Zooming Out: Rediscovering Purpose in Crypto Investing

Have you ever pondered if the future of decentralisation represents a genuine necessity or merely an illusionary demand?

TL;DR

Taking a break from work allowed me to zoom out from the crypto world and rediscover the worlds beyond it, leading me to discuss a variety of topics including:

🌐 How cryptocurrencies & blockchains are 2 fundamentally different concepts

🔁 Pros & cons of decentralized databases and suitable scenarios for utilization

❓ Why a problem-solving approach isn’t suitable for crypto investing

🤝 The need for community-driven, consumer-focused valuations in crypto

🕰️ Shorter fund cycle is more suitable for crypto investments

📊 Verticals that will outperform should Consumer-focused & community-emphasis investment thesis be sensible

---

The past three weeks have been quite refreshing. I spent ten days attending to family matters and then enjoyed a wonderful founder's retreat with the broader firm. During those three weeks, I was completely disconnected from the world of cryptocurrency. My VPN failed to work as expected on my second day in Hainan, but I didn't feel any urge to fix it either. This break allowed me to gain some perspective, and I was able to see the world beyond crypto, which was quite invigorating. On my flight back to London, I couldn't help but ask myself an intriguing question: “Why are we investing in crypto?” To expand on that, I didn't feel like my life was negatively impacted at all by cutting off from crypto, especially during this bear market. It didn't seem like a necessity for me to use it daily. Are we creating unnecessary needs to fulfill?

To answer these two questions, I need to delve into the foundations of cryptocurrencies and work my way up to understand whether or not it makes sense to invest in them as a venture capitalist. First, it's important to distinguish between cryptocurrencies and blockchains, as they are related yet distinct terms:

In my understanding, the most basic form of cryptocurrency is a digital currency that operates on an open blockchain network. There is no need for a cryptocurrency to be created on a non-public blockchain, as settlement and incentivization currencies are typically chosen based on a combination of liquidity and regulations, which usually involves a fiat or fiat-based central digital currency. Cryptocurrencies are often used to represent monetary values, functioning as an incentive layer.

On the other hand, a blockchain is a decentralized, cryptographically secure digital ledger that stores data (such as financial data and identity information) as records in a chain of blocks that are usually tamper-resistant. Blockchains typically have nodes running clients that help compute state changes, leading to continuous block production.

Take Ethereum, for example. The cryptocurrency Ethereum is a non-fiat pegged digital currency with a market-discovered value designed to encourage node operators worldwide to perform computations that create and update states. All data generated during this continuous stream of computation are stored on-chain. Without middleware, anyone can access this data, often referred to as on-chain data. The states are essentially tables of data.

In essence, Ethereum is a decentralized database with multiple identical copies (as many as the number of full nodes) to maintain data continuity and increase fraud resistance. It also includes an incentivization layer to encourage computations that maintain and update the database.

By design, no decentralized computation structure can achieve the same level of efficiency as centralized computation, given the same hardware level. This is because there are physical distances to cover between nodes, which is part of the broadcasting process needed to reach state consensus. Therefore, despite all the scaling solutions, it is unlikely for Ethereum to operate at the same efficiency level as centralized computers. Moreover, multiple copies of the database result in higher storage costs.

Ethereum is a database with higher computational and storage costs while being slower. However, it is decentralized and trustless, with a set of rules for reaching consensus. No single entity is in charge of proposals for changes, and no intermediaries outside of nodes are required for any data creation or update logic to execute. Similar pros and cons apply to most other blockchains.

Understanding the nature of crypto and blockchain leads to two more questions:

1. Which databases would make sense to be replaced by blockchain?

2. Under what scenarios would we necessarily need to create crypto on top of the underlying blockchain?

Blockchain might be a good idea to use instead of a traditional database when the benefits of decentralization, trustlessness, removal of intermediaries for state updates, and security outweigh the drawbacks of higher computational costs, storage costs, and slower performance. This could lead to blockchain being applied in areas such as supply chain management, healthcare, voting systems, and identity management, where data integrity often matters more than computational costs. The removal of intermediaries is desirable for many financial services, as middlemen are usually productivity bottlenecks in this field – blockchain might actually improve the efficiency of many financial activities.

If a blockchain-based protocol could not function as intended without an incentivization layer, then the creation of a cryptocurrency to coordinate the system is necessary. For example, Ethereum's miners would have little to no incentive to compute without getting rewarded, and Uniswap's liquidity providers would find it hard to justify impermanent loss without $UNI rewards. A thoughtful economic design is usually required for token prices to stay afloat, but that's a topic for another time.

We've been discussing investing in crypto based on a problem-solving approach, and the logic stands as long as solving problems leads to a positively correlated value driven towards the problem solver (usually the company or protocol). These value accruals could then be reflected in the increase in the valuation of the asset. As most venture capitalists target long-term holdings, the defensibility of the problem solver is usually a desired property, as it will reduce the volatility of the asset valuations.

However, there are two aspects of crypto that make it not ideal for the same set of logic to be applied directly.

The first aspect has to do with the underlying technology (Open Blockchain). Blockchain is often tamper-resistant, which requires the source code for the blockchain or related applications to be open-sourced. This makes it public and serves as a transparent way to keep records in order to eliminate any operator tampering or revisions. Consequently, the "tech moat" largely vanishes. Blockchain data is also openly accessible, meaning the "data moat" is gone as well. It is usually more difficult for a pure on-chain protocol to build long-term defensibility compared to similar technologies using a centralized architecture.

The other aspect is not related to its underlying technologies, but the fact that crypto is a much more accessible financial instrument than others. This stands true for both teams and early-stage investors wanting to exit, as well as retail investors and traders. Combined with a variety of other reasons beyond the scope of this discussion, crypto participants are heavily influenced by herd mentality, arguably more so than stock and other financial instrument participants. The crypto community, therefore, reaches consensus much faster than other financial communities. Asset valuation is a reflection of market participants' consensus — in crypto, the consensus is majorly influenced by the community (retail investors). Do retail investors care about what world-changing problem one protocol might be solving? Probably yes, but I think most everyday investors would still find it easier to price an object based on its value added to their everyday life. This could include how much more money they could make by interacting with the protocol, how convenient it is to use the protocol, how much joy they get from the project, etc. Hence, I will never expect a complicated option protocol's tokens to outperform a simple DEX in price, given that they have the same level of marketing efforts.

There's a reasonable case to be made for the involvement of institutional investors, but it's unlikely they will dominate the market during the next bull run (assuming it occurs). The rapid dissemination of information via social media creates a favorable battleground for retail investors, and the unconventional nature of crypto investing for most traditional investors makes it a less familiar territory for them to navigate.

Investing in blockchain and investing in crypto are two fundamentally different concepts and require different investor angles. In my opinion, crypto is similar to consumer investing, but we need to put a much stronger emphasis on the protocol's ability to create positive buzz, while blockchain (non-open) investing is very similar to tech investing.

Assuming my understanding of how to best approach investing in crypto and blockchain is sensible, I feel more comfortable answering, "Why are we investing in crypto?", or better phrased: "Should I continue to invest in crypto?"

I thoroughly enjoy spending time with crypto communities; that's my root. I couldn't think of a better way to spend my spare time. If passions do lead to better craftsmanship, I hope I will have a stronger understanding of what might cause a positive buzz in our community than most other peers. On top of that, one aspect of crypto which I didn't get the chance to mention in the above passages is the fact that most projects will be able to exit much faster than traditional equity-based projects. This leads to much faster price discovery by the market, and hence much shorter feedback loops for VCs. If I do it right, I will be able to generate outsized returns for my limited partners in a much shorter timeframe. If I do it wrong, I will be able to learn from my mistakes and apply learning in much shorter iteration cycles. Selfishly speaking, I think crypto is a great learning ground.

The next question to be answered is, "Are we creating unnecessary needs to meet?"

This is a much longer-term question and could get quite philosophical, but the short answer would be that any database that would benefit from a blockchain structure while requiring a public coordination mechanism based on incentivization could really benefit from crypto. In that sense, we are solving necessary needs. Though subtle for now, I do believe that as computational power progresses and as AI evolves, the idea of taking back your data ownership and having a set of law-like codes will become more prevalent. By then, blockchain and hopefully crypto will become much more observable needs in society. However, we are indeed creating certain unnecessary needs to meet in a few verticals of crypto, as it doesn't make sense for everything to live on-chain.

To finish off, I want to extend my thinking and give my two cents on how I want to invest in crypto as a VC. Non-public blockchain investing is also a very interesting sector, but I think the methodologies around that area are much more of a consensus in the VC community right now than those of investing in crypto.

Due to the fast enter/exit cycle of crypto, I doubt if a 10-year fund life cycle would still be the best setting for most crypto investments. I don't recall seeing many teams who haven't released their tokens within 5 years of inception. Given most protocols have a cliff+vesting period ranging from 2-4 years, and there are various OTC methods pre- and post-token launches, plus the short attention cycle in crypto, I reckon crypto funds should aim for a 5-8 year fund life cycle, depending on how aggressive they are and what stage they tend to invest in.

In terms of sectors to focus on, I want to stick to my consumer-focused + community-emphasis thesis. For example:

1. Infrastructure that serves consumers (when consumers experience it and like it, with appropriate narrative fits such as L2, the token price could potentially do well).

2. Gaming studios would likely sustain a seemingly high valuation on launch should they create titles that reach mass audiences. I think that will happen in the areas of casual to mid-core, and perhaps possibly with extraordinary AAA studios. Gaming UGC platforms and distributors would do very well for the same logic, while game development tools might need to justify their valuations.

3. The lure of making outsized returns based on simple executions will always win in DeFi over making stable, constant returns through sophisticated methods.

4. Decentralized socials will do well as an overall sector, but the competition between protocols will be fierce, and the speed of capital rotation will benefit funds with trader mentalities.

I find it hard to persuade myself that many B2B businesses would justify "high valuations" nor would they find appropriate reasonings for token launches.

Additionally, it will be worth thinking about how much room for imagination one could have, e.g.., Curve vs. Uniswap, given one only covers stable coins while the other deals with practically every token. Market sizes matter here, though extraordinary protocols expand the market sizes.

As we reach the end of this discussion, it's clear that the crypto landscape still holds many unknowns, but that's precisely what makes it ripe for exceptional returns and groundbreaking advancements. As protocols evolve to become faster, more efficient, and user-friendly, we're on the verge of reshaping online identity and ownership in unprecedented ways. Just as the PC spurred innovation beyond what mainframes or mini-computers could offer, crypto will be a platform for innovation that would never come from traditional institutions such as the tech giants (I also don’t see how they would ever be incentivized to). The journey ahead for crypto is both thrilling and full of potential, and I'm eager to see where it takes us.