Digital Assets: More Than A Passing Fad

In the third episode of Cowen’s Thematic Outlook Podcast Series , David Kroger, Vice President and Digital Data Scientist at Cowen Digital and Bill Bird, Head of Thematic Content discuss increased institutional participation in digital assets and other factors that support the view that digital assets are more than just a passing fad.

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Transcript

David Kroger:

While the market is focused on art, which is cool, the market doesn’t see the full potential of NFTs.

Bill Bird:

Hello everyone. And welcome to Cowen’s Thematic Podcast. I’m Bill Bird, head of thematic content at Cowen. And I’m really excited to be here with David Kroger. David is a digital data scientist and a member of Cowen’s digital asset team. Each month our Thematic Podcast discusses areas of emerging growth and disruptive innovation, topics that are of pivotal interest to investors and corporate executives. The raw materials for the themes will unpack are Cowen’s proprietary data sets and Cowen’s ahead of the curve series where so much of our thematic work is expressed throughout the year. Today’s topic is digital assets. Numerous surveys, and our own experience at Cowen point to increased institutional participation in digital assets. At the same time, the government is preparing for action on several fronts. For example, the Biden administration recently signed a March 9th executive order to ensure responsible development of digital assets. These factors support the view that digital assets are more than a passing fad.

                In today’s interview, we discussed some of the core themes surrounding this emerging asset class, but before we dive in, I’d like to provide some background on our guest, David Kroger. David is vice president and digital data scientist at Cowen Digital, which offers high touch spot trading in 16 tokens plus secure and compliant institutional grade custody. David is a thought leader on digital assets, including blockchain based protocols, NFTs, and cryptocurrencies. He’s known for the breadth of his coverage of cryptocurrency, his knowledge of how the ecosystems work, and his tracking of alternative data to gauge how digital assets are developing. David welcome, and thanks so much for joining us today.

David Kroger:

Thanks for having me on.

Bill Bird:

David, for the benefit of our non crypto native listeners, how do you begin to evaluate cryptocurrencies?

David Kroger:

That is a question we’ve been getting a lot from our clients, both crypto native and traditional funds. For the listeners that aren’t familiar with the crypto space, there are metrics called on-chain metrics. These metrics are like the equivalent of fundamentals and equity research. Examples of on-chain metrics are daily transactions on-chain, average fees paid, and number of wallets. We can take these metrics and call the fees accrued on the network revenue and deduct expenses from the network like stake and rewards. You can then add a growth rate project out forward earnings and apply multiple to start getting valuations.

                Now, this is not necessarily a given as there are a lot of assumptions in that base explanation. For example, staking, which is the reward given for those who secure the network and improve a stake model, may not be seen as an expense or that cryptocurrency shouldn’t be earning revenue at all, as any access should be paid out to those securing the network, which brings me to another way we build the models. Taking in a variety of metrics like on chain metrics in combination with alternative data like job postings, GitHub development, decentralized scores, app downloads, search trends, and other alternative data sources. We can take all that and use statistical analysis to find variables that are interesting, which may differ from coin to coin. After building data models, knowing key performance indicators, and understanding the underlying technology behind the protocol, you have to then understand how it stacks up against other protocols and the key differences. This is another question I get asked often too. This is outside of trading models like momentum trading to really get to understand the value of a cryptocurrency. You can also apply similar logic to evaluating NFTs too.

Bill Bird:

David, NFTs as you mentioned, there are big part of the digital asset space. There’s been a lot of money made in NFTs and no shortage of controversy. What’s your perspective on this asset class and how do you see it developing?

David Kroger:

Yeah. I mean, you’re certainly right about there being no shortage of controversy from hacks to monkey images, NFTs have been a hot topic of discussion. I would like to start by defining NFT because there’s a common misconception that NFTs are just profile pictures or digital art. NFTs are non fungible units of data stored on the blockchain. This means NFTs represent digital assets. I think this distinction is important as right now, while the market is focused on art, which is cool, the market doesn’t see the full potential of NFTs. For example, there have been a couple of companies making NFTs that represent real estate in a legal and compliant way. The NFT represents the deed of your house, making ownership a lot more liquid and reducing traditional real estate fees paid. The first sale was done actually a couple of months ago in Florida by a business called Propy.

                And there are multiple other businesses following the same approach. A different example is using NFTs for tickets. There are a couple of reasons to do this. The first being when NFT ownership is transferred, a fee is paid back to the creator of the NFT. This means that say a baseball team could get a cut of all transactions on the secondary market, which could be set to anything, but is typically around 5%. The other cool thing is that the baseball team can see who owns their NFTs and then send them another NFT which could represent a coupon for the next game. And then they would know this person is interested in their game since they already hold the ticket represented by the NFT. This could totally change how businesses market and I suspect that many of them are talking about it as we see big brands like Nike, Gucci, McDonald’s explore NFTs.

                One more example to really drive the point home and my personal favorite, say you are in the metaverse wearing a VR headset, playing cards at a casino. This is done in a compliant way since you’ve provided personal information like your age and address. A virtual server asks if you like a drink and you say yes, the casino could send you an NFT that represents a free drink by a restaurant near you, redeemable through Uber Eats or another transportation service. Then use the NFT, which executes a smart contract to have the cocktail delivered to your house in real life as you enjoy playing in the metaverse.

                Lastly, the NFTs of art and profile pictures that exist now, most are not worth anything, will head to zero. However, say the top 0.1% are actually doing something really cool with their brands and DAOs. DAOs for those who don’t know are decentralized autonomous organizations, but you can think of them as LLCs, but instead of having a CEO that makes decisions, decision making is disseminated across all members. There are all types of DAOs with different focuses, some focus on NFT collections, building a pool of digital assets, and then those assets get paid out to the members. Others can focus on dating and other sectors of science and research like living longer and more.

Bill Bird:

David, let’s shift gears and move over to decentralized finance. What are some of the recent developments you’re seeing there? Are institutional investors interested in this space? Would love to hear your thoughts.

David Kroger:

Yes. Institutional investors are very interested in this space. When I talk with people and clients unfamiliar with the space, they are shocked to hear that you can earn around 7% APY on stable coins, like USDC and at a high level, the yields are earned through lending the stable coin to other parties securely through smart contracts. And that’s just stable coins. I mean the crypto native funds are looking at liquidity pools where you borrow from one exchange, let’s say 5% interest rate and then stake it in a pool that earns 12%, but hedges their downside risk, earning a Delta neutral rate. Some recent developments in the marketplace have been twofold. The United States has been cracking down on yields being offered to retail investors. I wrote about this one in one of our weekly’s, but effectively Celsius, which is a crypto lender was offering yields up to 19% on different cryptocurrencies.

                But had to stop their product offering under regulatory pressure. We saw a similar thing happen to Coinbase and a platform called BlockFi who paid 100 million in a settlement to the SEC over these interest accounts. The other thing that I’m seeing are these DeFi DApps or decentralized apps are offering yields that are not sustainable to users to draw them to their network. Some people are viewing this as a marketing expense. However, the problem becomes that the users are chasing yield and are not very sticky. And since the yield is not sustainable, once it is lowered, lots of people take their money and leave to the next DApp offering high yields. So DApps are currently discussing long-term solutions to the problem like requiring lockup periods.

Bill Bird:

David, there’s been a good deal of excitement around Ethereum 2.0. At a basic level, can you talk about what it is and why does it matter?

David Kroger:

Yeah, Ethereum is the second largest cryptocurrency by market cap and is switching from proof of work to proof of stake. Most cryptocurrencies, excluding Bitcoin are already proof of stake, which just means different ways for the blockchain to come to consensus. Proof of stake has been looked on more favorably as it’s supposed to decrease Ethereum’s energy intake by 99%. Ethereum 2.0 more recently rebranded calling itself consensus layer because the terminology of E 2.0 caused confusion, leaving people wondering if they need to do something to upgrade, which then resulted in people being exploited by those that took advantage of the lack of knowledge. The upgrade was supposed to come out around this time, but has been pushed back and I quote a few months with most people expecting the upgrade to actually come at the beginning of next year or at the end of this year. The upgrade is focused on three things, sustainability, which I touched on, security and scalability, but there are a lot of misconceptions around the upgrade that are worth pointing out.

                For example, I’ve seen online forums that this upgrade will be the solution to the high transaction fees on Ethereum. The upgrade will help, but layer two solutions will still be needed and is not the silver bullet people are anticipating. Vitalik for example, who is the co-founder of Ethereum has said so himself that layer two solutions will be needed in the short to medium term, as well as developers from the Ethereum Foundation has also said that as well. And for those that don’t know, layer two solutions at a high level just means a solution to help scale an application by processing transactions off Ethereum, while keeping the security measures in decentralization. The transactions processed, then get rolled back into Ethereum, all which is done through cryptography. This is going to help lower the overall transaction fees, which will help adoption across the long term.

Bill Bird:

David, the blockchain trilemma term by Vitalik, who you just referenced, addresses some of the challenges developers face in creating a blockchain. Could you unpack that a little bit to help us understand what is the trilemma and what are the trade offs and how do you think about it?

David Kroger:

Yeah, that’s a perfect segue. The blockchain trilemma refers the idea that a cryptocurrency wants to be decentralized, secure, and scalable, but can only choose two of the three. Knowing this is a fundamental to analyzing and understand cryptocurrencies and the way they run and why they do. Given that security is a top priority, cryptocurrencies face choosing between decentralization or scalability. Of course, many coins claim to have solved this problem saying they have all three and some are closer than others. But the trend has been to focus on scalability over decentralization. This is because getting users on-chain and engaging in a cryptocurrencies ecosystem is important from both an adoption and an investor standpoint. Having people engage in your ecosystem becomes a lot harder if it doesn’t scale resulting in transactions costing tens or hundreds of dollars. This is partly why many people emphasize metrics like transactions per second, and the cost per transaction.

                When you have to charge someone $100 to move $50 worth of assets, it makes no sense. And people will go leave for alternative platforms. With many cryptocurrencies focused on scalability, decentralization has been less focused on. This of course, goes against the crypto ethos of being decentralized. However, data and discussion show many people do not really care if systems are decentralized as users store their digital assets on centralized exchanges. We also see this with Ethereum as they’re an older chain relative to some of the big players now, and they have focused on decentralization over scalability. And which is part of the reason why we see these high gas fees and the move to E 2.0 now.

Bill Bird:

David, we’ve been discussing some of the technical factors of digital assets and some of the challenges, et cetera. David, if we zoom out to the big picture and really think about where all this is headed, where do you see the digital asset space going in the next five years?

David Kroger:

Yeah, I mean, if I had a crystal ball, I’d probably be somewhere on a beach sipping a Mai Tai, but in a perfect world, we would like to see regulatory clarification on digital assets. And then around the same time, we’ll see more traditional institutions consider either using the technology like smart contract automation or at least investing it in keeping some of their coins on their balance sheet. In the next five years, user interfaces and technology hurdles will be lowered even today, sending assets from a wallet to another wallet can be scary because if the wallet address is not correct, you can’t try again and there are no do-overs. You just lose your asset. Hopefully this changes as wallets upgrade to a more comprehensive list of approved and verified wallet, reducing the risk of accidentally losing your money. I also look forward to a cleaner design with more explanations built into the wallet.

                Right now you have to trust users on Reddit and YouTube video tutorials to walk you through the more technical steps. I’m also keeping an eye out for really big DApps or again, decentralized apps. Right now retail users look at NFTs, some playing DeFi pools, but outside of finance applications, there are not many real reasons for someone to engage on the blockchain yet. Video games on the blockchain could start to bring some people in, but good video games usually require massive budgets and experience teams and play to earn gaming has only been a focus in the past year or so. Alternatively, I think something like putting a Spotify on the blockchain could be really interesting as everyone enjoys music and artists could get paid more.

Bill Bird:

David, what are some of the challenges you see in the crypto space, as you think about where the market is headed?

David Kroger:

So immediately, what comes to mind is regulatory risk and you can break out regulatory risk into a couple of different buckets. The first being the environmental concerns surrounding Bitcoin mining. The solution, I think is to just educate and teach lawmakers about the impact crypto mining has backed by studies and data would be a great first step. Another regulatory risk is a lack of retail knowledge. A fear that I have is that something in crypto becomes very popular and ends up losing a lot of people, a lot of money. And in kind regulators point to that case to overregulate the market setting that they’re just protecting consumers. There’s also the concerns that some lawmakers point out that Bitcoin threatens the financial strength of the US dollar, which is a real concern. And the IMF frequently discusses how adoption of Bitcoin in other countries are posing a risk to us now.

                Something in my day to day that I face as far as challenges go is inconsistent data. When trying to find data on digital assets, there’s no fact set or Bloomberg of crypto data yet. They’re developing third party data vendors, but because on chain metrics often require having a validator on their network, which can be expensive, different types of data is fragmented across different vendors. Additionally, because there are so many new vendors entering the space, data cleaning standards aren’t established, which leads to different data across vendors, even though they both claim to pull from the same data source.

Bill Bird:

David, can you tell us more about Cowen Digital and the role it plays?

David Kroger:

Yeah. We are creating the Cowen platform that institutional customers have known from Cowen in equities and fixed income research, sales, trading execution, banking, VC, cap intro, all the verticals that we service for traditional finance, we offer in the digital side as well. On the execution side spot trading, low and high touch and we are currently building out derivatives, borrow lending, shorting financing, and swaps. We also provide comprehensive coverage on the digital asset space for institutional investors to get involved, adding in custody with standard custody and fund admin with MG Stover, we can cover an institution’s full life cycle for the product. We really aim to be that white glove service clients come for.

Bill Bird:

David, let’s shift to something on the lighter side. Dogecoin originated as a joke. Was wondering if you could talk a little bit about it versus Shiba Inu and help me understand where this fits in.

David Kroger:

Yeah. So this has been a coin favorite on the retail side and institutions have taken notice. Dogecoin originally as a joke, as you mentioned, is a copy and paste code of light coin, and it’s currently Elon’s favorite cryptocurrency. It gained popularity as Elon made more jokes and memes about it on Twitter and the thesis surrounding the coin and its massive success is that the thinking was that because Elon was backing the coin that the right engineers would come in to overhaul the functionality of the coin while keeping the same meme kind of branding and usable and that’s loved by the public. However, this hasn’t happened. Dogecoin still is the same kind of coin that it was years ago, that doesn’t offer much functionality outside of being a joke. Shiba Inu on the other hand kind of comes from the same ground as Dogecoin.

                It came after Dogecoin and played on the same basis that it’s got a dog as it’s mascot on the token. But what’s interesting is that Shiba Inu is actually building out some of the functionality and cool tools in the ecosystem that people had hoped to see from Dogecoin. Shiba Inu has a decent decentralized exchange, which is called the DEX and has its own inside kind of ecosystem currency called Bone. So it’s interesting to see how these coins will play out because they are in fact, fairly large on Reddit and both Reddit, Twitter, and by market cap. And memes can really drive momentum into other cryptocurrencies as well.

Bill Bird:

David, your team does quite a lot in servicing the digital asset theme. As you look ahead, what are some of the events or expert calls that you plan to host in this digital asset space?

David Kroger:

Yes. Love the question. We recently put a deep dive series on Avalanche and I have planned a discussion with John Wu, president of Ava Labs on May 26th. Ava Labs is the architects behind the Avalanche cryptocurrency. In continuation with our deep dive series, we plan on offering corporate access complimentary to the deep dive series on some of the largest coins that we continue to plan putting out. We also are hosting many dinners across the country and at crypto events like Permissionless. The dinners cover a variety of things relating to crypto. One dinner that might be of interest to non crypto native listeners will be on July 12th where Jaret Seiberg, who’s our Washington research analyst, Stephen Glagola, who’s our equities crypto mining analyst and myself will be discussing the space. Lastly, I always offered to do teach-ins for our clients, whether it’s crypto native funds wanting to explore the technicalities of a protocol to an equity analyst wanting to understand how blockchain works and how it might affect their portfolio holdings.

Bill Bird:

Well, David, as we wrap up today’s podcast, this has been incredibly helpful and interesting. And I just want to thank you for sharing your thoughts and also thank you everyone for taking time out to listen. Until next time, be well and see you soon.

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