The Snowball Crypto Thesis | (Part IV) Liquid Venture Capital


Key Points


  • Crypto-assets have had high historical returns - 109% 8-year CAGR for BTC, 278% 6-year CAGR for ETH


  • Daily return distributions have fat tails with positive skew, signifying more homerun returns than negative outliers

  • Crypto-assets have displayed high volatility - ~80% annualised volatility for BTC, ~120% for ETH


  • Despite higher volatility, crypto-assets have superior historical risk-adjusted returns compared to other liquid assets - 1.37 6-year Sharpe ratio for BTC, 1.41 for ETH


  • Crypto-assets are bets on emerging technologies, which are likely driven by adoption and network effects, with returns and time horizons similar to VC investing

Crypto-Asset Risk-Return


The previous posts in our Crypto Thesis detailed the qualitative aspects of crypto-asset investments, ranging from the narratives driving bitcoin adoption, other crypto use cases, as well as value accrual and value capture mechanisms for different types of crypto-assets.


This post seeks to complement the previous articles by exploring various historical crypto risk-return metrics, focused on the two largest crypto-assets by market cap (BTC and ETH).

Crypto Returns


The crypto markets are known for mind-blowing returns given the high volatility and relatively small size of the nascent asset class. Over the past eight years, BTC has returned an average of 109% p.a., while ETH has returned 278% p.a. in the last six years. The returns alone were a big factor as to why I decided to dive deeper into these markets.


Thus, I thought it would be useful to examine the historical returns through a quantitative lens to see what exactly I was getting into.


Crypto Return Distribution


Over the past ~8 years, the bulk of BTC’s daily returns fell within the -7.5% to +7.5% range, with long tails on either side of the curve, signaling a relatively high tendency for outsized daily gains and losses.



Meanwhile, the magnitude of BTC’s daily returns has been tapering over time, likely due to base effects, driven by the increasing market cap. That said, large daily price spikes are still quite common in recent times.



ETH’s daily returns over the past six years are similarly distributed to bitcoin, albeit with most daily returns falling within the -5% to +5% range, with longer tails on either side of the curve. This may be because ETH is a relatively newer asset, with possibly less liquid markets which promote highly reflexive price movements.



Like BTC, I also observed how the magnitude of ETH’s daily returns have been narrowing over time as the market matures. Large daily price spikes are also still common for ETH.



Crypto Return Skew


BTC and ETH returns are mostly positively skewed on a 6-month rolling basis, signifying more extreme outliers on the right tail compared to the left tail.



Crypto Return Drivers


I have briefly covered the investment case for BTC in our first article, which concluded that I would not be too worried about the different narratives driving BTC, as long as they are successful in improving the adoption of the Bitcoin network. This is because the long-term value of the Bitcoin network should be linked to the number of people using the network. The logic here is simple – existing users will benefit from additional users being onboarded since they can now receive/transfer monetary value to these additional users.


The same logic should apply to ETH as well. Existing users of the Ethereum blockchain will benefit from additional developers building DApps, traders and investors using Ethereum for on-chain transactions, as well as a host of other use cases like NFTs and music streaming that further perpetuate the network effect. Therefore, given that both BTC and ETH are likely driven by network effects and are in the midst of their respective adoption cycles, it is unsurprising that the returns of BTC and ETH are correlated with each other while being negatively/weakly correlated with other liquid assets.



To visualise this relationship between the value of crypto-assets and the adoption rates of their respective networks, I plotted scatterplots showing the market caps of BTC/ETH with respect to their networks' number of active addresses. You can explore these relationships in the interactive Tableau view below (best viewed on desktop).


(Data Source: CoinDesk, Glassnode)


Crypto Volatility


While I certainly did not need charts to tell me that crypto markets are volatile, it does help when numbers can be put to the narrative.


The annualised volatility of BTC and ETH have been falling over the past few years, with BTC settling at ~80% volatility while ETH’s volatility is currently at ~120%. This means that on average, an 80% and 120% price move within any given year can be expected for BTC and ETH respectively. For comparison, the 6-month implied volatility of the S&P 500 ETF (SPY) is currently at ~17% as of writing. Notably, ETH has been consistently more volatile than BTC, which again could be because of its smaller market cap.



I believe that part of the reason for crypto markets' high volatility is the high amounts of leverage being employed during times of speculative fervour and a lack of a centralised entity to boost sentiment and backstop losses in times of widespread market turmoil. In up markets, this results in big momentum-driven moves, while reflexive sell-downs can also be expected during market downturns as leveraged positions are liquidated regardless of price.


This view is supported by BTC futures open interest peaking at ~US$27.5b as BTC reached US$63K around Apr '21 before the mass sell-off in May '21.



During the May '21 liquidation event, >US$10b of leveraged longs were unwinded, sparking a fierce sell-off to ~US$30K levels. While this only captures derivatives data, it could be a proxy to understanding how margin positions unfolded in the spot markets.



Mark Cuban sums up this situation well - "De-Levered Markets get crushed. Doesn't matter what the asset is. Stocks. Crypto. Debt. Houses. They bring forced liquidations and lower prices." Crypto markets are a wild west free frontier without centralised backstops, and de-leveraging events are allowed to occur until the market finds a natural bottom. With that being said, high volatility cuts both ways - outsized volatility is arguably a big reason for the potential of outsized returns. Therefore, understanding the dynamics of crypto market structure is key to developing a finer appreciation of the market's high volatility.


Crypto Risk-Adjusted Returns


To measure the risk-adjusted return of various liquid assets, I compared their 6-year Sharpe ratio. Surprisingly, despite BTC and ETH’s significantly higher volatility, they still outperformed the other liquid assets on a risk-adjusted basis.



Crypto-asset Investment Mindset – Liquid Venture Capital


With a better understanding of historical crypto-asset risk-return metrics, I started to see how investing in crypto was somewhat similar to investing in earlier-stage companies:

  • Investing in emerging technologies that thrive on network effects – Existing users benefit from additional users being onboarded onto the technology/network

  • High long-term returns – 109% 8-year CAGR for BTC, 278% 6-year CAGR for ETH

  • Fat-tailed return distributions with positive skew – relatively higher chances of homerun returns being positive rather than negative

The major difference here is that crypto markets trade 24/7 and can offer investors exit liquidity almost anytime, anywhere while VC investments tend to be illiquid due to lockups and relatively weak secondary markets. This leaves me with a tough tradeoff – the fact that I would have to deal with Mr Market 24/7 might lead me to lack the patience before the technology S-curve fully plays out.


Conclusion


In my opinion, investing in crypto-assets is similar to investing in early-stage companies dealing with emerging technologies. These technologies and companies are often unproven but could potentially be big winners once they reach a critical mass of adoption.


For this reason, I would be adopting a long-term horizon for my personal crypto-asset investments. I would also be on the lookout for other desirable qualities in crypto projects such as a large TAM, vibrant communities, product-market fit, and a meaningful value capture mechanism. Only then would I be comfortable with withstanding upwards of 80% annualised volatility during my holding period.


Having been following the crypto space for the past few months, I was positively surprised by the rapid pace of innovation and the level of community engagement that various crypto projects have demonstrated. We truly live in exciting times and I look forward to participating in the progress of the industry.


Thanks for reading,

Bryan


Disclaimer: I own BTC and ETH. 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: Omar Flores on Unsplash


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