The Thermodynamics of Crypto Investing

The first law of thermodynamics states that energy can neither be created nor destroyed, only altered in form. The same law can be appreciated in investing, where risk and return are never created or destroyed, just transformed through an investing cycle. You may also have heard the popular crypto meme, “Everyone buys bitcoin at the price that they deserve.” These two statements are saying the same thing, just in slightly different vernacular: As the various structural risks of crypto investing change over time, the opportunities for returns change, too.

Once upon a time, when bitcoin (BTC) came to life, there were many risks. One of the first primordial ones was “existential risk.” Back in 2014, it was not clear if bitcoin was going to make it, especially after the Mt. Gox hack. This was the baffling “funny money” era, when an unsuspecting pizza lover spent 10,000 BTC (now worth about $300 million) for a pair of pies. As the market eventually reduced its assessment of existential risk, the value of bitcoin rose, finding a new price equilibrium for new investors who no longer needed to worry about that particular risk.

Then there was “financial/funding risk,” i.e., whether enough capital would be mobilized into this asset class to lead the imagined technological revolution. This risk was ultimately reduced by massive inflows of venture capital, which reached over $50 billion in 2021 to 2022. As another dimension of crypto’s multivariable risk calculus was removed, the price jumped once more. In 2023, we would argue that regulatory risk is the next domino to fall. While, at times, progress may be shrouded in fog, we believe that crypto will work through this risk (as we’ve already seen outside the U.S.) and usher in the next transformation of risk.

Many risks still remain, of course, which is why investors still have the chance for outsized returns – though as each risk falls, returns become incrementally smaller.

So, if this risk-return energy is not destroyed, what does it become? As regulatory risk takes center stage, we see a continually transforming landscape for digital alpha investing. Consider:

• Offshore market makers are decreasing volume, which affects quantitative market-making and high-frequency arbitrage trading strategies.
• Government lawsuits that target altcoins as potential unregistered securities affect the viable universe of token selection alpha for fundamental investors.
• Rules around qualified custody affect all on-chain strategies, where today’s cutting edge of financial engineering and market structure innovation live.

In other words, while each incremental return opportunity for crypto beta is less significant than the prior, the opposite is happening for crypto alpha: The reduction of these later-stage risks is paving the way for extraordinary financialization and institutional adoption. Yet, this transformation creates an “allocator’s dilemma.” You can’t just offhandedly invest with the largest funds as a sure-fire path to success. Instead, we are currently in an exceptional era for capacity-constrained smaller funds, which have a unique opportunity to outperform. But, of course, that won’t last forever as the thermodynamics of crypto investing continue to transform. Astute institutional investors would be well-served to consider what kind of stake they want to have in this moment of transition.