage in transactions like borrowing, lending and trading in an open, permissionless manner


  • Decentralised gaming could spur robust virtual economies built on interoperable standards


  • Innovations around NFTs and content platforms could help digital artists better monetise their skillset


  • It is important to grasp the value accrual mechanisms of various crypto-assets since they are designed to fulfil vastly different economic functions

It starts with bitcoin


In Part I of The Snowball Crypto Thesis, I laid out the case for how the recent macro conditions of easy monetary policy and asset price inflation have strengthened bitcoin's digital gold narrative. With increased retail, corporate and institutional support, the probability of wider bitcoin adoption should increase. That being said, this should not be crypto's end game.


Moving further out on the risk curve


Once investors wrap their heads around Bitcoin and get comfortable with the underlying blockchain technology, my guess is that they would be more willing to explore other crypto projects further out the risk curve in search of the next risk-adjusted bet.


Bitcoin's underlying blockchain technology has spawned other blockchain networks like Ethereum and Solana which support smart contracts, enabling innovation in other verticals and use cases aside from stores of value and payment networks. In fact, various crypto protocols are already demonstrating product-market fit and real-world adoption.


In light of this dynamic, I believe that the dominant use case of crypto is unlikely to be merely a macro hedge. Instead, a non-zero allocation to bitcoin could be a gateway to discovering arguably more important use cases of crypto, which would widen one's investment universe.


In the following sections, I will detail three verticals where the use of crypto networks have gained traction.


Decentralised Finance- An alternative financial system


Smart contracts have enabled a parallel financial system to emerge in the crypto world - a segment known as decentralised finance or DeFi. The total value locked (TVL) in DeFi applications has reached a respectable US$67b as of writing.



In traditional financial systems, transactions like payments, borrowing, lending and trading are done via centralised intermediaries like banks, exchanges and clearinghouses. In DeFi, the execution of direct transactions are facilitated by smart contracts, lines of code that represent rules that transacting parties have to abide by.


Crypto investment firm Pantera Capital points out that there are five primitives to any financial system, as shown below:


Source: Pantera Capital


On the Ethereum network alone, many live projects have been developed to take up the role of these primitives, effectively forming a composable financial system on the blockchain.

  • Unit of Account - DAI, USDT, USDC

  • Exchanges - UniSwap, SushiSwap, ParaSwap

  • Lending and Issuance - Compound, Aave, Maker

  • Margin & Leverage - dYdX, Perpetual Protocol, Alpha Finance


Source: Yearn Finance


All of these primitives work together in an interoperable fashion, which allows investments to be more capital efficient and convenient. For instance, one can deposit capital into the yield aggregation protocol Yearn Finance to earn interest on their crypto-assets. On the back end, Yearn's code directs the capital to various lending protocols like Compound and Aave to earn interest. The protocol would also rebalance the funds such that the depositor earns the optimal interest at all times across various whitelisted lending platforms There are also other strategies in place which take advantage of liquidity mining incentives of protocols like Curve to further boost yields.


This is almost like having an app that constantly helps depositors move around the funds in their POSB bank account to other banks like OCBC & UOB and various money market funds, such that they are always earning the maximum possible interest rates available on the market. As far as I know, such services do not exist in traditional finance.


While still nascent, this segment of crypto could act as a proof of concept for an open, permissionless financial system that runs 24/7. Over time, I believe DeFi could provide a better alternative to the traditional financial system, starting with verticals where intermediaries appropriate a significantly larger chunk of the value pie vis-a-vis consumers, such as in the case of savings/money markets and remittances.


Gaming - Virtual economies and the Metaverse


In the current state of gaming, players either purchase a video game (via physical disk or downloadable software) or engage in free-to-play games that monetise via ads or in-game items/downloadable content. Blockchain technology could turn current gaming business models on its head, granting gamers the ability to earn money while playing games.


Source: Axie Infinity


An example of this would be the case of a rural community in the Philippines making use of the play-to-earn Ethereum-based blockchain game Axie Infinity to support their daily needs in the wake of the economic downturn caused by the COVID-19 pandemic. The gameplay involves breeding, battling and trading digital pets called Axies, which are non-fungible tokens (NFTs) on the Ethereum blockchain. Gamers have to farm or purchase the in-game currency small-love potions (SLPs), which can be used to breed Axies. Gamers can then sell their Axie NFTs and SLPs on various marketplaces and exchanges.


The concept of virtual economies is not unheard of in the traditional gaming world, where gamers actively trade in-game items like wearables and avatars. Even during my childhood days of playing MMORPGs like MapleStory and RuneScape, my friends would buy in-game currencies like mesos and gold using real money such that they could be richer in their respective virtual worlds.


Decentralised games have the potential to build more robust virtual economies due to verifiable scarcity and true ownership of virtual assets. This prevents situations where game developers inflate the supply of in-demand virtual items, or if game development ceases, rendering all in-game possessions worthless. In addition, decentralised games cannot be shut down due to a single centralised location being compromised. Therefore, gamers could be more incentivised to engage with decentralised games if the gameplay and user experience match up with traditional games.


Source: OpenSea


Moreover, the interoperable nature of NFT in-game items could increase their utility and real-world value. For games built on Ethereum, in-game currencies and items are typically ERC-20/721/1155 tokens, which enables interoperability across different games on the same blockchain. For example, players could technically use the same virtual in-game wearable NFT across multiple games. The traditional gaming parallel would be using the same CS:GO skin in another game like Fortnite. Gamers would also be able to cash out their in-game currencies/assets by making use of marketplaces like OpenSea, or decentralised exchanges like UniSwap.


Source: BecauseXM, Ready Player One


COVID-19 has accelerated our use of computer-generated virtual realities, ranging from interacting with friends and family via video conferencing software to millions of people attending a Travis Scott concert held in Fortnite's virtual world. By layering on the availability of interoperable standards and foundations of a virtual economy, the usage of blockchains in gaming could bring us closer to realising the concept of the Metaverse.


Creator Economy - Power to the people


NFTs have been all the hype recently. Earlier this year, digital artist Beeple dominated headlines for selling a piece of digital art as an NFT for US$69m at a Christie's auction.


While NFTs help digital artists better monetise their artwork, this has sparked debate on whether digital art should have any sort of value. I believe this is a moot point. Humans have traditionally assigned value to scarce pieces of art, regardless of their medium. This ranges from sculptures, drawings, paintings, books, photographs, and now to intangible media like JPEG files. Another common argument against NFTs would be that anyone can take a screenshot or make a copy of the digital file, which renders the original worthless. However, a well-skilled artist can technically make an exact replica of the Mona Lisa, but the replica is unlikely to accrue value. The key innovation unlocked here would be the verifiable scarcity of the NFT on the blockchain, which gives art collectors the piece of mind that they are owning an original piece, and hence allows value to accrue to it.


Other innovations around NFTs include the artist's ability to embed a royalty payment into future purchases of the artwork. This would allow artists to partake in any additional economic value created in the secondary market. Owners of valuable NFTs are also able to collateralise their digital assets using platforms like NFTFI and take out loans on that collateral value. This would allow for NFT owners to unlock liquidity on their art pieces, something that is already prevalent in the traditional art world.


Source: Audius


Besides art, the use of blockchains can help other content creators like musicians by reducing the value leakage associated with middlemen. For instance, according to a report by Citi, music artists only received 12% of total music revenue in 2017, due to costs associated with running distribution platforms like radio networks and record labels. Audius, a music streaming protocol running on the Solana blockchain, aims to solve this problem by potentially allowing artists to receive 90% of streaming revenue.


To be clear, NFTs and other tokens might go through multiple boom-bust cycles, similar to how the art market exhibits a cyclical behaviour. However, it is likely that the underlying blockchain technology should continue to thrive if projects and teams continue to innovate and create value for users.


From value creation to value accrual


The above examples barely scratch the surface of the different crypto use cases. There are many crypto projects aside from Bitcoin aiming to solve problems in different verticals. Some may succeed and most are likely to fail, but I am fairly certain that crypto is here to stay.


This leads to the topic of the investability of various crypto-assets. Just because a crypto-protocol/company/organisation creates value for users does not necessarily make them good investments. Some crypto-assets like Litecoin and Tron serve a utility function - users can use them to pay for transaction fees for using their networks to transact. Other crypto-assets such as Sushi and Luna resemble capital assets like equity - investors (stakers) are able to receive dividend-like cashflows that are proportional to the growth of the network.


It is therefore important to not generalise crypto-assets since different assets serve different economic functions. This is a topic that I will discuss in Part III of The Snowball Crypto Thesis.


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Thanks,


Bryan


Disclaimer: This article is not an investment (buy/hold/sell or otherwise) recommendation, this is only for educational and discussion purposes. This article is not tailored to the specific circumstances of any reader. I/we/The Snowball do/does not purport to be in the business of providing financial advice and the contents of the article should not be regarded as such.


Cover photo source: Mark Olsen


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