In general, liquidity is good. Investors are typically willing to pay a premium for liquidity. In today’s newsletter, we explore the problem that too much liquidity can sometimes bring to an asset class, such as with cryptocurrenies and blockchain currently.
A popular investing approach in cryptocurrencies is a simple “buy and hold” strategy. Although public blockchains offer transformational promise, the immediate roadmap still remains overshadowed by the early, experimental nature of blockchain technology and its inherent challenges, resulting in wildly unpredictable price swings. A ‘buy-and-hold’ across a few crypto themes is akin to a traditional VC betting on one or two key plays across a thematic smorgasbord, with the difference being that VC investments are inherently illiquid, while blockchain investments, at least in the cryptocurrencies themselves, are highly liquid. Another key difference between investing in promising technology startups and cryptocurrencies for retail investors is that technology companies are sufficiently de-risked by the time they become available to the public. In every cohort of startups that set out to solve a problem, only a handful manage to get out of the gate and have anything like a reasonable exit, while the vast majority sink without a trace. Extreme competition in the formative years kills all unsound projects/teams and the winner(s) who makes it big as a product of natural selection becomes available for retail investors to invest in.
In the blockchain world, we are right now in a phase where we have access to a number of competing experimental technologies from a very early stage, leading to extreme chaos and uncertainty over expectations around the final outcome. Reflexivity plays a part in amplifying volatility as well, and the fear (or hope) of a particular cryptocurrency going down (or up) becomes a self-fulfilling prophecy. A “Buy and hold” index strategy might be the eventual winner, but with the possibility of a 90% mark down before a 100x return from the level you enter, wise investors might want to pay heed to the Keynesian dictum - markets can remain irrational longer than you can remain solvent – The scenario today with the crypto markets therefore begs the question - Is the enhanced liquidity a blessing or a curse? Are investors paying a liquidity premium or are they getting a liquidity discount, for the enhanced liquidity embedded in crypto?
Active strategies that provide a floor to the downside exposure can be used to mitigate the risk of extreme markdowns. Some time ago, we had started tracking an index strategy (www.108token.com
), that tracked the top-15, supply-adjusted market-cap weighted cryptocurrencies. This had its ups and downs, while still out-performing either BTC or ETH over the past couple of months. We then decided to devise an active strategy around our passive-style 108 token. The idea was to down-side protect the portfolio in a bearish market environment and book profits periodically in a directionally upward market. We tracked the strategy for roughly three months, beginning from Sep 1st and until Nov 27th. Fiat Dollar returns
of the active 108 strategy versus our passive 108 token, BTC and ETH,
as well as traditional benchmarks such as S&P 500 and Gold are captured in the graph below.