Digital Asset Thematics & Sectors

At CoinShares, we have been investing in crypto assets for the last seven years. While the short term cycles in crypto have drawn both awe and ridicule from investors, we have stayed focused on the long term narrative, and formed our firm around this perspective. We need to have a perspective on whether the world will be different as a result of crypto, and if yes - as we believe, how to position your portfolio around that change.

Over the last nine months, crypto assets have grown exponentially, growing from an aggregate market cap of less than one trillion dollars to over US$2.5 trillion. While the staggering rally has been exciting, the price is actually the least exciting thing about crypto assets. Investor positioning highlights individuals favouring technology and a global, distributed, digital financial system.

We summarize the trend for crypto using a framework we call the 3Ds - digitization, driverless banking, and distribution. Taken together, these three trends are fundamentally changing our global financial infrastructure, the profitability of our financial institutions, and the very fabric of our capital markets.

The trend of digitization has fuelled the last decade of FinTech innovation, but the core of banking and financial services has largely been left untouched. Financial innovation has nibbled at the edges while leaving core infrastructure intact. Just as the internet made communication borderless, interconnected, low cost, and real-time, financial markets and commerce are about to undergo an era of rapid transformation that will enable digitisation of all core banking functions. New financial markets are being built entirely on public blockchain networks and core financial functions, such as borrowing, lending, hypothecation, trade, structuring, derivatives are all happening in a natively digital structure, without intermediaries or institutions.

Regulation in the space remains a challenge, but experience shows (e.g. Uber) that if a product is powerful enough, it's possible the regulations can change to meet the software and not the converse.

It is easy to shrug off crypto but the size of the industry is staggering. Bitcoin alone is now trading over US$10bn per day, double that of the London Stock Exchange. Stablecoin volume such as Tether has a daily traded volume of ~US$170bn. The total value of NFTs (digital art work) traded in 1H 2021 was US$2.5bn. The DeFi network (Decentralised Finance) now totals US$100bn. Production-ready software is already operating at scale that could be distributed very quickly by any big tech platform. These stats indicate a rapidly growing industry that is becoming too hard to ignore.

At the crux of thematic investing is the understanding that what got us here is unlikely to get us where we’re going. It is an approach that focuses on predicted long-term trends rather than specific companies or sectors, enabling investors to access structural, one-off shifts that can change an entire industry. It is also an approach that has often led to volatility and ridicule for early adopters but yet is commonly implemented by the most successful funds.

Thematic investing helps investors select companies that will benefit most from these rising trends and we can draw parallels to that in the digital asset world. Gold is a technology that can transport value, and has been used as such for millennia. Once introduced into economies, its superior monetary properties caused it to replace lesser existing monies such as cattle, salt or clams. Digital assets are a new idea that brings technology to money in the same way that gold and silver did thousands of years ago. We believe the thematic effect is likely to be similar.

Digital assets are heavily reliant on the rapidly growing internet. Data from the United Nations now highlights that there are now 3.8 billion people (48% of the world) who own a smartphone, up by about 40% between 2016 and 2020. As smartphones are now widely used, have internet access and sophisticated operating systems, they are an ideal mobile platform to provide access to financial apps. Such apps could give access to digital assets, savings products, or new payment rails to conduct their day-to-day business, offering the current 1.7 billion unbanked people around the world global access to financial services for the first time.

We believe there is huge potential for Bitcoin and other digital assets to both improve access to permissionless financial services and to modernise the incumbent banking and finance system. Some of this new infrastructure is already well-developed and currently in use.

Here we document the 3 key themes and the primary sectors that have formed as digital assets continue to evolve.

Digitisation is essentially the conversion to or creation of an item of utility or monetary value on a broadly distributed global peer-to-peer network. Bitcoin is an example of a layer one solution, much like the incumbent Fedwire system in the United States, allowing banks, businesses and government agencies to make gross USD settlements via the US Federal Reserve. Bitcoin can be seen as the central bank of digital assets, being both the issuer of money and the settlement equivalent of Fedwire. Unlike a traditional central bank however, there is no flexibility in the issuance of bitcoin in the Bitcoin monetary system.

Operating via the Bitcoin protocol ensures that settlement is both efficient and highly secure. High levels of security however, comes at the cost of transaction speed. This is why Bitcoin shouldn’t be compared to a payment aggregator such as Visa which is a layer two solution relying on settlement via the Fedwire system. A more apt comparison to Visa would be Bitcoin’s Lightning network, which is used for instant low cost consumer payments using the bitcoin digital asset and settled on the Bitcoin blockchain.

The digital asset world can take many steps further than this, offering value and utility in a wide variety of forms;

• Ethereum is essentially a global virtual computer with a payment token rolled into it. Innovative uses have already been developed such as a smart contracts platform. This has led to rapid growth in decentralised finance (DeFi) which we have written about here.

• Utility tokens – A digital token assigned a particular function by its issuer(s), typically sold or rewarded to fund the initial development of a project, and later used to purchase goods or access services offered within such a project. Ethereum’s ether token is an example of this. Another example is issued by Binance, a crypto exchange. Here, the issued tokens were used to develop the exchange and the Binance blockchain, and they can now be used to discount trading fees on the Binance exchange, or to execute smart contracts or other computations on the Binance Smart Chain.

• Stablecoins are backed by an asset, typically a fiat currency, which offers 1:1 parity. They are often used as short-term deposits by digital asset traders or businesses, particularly trading desks involved with cross-exchange arbitrage. Stable coins are becoming increasingly popular as they do not have the same money transmission laws as many fiat currencies and can be settled in a matter of minutes or hours. At the time of writing, trade volumes in stable coins are greater than US$200bn per day.

• CBDCs (Central Bank Digital Currencies) have only recently gathered pace, but according to the Bank for International Settlements over 80% of central banks are now actively researching them. CBDCs are very similar to stablecoins in terms of the settlement speed and interoperability they are hoped to offer, but they would be the official central bank version of their underlying fiat currency and therefore require no backing or peg. https://coinshares.com/research/why-cbdcs-arent-a-threat-to-bitcoin

• Tokenised assets represent ownership of a real tradeable asset, similar to the process of securitisation in the traditional financial world. Many assets can be tokenised, such as gold and silver, or more recently intangible assets such NFTs or patents. It essentially gives access to ownership and trading of external assets within the blockchain ecosystem.

In the traditional banking model, central banks create electronic money reserves and grant access to commercial banks. Commercial banks then create services such as lending, borrowing, hypothecation, derivatives, trading, custody and cross bank interoperability. These services are then distributed via bank accounts to serve end clients, and require some degree of human oversight.

In a model that uses a distributed ledger everything has essentially been digitised. This new digitised layer can be fully automated, free of human oversight, in what can be described as driverless banking. Driverless banking includes all the features of the traditional banking model, from central bank issuance of money, lending, borrowing etc all the way through to the bank accounts (wallets) that serve end clients.

This digital asset infrastructure is at a far more advanced stage than many realise. Currently in full-scale operation are DeFi (nominally decentralised, but perhaps better described as unregulated finance) trading venues such as Uniswap which hit a daily record trading volume of US$7.17bn on March 29th 2021. This is 4x more volume than Coinbase while operating in a completely automated fashion. To help put this scale in perspective, this year the London Stock Exchange’s daily traded volume has ranged from US$3.3bn to US$6.6bn.

Examples of other areas in DeFi that are now well developed are the borrowing and lending platforms. As of September 3rd 2021 Aave and Maker have a TVL (Total Value Locked) of US$17.2bn and US$13.8bn, respectively. DeFi Pulse estimates the TVL for the whole DeFi system at US$97bn, up 940% over the last year (September 2020 to September 2021).

Custody and settlement platforms now exist such as Fireblocks that do onchain custody, Fireblocks currently have 400 institutional clients and have securely transferred over US$800bn digital assets.

While the 2nd layer, driverless banking, is gathering pace, the end consumers remain a niche group. The challenge for digital asset providers is understanding how to get digital assets through this banking service layer and into the hands of regular consumers. At present there are approximately 0.8 million active wallet addresses in Bitcoin – Facebook has 1.88 billion daily active users. Integrating a wallet into a large social media network would dramatically improve wallet exposure to customers and increase the network effects of digital assets.

This would go a long way towards adding the same global acceptance and functionality that gold used to have in centuries past.

Due to their multifunctionality and heterogeneity, there is still no broad agreement on how to categorise digital assets as many often straddle multiple digital asset sectors. As the digital asset space evolves and matures, sector definitions are beginning to reveal themselves. We particularly like the categories defined by Andreessen Horowitz and we detail them below, having added a few other emergent sectors.

Source: Andreessen Horowitz, Messari, CoinShares

At the core of digital assets are complex hardware and software based infrastructure. Just as an electricity company has a grid and power stations, so do digital assets have mining hardware, nodes, software implementations and cloud infrastructure. In a similar fashion to existing platform-as-a-service (PaaS) infrastructure, providers coordinate and maintain access to the infrastructure that powers blockchains.

• Bitcoin & Ethereum

   

Decentralised finance strives to replicate financial services that are traditionally offered by institutions and intermediaries, but within cryptocurrency platforms using open protocols and sets of collaborators. The overarching goal, in alignment with the origins of cryptocurrency, is to provide an alternative to legacy financial infrastructure that is more accessible, transparent and reduces trust in centralised parties.

Over the last couple of years, DeFi usage has been explosive with millions of users now accessing various products across several different platforms. The rapid development and adoption of DeFi products has therefore unsurprisingly caught the attention of users, investors and regulators alike.

• Uniswap, MakerDao and Aave are good examples of this very broad sector. We have written extensively on this subject here.

   

A key challenge in existing cloud storage is that the ledgers are mutable and can therefore be deleted or changed easily, leading to vulnerable and variable datasets. A Harvard Law study highlighted how 50% of links in supreme court cases did not work anymore. Furthermore, having a large corporation administer data is precarious as it may not exist in 100 years time and a user risks losing the data if they do not pay. Developing storage features in a blockchain structure enables a permanent internet that is akin to reliable long-term data storage where information/data is decentralised while being easily accessible. Digital assets require a one time payment that is typically priced at around one cent for 4-6mb of data. This is typically more expensive than the annual fee for existing centralised cloud storage but makes sense for long term storage.

• Arweave and Filecoin

When the internet began being used by the public it was free from business models that incentivised companies to watch and track users, who often sold personal data in the process. Today, selling personal data is big business, but sadly user data is often hacked, leading to significant security breaches. The Web 3.0 being built on Ethereum is enabling users to own and use their personal data without exposing their data to the public. Privacy in this case is not about obscuring identities for potential use in criminal activity, rather obscuring a user's wallet balance, address and other sensitive information from operators that may want to target them for commercial or nefarious reasons. Privacy coins allow corporates and individuals to utilise their most sensitive data, keeping it secure and private, while complying with local regulations.

• Oasis Labs and Orchid
  

Following the launch of Bitcoin in early 2009 the first exchange to fiat currency occurred in October 2009. As Bitcoin became more prolific, so too did exchanges. Today there are 15 exchanges globally that share roughly 80% of the overall market volume (based on Kaiko data), although there are over 300 digital asset exchanges that offer a wide variety of services across multiple currencies. Exchanges offer custody of assets at varied levels of sophistication while fees can vary greatly too. Exchanges can be hugely profitable with the recently listed Coinbase posting a net income of US$1.6bn over Q2 2021 with a trading turnover of US$462bn over the same period. Coinbase’s daily volumes at US$5.1bn are now similar to the London Stock Exchange which traded a daily average of US$5.5bn over the same period. We estimate the Bitcoin spot market alone has traded US$12bn per day on trusted exchanges in 2021.

• FTT & Binance coin

Enterprise focussed digital assets typically utilise blockchain technology to overhaul existing financial market infrastructure, making systems more efficient and lower cost. They typically provide a set of sophisticated institutional level trading, indexing and analytic tools for digital asset management. They also combine all the merits of transparency and data integrity to Wall Street, consequently, some enterprise coins have already secured transfer agent licenses from the Securities and Exchange Commission (SEC).

• Axoni & TradeBlock

Existing banking infrastructure makes it difficult for those in poverty or emerging economies to have a bank account without incurring prohibitive expenses. Banking & payments coins allow anyone with an entry level smartphone (~48% of the world) easy and cost effective access to financial services. Other advantages include rapid transactions globally that are transparent, secure and scalable. Existing financial institutions are beginning to take advantage of these merits helping them expand into new markets, eliminate pre-funding through on-demand liquidity services, benefiting both individuals and companies

• Ripple & Diem

Although NFTs (Non-Fungible Tokens) have existed for some time, it is only recently that the broader public has become aware of them. They are primarily known for being used as assets in gaming but have broadened into real estate, defi (insurance and tokenised liquidity), fixed income, art and redeemables for events.

• Due to the diverse nature of NFTs it is hard to directly replicate NFT prices in a single coin, but there are a broad stack of assets that support them, from layer 1 solutions such as Ethereum and Solana, storage such as arweave, financialisation such as Niftex and frontends such as OpenSea and Zapper.
  

Media coins challenge the incumbent music industry by re-establishing the way music is produced, bought, sold and listened to in a fair and transparent way. The artist’s creative works are time stamped and secured while music venues are able to curb counterfeit tickets. Record companies can easily trace music streams to enable instant equitable pay to all artists who contributed to songs or albums. This helps eliminate expensive middlemen and establish a point of origin for music creators. Many high profile artists advocate decentralised technologies in music and some streaming services are making acquisitions in the sector.

• Audius, MediaChain & Choon

Investors worried about loose monetary supply and inflation have found that Bitcoin is of finite supply while potentially being an inflationary hedge. Alongside bitcoin’s growth in scope and size, its evolution is making it increasingly apparent that it is being used as a store of value. We believe that as Bitcoin becomes more financialised, the more it will start acting as a store of value. Evidence for this is in the ~US$60 billion of assets currently in Bitcoin ETPs, funds and trusts and its growing acceptance as collateral for debt financing in fiat currencies.

• Bitcoin and other finite supply coins. We have discussed Bitcoin as a store of value extensively here.

There are businesses that do not have crypto currencies associated with them but are crucial to the underlying infrastructure. These businesses have either existed before digital assets or are new industries created as a direct result, both of which have greatly benefited from their proliferation. They can be subdivided into the following categories:

• Digital asset proof-of-work (mining), where digital assets are often created and their transaction histories secured, requires significant amounts of electricity. The proof-of-work process is very competitive and crucial for miners’ bottom-line, therefore miners seek the most cost-effective solutions for power delivery. Consequently, miners often look for “stranded power”, where local power production capacity is often not fully utilised and is therefore low cost, such as remote hydroelectric power plants. In turn this helps power producers become more efficient as they are paid for the power that would otherwise be stranded.

• According to the Cambridge Centre for Alternative Finance, Bitcoin currently consumes around 90 terawatt hours per year (September 2021), roughly the equivalent of the Netherlands.

• Alongside the growth of Bitcoin, mining operations have grown too, from relatively small operations to what is now a multi-billion dollar industry. The mining companies purchase and maintain mining hardware, delivering returns when they sell the mined digital assets on the respective blockchain network.

• Mining pools are organisations that allow smaller miners or individuals to pool their mining power, helping increase their overall mining efficiency. The mining pools typically charge a fee ranging from 0-3%, highly dependent on the size of the client.

• Hosting companies provide users with access to mining hardware, allowing users to take advantage of economies of scale and mine from their hosting centers. This approach to some extent reduces the companies’ exposure to the volatility of digital assets, with the price risks essentially being transferred to the users who are typically locked into time-based contracts. Some investors treat this as a yield play, while others like it for its ability to generate non-KYC’d bitcoin.

• Mining hardware comes in two primary forms, ASIC & GPU mining. Originally mining was solely operated on hardware from existing personal computers, typically using the power of the CPU. This has since progressed onto using the very powerful graphics processing units (GPUs). GPU mining has grown very popular and has been very lucrative for GPU producers. The Ethereum protocol is usually mined on GPUs and many of the more centralised protocols conduct regular hardforks to ensure mining remains GPU-driven.

• As the industry has grown, dedicated mining hardware called Application Specific Integrated Circuits have been created for the protocols offering the highest mining revenues., ASICs increase the security of a protocol by ensuring that the mining hardware is non-repurposable—this incentivises miners to act in the best interest of the protocol so as not to destroy the value of their capital. Bitcoin is an example of a digital asset mined more or less exclusively ASIC hardware..

• Digital assets can be custodied on simple USB sticks, although this is not particularly secure. Custom wallet hardware is therefore commonly used allowing both secure and self-sovereign custody and easy transfer of digital assets even for casual users. Dedicated wallet hardware is used across many industry levels from retail users to professional custodians.

• Some companies also specialise in the production of full nodes for the protocols able to run on small, cheap computers. Bitcoin is an example of a protocol that can be run on a Raspberry Pi setup costing less than US$100. There are now multiple providers of out-of-the-box solutions for users wanting to become peers on the Bitcoin and Lightning networks.

   

This new digital functionality, enabled through technology, is what powers the value in these crypto networks. Adding up the 3 layers, digitisation, driverless banking and distribution is what makes a transformative difference between the old banking tier system and the new one. Furthermore, the digital asset network isn't just transforming the financial world, it is overlapping many different existing sectors and we are likely to see its use expand and diversify over time.

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