Liquid venture capital or will shape a more efficient encryption market?

Innovative investors should pay close attention to liquidity. Technology trends can change abruptly, and today's best startups may not maintain their momentum tomorrow.

Original title: "Liquid Venture Investing in Crypto"

Written by: Arthur0x, DeFiance Capital

Compiler: Qianwen

No frontier market has generated more investor interest in recent years than the cryptocurrency market.

Cryptoassets are still in their early stages and there is currently no generally accepted valuation framework for investors to refer to. The crypto market is full of price speculation and hype, and pays little attention to fundamentals—a meme coin with zero utility can gain billions in market value in a short period of time. Unlike traditional markets, early stage projects/protocols are similar to start-ups that are still in the seed or A round stage and tend to list coins on the open market. At the same time, the ease of injecting liquidity into decentralized exchanges for newly created cryptocurrencies has combined to make the cryptocurrency market one of the most dynamic yet challenging investment markets today.

Unbalanced capital flow, leading to market structure disorder

There are currently four major categories of cryptocurrency market participants: retail investors, cryptocurrency trading companies/hedge funds, large companies (Tesla, Tether, Microstrategy, etc.) and venture capital (VC).

Many retail investors don’t do serious research and analysis when considering cryptocurrency investments — which explains why memecoins and many yet-to-be-delivered cryptocurrencies are among the top 10 for trading by market capitalization.

Cryptocurrency hedge funds/trading firms generally tend to trade based on short-term market movements. And big companies haven’t yet set foot outside of Bitcoin, and even with Bitcoin, big companies have dabbled only sporadically.

Venture capital is the way most institutional capital invests in the cryptocurrency field in recent years. Cryptocurrency-native venture capital and traditional venture capital have received huge financing as examples. In 2021 and 2022, venture capital firms invested more than $37.7 billion and $31 billion in cryptocurrency startups, significantly exceeding the total investment in all previous years.

Source: The Block Research

In contrast, in liquid markets, there are few structural buyers of cryptocurrencies, as long-term institutional capital flows to venture capital, which takes a large share. This problem is not unique to the cryptocurrency market. The long-term participation of other categories of market participants also varies according to market conditions. Even though some venture capital firms can operate flexibly and directly invest in liquid cryptocurrencies, they usually focus on risky transactions in the primary market due to professional knowledge and the structure of venture funds. Even if they invest in liquid cryptocurrencies, they usually do so on a separate basis. Transaction processing, rarely actively managed based on the latest fundamentals. They also seldom overweight the project investment, even if the price may be lower than when they bought it and the market suitability of the product is further proved.

Imbalanced Market Structure Brings Huge Opportunities

For investors who are willing and understand how to navigate the liquid cryptocurrency market, this misalignment of the market structure is an excellent opportunity to generate attractive risk-adjusted returns. Although the concept was succinctly explained by Kyle and Tushar of Multicoin Capital 6 years ago, it still applies today. Most cryptocurrencies today are basically liquid venture capital (except Bitcoin), and because the field is still in its early stages, most cryptocurrencies are young, less than five years old, with high potential returns, exhibits a fat-tailed distribution.

For most investors with limited capital, investing in cryptocurrencies through a liquid venture capital approach will yield the best risk-adjusted returns given the dynamics of the space. This approach allows investors to earn venture capital-like returns while being able to manage the investment as an asset with public market liquidity. There are many cases where most of the returns for these cryptocurrencies come from liquid markets following a Token Generation Event (TGE). This is important because cryptocurrency networks also exhibit a power law where market leaders can maintain leadership and dominance, as evidenced by the dominance of big tech companies in US stock market capitalization today.

Source: CoinGecko, ICODrops as of March 27, 2023

Since liquidity risk cryptocurrency investors can adjust position size and manage investment risk in real time based on changes in fundamentals, they don't need to cast a wide net in hundreds of projects to offset their investment with some 50x to 100x returns Instead of the rest of the underperforming stocks in the portfolio, you can focus your investments on 10-20 higher-return projects that generate solid risk-adjusted returns.

At the same time, this strategy enables investors to better manage investment risks, because they can wait for the relevant cryptocurrency protocols/products to get more market verification, and then make additional investments. Conversely, if the cryptocurrency does not meet the initial expectations, reduce investment.

As Kai Wu of Sparkline Capital puts it:

“Investing in early-stage innovation projects has very high implied volatility. Due to the existence of power laws, startups present a very wide range of outcomes. Crypto tokens allow us to directly observe this volatility, which is usually annualized. up to 100%.

Therefore, innovative investors should pay close attention to liquidity. Technology trends can change abruptly, and today's best startups may not maintain their momentum tomorrow. Liquidity allows investors to change direction at any time in a rapidly evolving environment. "

Fundamental investors are the key to developing an effective cryptocurrency market

Broadly speaking, for the cryptocurrency ecosystem, liquidity venture investors can play a key role in establishing a strong co-ownership culture in Web3, where token economics and governance enable product users, startups and Investor incentives remain consistent. For example, capital and liquidity support from investors can help solve the cold start problem of DeFi protocols and promote the adoption of protocols. These investors can also play a practical role in the development of the protocol, such as actively participating in governance and providing input on the strategic direction of the protocol/product.

Finally, the emergence of more and more liquid venture investors who focus on fundamentals in the market will help improve the market efficiency of the public market of cryptocurrencies, help cryptocurrencies achieve their fair value, and balance the excessive number of private placement VC investors .