If Crypto Is Anything Like Fixed-Income, It's Going to Need a Fatter Textbook

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.

Very few people can claim a full grasp of bitcoin from the jump. Most start as skeptics, then after a few months some become a bit more open-minded (albeit still confused), and then eventually succumb to Plato’s Cave, emerging years later as educated and passionate adopters and evangelists. It is no small feat to grasp the philosophical, economical and psychological nuances of the world’s largest digital asset.

And that’s just bitcoin. What happens when someone dives into the rest of the opaque world of digital asset investing? 

See also: Jeff Dorman - Crypto Needs a Rational Value Investing Model

The term “cryptocurrency” is a misnomer.  While a select few are in fact “currencies,” this broad label is actually not nearly broad enough. “Cryptocurrency” implies a very simple construct where each currency can be traded peer-to-peer on an open protocol as a medium of exchange. But today we have a more complex digital asset ecosystem. The majority of today’s digital assets have unique sets of properties, and thus require different methods of analysis and comprehension. We’ve come a long way from the days when we analyzed every “cryptocurrency” using MV=PQ, a monetarist theory whereby if supply of money increases, economic activity will increase (where M is the money supply, V is the velocity, P is the price of goods and services and Q is the quantity of goods and services).

Today’s digital assets universe is similar to the fixed-income market. Most people understand the basic concept of debt and can explain what a bond is, yet the “Handbook of Fixed Income Securities” written by Frank Fabozzi is over 1,300 pages long! Clearly, there is more to the bond market than just coupon payments and principal repayment. This “fixed-income bible” is required reading for anyone who begins their fixed-income journey.

The book discusses bonds with different maturities, different coupons and different covenants. It discusses different issuer types (government, municipal, investment grade, high-yield, distressed, asset-backed, etc.) and distinguishes between bond features (callable, put-able, convertible, sinkers, bonds with warrants, etc.). It discusses important valuation concepts such as duration and convexity and introduces “bond math” and recovery values. Clearly a “one size fits all” investment framework would not be prudent for such a complex topic.

Similarly, the digital assets ecosystem has evolved from the early days of simple homogenous “currencies” to an ecosystem now worthy of its own long explanatory handbook. We can now invest in, and utilize, digital assets issued by faceless entities, decentralized projects, digital asset corporations, traditional non-crypto companies, individuals and soon-to-be governments. The investment vehicles consist of SAFTs, private tokens, public tokens, DAOs, and digital debt and equity instruments. We have tokenized time, predictions, basket tokens and NFTs. Some digital assets are true utility tokens meant for a targeted use case on a specific platform. Others are quasi-equity/quasi-utility tokens with amortizing features, dividends or buyback/burn mechanisms. And, of course, we’ll eventually need a whole chapter dedicated to security tokens, which one day will look more like straightforward financial instruments.  

Analyzing value accrual for these digital assets requires blending traditional finance valuation techniques (like a P/E ratio) with token design mechanisms intended to drive active network participation. For example, the growth in the total value locked (TVL) for DeFi tokens (up tenfold to $1 billion in a little over a year) demonstrates that using high staking rewards (inflation) to reduce velocity and float has the potential to create a long bias for holders and increases the costs of borrowing, making it hard to short the token. In addition to inflationary rewards, these early adopters are providing collateral to the staking pool and earning yield based on the transaction fees the platform is generating, which once again, lends itself to traditional cash flow analysis.

We’ve barely scratched the surface, and we’d probably already be on page 100. 

See also: Jeff Dorman - What I Learned the First Time I Lost a Million Dollars

There are a myriad of issues holding established investors back from entering the digital assets space, but using a proper narrative and setting more realistic expectations can help investors better understand how to view and analyze this new asset class. Over time, as with fixed-income, digital asset participants will begin to specialize. Investors with certain unique skill sets and investment goals will begin to focus on the subsets of the market that appeals most to them, or best fits their goals.  

The digital assets space is new, different and still largely misunderstood. But so are all new asset classes and products when they are introduced. From high-yield bonds to credit default swaps to exchange-traded funds, each new financial product started out slowly before becoming widely understood, investable products. Don’t be surprised if a large broker-dealer one day has separate floors for mining/staking, trading NFTs [non-fungible tokens] and underwriting security tokens.  

And I’d expect a very thick book (most likely in digital form) to be required reading before anyone is allowed on the floor.