Jeff Dorman, a CoinDesk columnist, is chief investment officer at Arca where he leads the investment committee and is responsible for portfolio sizing and risk management. He has more than 17 years of trading and asset management experience at firms including Merrill Lynch and Citadel Securities.
Finding the most appropriate place to park or invest money is a subjective exercise based on the risk tolerance of an individual (or firm). But it gets even more subjective when investors begin to think about “return of capital” more than “return on capital.”
Many investors stay invested in stocks throughout drawdowns, believing equity investing is about long-term historical average returns and not day-to-day or year-to-year fluctuations. Plenty of other investors prefer the safety of government or corporate bonds due to their seniority and stable cash flows. Some become concerned about counterparty risk and move money out of banks and brokerages and into cash, while others fear cash and move to gold to protect against inflation or lack of trust in local government. And, of course, a small but rising group of people want to rid themselves of as many systemic risks as possible and move into bitcoin (BTC) or other digital assets.
None of these opinions are wrong. All have some merit.
But the different value drivers of equity, debt and digital assets may begin to manifest from the seemingly inevitable recession that will result from the current COVID-19 pandemic. All three are arguably part of the new “capital structure” now, but each creates value in entirely different ways.
- Debt = Claim on assets
- Equity = Assets minus liabilities or a claim on excess profits/cash flows
- Digital Assets = Claim on future services and customer growth
Given this backdrop, it’s possible digital assets are the only asset class not actually affected by a recession.
Companies and projects in the digital asset world pre-fund themselves via the sale of tokens, thereby creating a service liability in how the token is ultimately redeemed in the future. The token can unlock usage of the product, can be used for discounts on services rendered, or in some cases can even gain economically via direct claims on future revenue.
This process is similar to companies that sell gift cards, which tend to speed up revenue recognition (booked upfront), but create a liability for the company in terms of future services/products delivered. Airline miles behave similarly as customers can earn them (or buy them), but it creates a future service liability for the airline. Notably, these future services don’t disappear during a recession and, as such, technically do not lose value.
The difficult conditions caused by global quarantine are simultaneously creating both demand shocks (lack of customers, job losses) and supply shocks (lack of production). This is having disastrous effects on revenue and profits (destroying equity value), and asset coverage (destroying debt recovery), but to date has had little to no effect on customer loyalty (gift cards/airline miles) or future service claims (tokens).
While fundamentals may not have mattered in the past 10 years as the “everything bubble” inflated all assets, we believe they will matter in the years ahead as revenue stagnate and debt begins to impair cash flows. At times like these, we are reminded equity and debt valuations rely on actual cash flows and hard assets, not just agreed-upon expansion multiples. Historically, the best combination for multiples has been strong growth and low inflation, but we are now entering a world of below-average growth and above-average inflation.
Further, most companies with debt and equity rely on physical customers and physical locations, and almost always rely on supply chains (with the exception of certain e-commerce companies). Conversely, most crypto companies and projects don’t have physical stores, customers or supply chains. They are the epitome of a “truly digital world.”
From crypto trading exchanges, to video games and virtual worlds, to decentralized finance and web 3.0, the shift from physical to digital is happening, and we believe COVID-19 is further accelerating this evolution. Just as your Delta SkyMiles and Target gift cards don’t go away or lose value during an economic crisis, neither do the intrinsic value of digital assets. These tokens are claims on future services, not claims on revenue, profit or assets. As a result, most of these digital projects and companies appear to be immune to demand shocks and supply shocks. One day we may even say “digital assets are recession-proof.”
Crypto prices may, of course, still go lower. After all, risk is risk. But, in a fundamental way, digital assets are not actually losing value whereas the value of stocks and bonds is most definitely lower today than it was earlier this year. You could certainly argue digital assets are overvalued, but not because of what has transpired over the past six weeks.
Equity value is declining as profits decline. Debt value is declining as asset value declines. Fiat currency value is being devalued by money printing. Commodity value is being harmed by a reduction in economic activity.
You can argue digital assets never had value to begin with, but it is hard to argue their value is going down right now. In fact, it may be the only asset whose true value is unchanged.
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