Domain Money Advisors, LLC | 12/20/21
We are convinced that blockchain technology will transform the basic fabric of the financial system by creating an internet of value. At their core, blockchains bring value online into a digital, open and global financial system.
Public blockchain technology makes value of any kind fluid and programmable, creating a rich design space for entrepreneurs and developers. Examples today include Bitcoin and other popular cryptocurrencies, but we foresee a future where money, art, securities, illiquid assets, collectibles and much more are represented on blockchains.
Consequently, developers are building blockchain-based applications that interact with digital assets. These applications connect people and capital around the world and provide real value to users by providing liquidity, credit and yield with often better terms than the traditional financial system. As such, blockchain-based applications have seen significant adoption and we believe that this flywheel of innovation will perpetuate this trend well into the future. We think this expansion will continue until the point where all financial services - spending, borrowing and investing - are built on top of blockchain technology. (For more info see our piece Why Blockchains Matter)
Accordingly, we are bullish on crypto generally and more specifically on protocols and applications that serve important purposes on what we call The Blockchain Technology Stack.
The Blockchain Technology Stack is a conceptual model for the blockchain ecosystem. It is referred to as a “stack” because it is composed of various technologies that are built on top of each other.
At the lowest level are distributed ledgers, distributed data storage and smart contract protocols. Examples of these include Bitcoin, Ethereum, Terra and Solana. Bitcoin has basic functionality sufficient to maintain the ledger for a simple cryptocurrency while Ethereum, Terra and Solana have embedded scripting functionality (i.e. can be programmed) that can be used to build smart contracts and therefore, smart-contract based applications.
This layer is the operating system that provides memory (or state), computing power and programmability which are leveraged by components higher up in the stack. Additionally, the operating system is distributed across thousands of computers known as “nodes” to create a permissionless execution environment for users and applications.
Primitive financial applications (DeFi) layer
The next layer of the blockchain technology stack includes primitive financial applications (DeFi) that are built using smart contracts and interact with digital assets. The power of this layer is “composability.” In production, composability means that these simple applications can be combined in different ways to create more and more sophisticated applications.
The term “primitive” is used for this layer because each component is a simple building block that can be combined with others. Primitive financial applications include money-markets, token exchanges, derivative exchanges, insurance and asset management. Specific examples include Uniswap, Aave, Compound, DYDX, Perpetual Protocol, Set Protocol and more. This layer has grown from $4B to $246B in global committed capital since the beginning of 2021.
The next layer of the stack is the aggregation and abstraction layer. This layer aggregates liquidity, credit and yield from various underlying primitive blockchain applications and provides APIs to embed blockchain functionality in user applications. A popular example of this is 1inch which routes orders to various decentralized exchanges, thereby leveraging their aggregate liquidity.
User application layer
At the top of the stack sits user applications powered by blockchain technology and primitive DeFi applications. Currently, most development has occurred on lower layers of the stack, however, there are a number of projects building clean and intuitive user interfaces. Examples include Parsec, Zerion and Instadapp as well as Coinbase.
We agree with many in the blockchain industry that over the next decade there will be massive growth in the overall adoption of blockchain technology. Currently, there are about 1-2M daily users (sum of avg. daily users of largest blockchains) who interact directly with blockchain technology. In the next decade it’s possible that this number will increase to 100M-1B (5-15% of global population) based on the following sources of growth:
Improving user experience - The current user experience for blockchain technology leaves a lot to be desired (e.g. long public keys that need to be perfectly copied and pasted). We see substantial development occurring on improving user experiences and are excited to see this work come to market over the next couple years.
DeFi - Broader adoption of DeFi as a competitor to traditional financial services. DeFi brings market efficiency and global liquidity to every user whether they are in Jakarta or Nebraska.
Cross-border payments - Stablecoins like USDC are primed to grow as the default way to move money around the world at a fraction of the cost and with much faster speeds than traditional mechanisms such as SWIFT or ACH.
Real world assets - Growth in real world assets (e.g. securities, loans, physical art, etc.) represented as digital tokens that can move easily around the internet and interact with DeFi. Currently, there is less than $100m in real world assets represented on Ethereum and this has the potential to grow to trillions over time.
Digital Art - The recent adoption of blockchain based digital art (NFTs) and the price people are willing to pay has made headlines. The transaction volume of digital art in Q3 2021 was over $10B. While this may cool off in the short term, NFTs represent a novel way for artists to monetize their work and we see a lot of potential growth in this area. We are also excited to see further development and interaction between NFTs and DeFi over the next few years.
Metaverse - Currently, digital collectibles (such as in-game items) are the property of game developers (e.g. Roblox) and users have no legal rights to those assets. Developers are creating games and metaverses with assets represented by tokens on blockchains that can be moved between experiences, sold for money and potentially interact with DeFi. The combination of gaming and blockchain has the potential to bring 3B global video game players onto the blockchain technology stack.
Unknown - Development on top of the blockchain technology stack is open to all developers and we are excited to see human creativity lead to assets, applications and experiences that no one foresees. The freedom to be creative is one of the reasons we are so bullish on this technology.
As we think about investing in blockchain technology we consider where the value of this technology will accrue.
Every time a user sends an ETH or USDC to another wallet, a portion of the transaction fee goes to Ethereum miners, and when Ethereum completes its "upgrade" to 2.0 some time in 2022, stakers will also likely receive proceeds.
Every time a user swaps a token for another using Sushiswap, the user pays a transaction fee to liquidity providers and to holders of SUSHI tokens.
Every time interest is generated by a yearn.finance savings vault, a portion goes to the yearn.finance treasury, which is governed by YFI holders.
There are revenues being generated by layer-1 blockchains as well as by applications on those blockchains. The total revenue generated across the entire stack over the last year was about $6.5B, which is already meaningful. That said, we anticipate that this will grow substantially over the next decade as the adoption of blockchain grows. Applying our growth forecast of 100-1000x to the current revenue of the blockchain ecosystem yields a revenue of $650B to $6.5T per year in the next decade. Applying a 15x multiple on revenue to arrive at expected market capitalization yields a potential aggregate market capitalization of $10T-100T.
Using a strict evaluation framework, our goal is to invest in cryptocurrencies that accrue value via transactions fees as well as those applications that sit on top of blockchains. This framework will apply to our investments across the entire Blockchain Technology Stack.
In our strategies, we make investments in cryptocurrencies that accrue value from activity across the entire Blockchain Technology Stack based on the following criteria:
Total addressable market - Does the protocol or application serve an important purpose and have the potential to facilitate substantial economic activity? How does the protocol or application fit into the Blockchain Technology Stack?
Product market fit - Is there material adoption or signs that robust adoption is possible?
Defensible market share - Does the protocol or application have comparative advantages vs. competitors or a replica (i.e. forked version)?
Developer community - Is there a developer community that is committed to the growth of the protocol or application? The long-term success of a project is highly dependent on retaining top developer talent.
Token value accrual mechanism - Does the token accrue value proportional to the economic activity the protocol or application facilitates? Are there cash flows that accrue to token holders?
In the long run, the activity conducted and facilitated by individual protocols will quite likely follow a power law, meaning that a handful of applications and protocols (~2-3 per category, 20 across the entire stack) will have dominant market share (>50%). The reason for this is network effects and economies of scale.
For example, rather than constantly pay to swap between blockchains, we expect that people will use a handful of widely used blockchains and avoid the need to swap back and forth. Additionally, users will want to use the primitive financial applications (e.g. exchanges, money markets) with the most liquidity that offer the best rates.
The goal of our investment team is to deeply understand the blockchain ecosystem and invest in the cryptocurrencies of blockchain protocols and applications (at all levels of the stack) that we think can be leaders in each category based on the above framework and our proprietary research.
Given the potential of blockchain technology, we suspect the returns on these category winners will more than sufficiently compensate investors for the risk associated with investing in an emerging technology. The current market capitalization of the cryptocurrency market is $2.2T and we believe it can grow to $10T-$100T over the next decade. Our goal is to invest our clients' capital in the cryptocurrencies that will benefit most from that growth.
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