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Arca 2022 Outlook: Themes & Narratives We’re Bullish On
by Jeff Dorman, CFA, Chief Investment Officer
Over the last few years, we’ve released annual and mid-year predictions focused on the source of growth for digital assets. Occasionally, we get a few big ideas right:
- In early 2020, we wrote about the rise in DeFi and rewards
- Mid-2020, we discussed the rise of NFTs
- Early in 2021, we discussed the rise in social / sports tokens.
Arca’s fundamental investment process begins with a top-down, thematic approach; these themes go on to drive Arca’s focus, time, and investment dollars. We believe that 2022 is going to be another incredible year of growth in select areas of the digital assets ecosystem. We reached out to members of the Arca team across legal, compliance, marketing, business development, and labs/innovation; we also tapped the investment teams from both our venture and liquid portfolios. Here are the themes where we will place a heavy emphasis in 2022 and beyond.
#1: The macro backdrop will be positive, despite a few periods of instability The macro landscape will be mixed in 2022, but will ultimately remain supportive for digital assets. To start, inflation pressure will likely subside. When inflation is low and tame, it greases the wheels of a productive capitalist system. Issues arise when inflation begins to erode real purchasing power, which becomes a tax on the population. Some have tried to dismiss inflation, while others have gone to the extreme, calling for hyperinflation. The reality, of course, lies somewhere in the middle. The inflation we’re seeing today is real, has been persistent, and is hurting people’s pockets. On the other hand, hyperinflation is not a real risk in a country that has an aging population, massive debt load, a highly diversified and dynamic economy, and controls the global reserve currency. Furthermore, year-over-year comps will get a lot tougher when comparing price changes to 2021 rather than against a 2020 depression (albeit quick).
We recognize the current inflation as a problem, but can do so without blowing it out of proportion. From an investing standpoint, it’s likely that we are in an “inflationary boom” economic quadrant, which is a pro-risk environment. While this may shift in the middle of 2022, it won’t be disastrous. Low rates, persistent but moderate inflation, strong growth, and a secular shift from analog to digital will continue to provide a favorable backdrop for investing broadly in digital assets.
Perhaps more importantly, the excessive money printing, the instability of our centralized government, and a general distrust of financial institutions have led to a continual deterioration of confidence in our traditional systems. Certain aspects of the blockchain-based economy offer people an alternative to the dollar and TradFi. Further, increasingly common technological shortcomings seen at traditional financial institutions will continue to erode their authority.
While digital assets will remain a growth asset in 2022, it is quite possible that additional segments of the ecosystem will begin a maturation process into a safe-haven.
#2: Growth in institutional capital will lead to increased prices and a changing lexicon away from Bitcoin This year, we’ve seen headlines with reference to institutional investors buying the most well-known digital assets—Bitcoin or Ethereum—for the first time, and that’s been a nice narrative. Behind the scenes, the institutions that manage the overwhelming majority of global investable assets have gone from uninterested to exploratory, and most recently, to a period of deeper due diligence. We will begin to see the culmination of that diligence as billions of dollars in new capital flow into the digital assets market.
As institutional capital enters the market in an exponential fashion, the marginal buyer will far outpace the marginal seller. 2022 will serve as further proof that digital assets are part of a secular shift rather than a short-term trade. The intricacies of institutional digital asset exposure have surpassed the previous “yes I have exposure” or “no I do not have exposure” bucketing of investments. Investors are already examining how digital assets can fit into their existing framework, and this trend will accelerate in 2022. Investors may not immediately dive deeply into the various sectors of the ecosystem, but they will surpass binary exposure.
As a result of education and allocations, anyone who still views the digital assets world in Bitcoin-dominated terms will be left behind, as this industry will prove to become more well-rounded. Terms like “AltCoins”—used indiscriminately to describe anything that isn’t Bitcoin—and “Bitcoin Dominance”—used to show the percentage of total market cap represented by Bitcoin—will fall by the wayside as more sophisticated capital enters the market. Further, as digital assets now represent currency-, equity-, fixed income-, real estate- and commodity-like features, we believe that digital assets will be viewed as more than just a 6th asset class. Instead, digital assets will be recognized as the technological wrapper for next-generation value and the digitization of all existing asset classes.
Bitcoin is likely to continue to increase in value versus the dollar, but true institutional investors are not looking at this space as a macro or beta play, but as an investment allocation to a growing technology that spans a broad swath of sectors and industries. This will lead to the adoption of terminology and taxonomies that fit within our existing investment landscape. According to the recent Crypto Literacy Survey, all but 2% of survey participants across the US, Mexico, and Brazil failed to score 60% or better on a quiz of basic concepts related to bitcoin, stablecoins, and NFTs. As companies prioritize educational initiatives, it removes the barrier to entry and leads to rapid growth.
#3 Regulation will be slow, but ultimately positive The most immediate and sensible forms of regulation surrounding stablecoins and centralized exchanges should be a near-term event, and will likely fall under existing laws and frameworks. This may appear draconian at first, but will ultimately lead to trillions of dollars of new capital entering the system, which should offset any price weakness. However, the current laws do not fit all digital assets or decentralized finance (DeFi) applications. New frameworks that encompass these areas will require new laws, which will take years to develop. This will be heavily influenced by new crypto-friendly Members of Congress and a powerful digital asset lobbying effort. As such, regulation is likely to persist as an overhang to digital asset prices, as indicated by today’s depressed multiples for real cash-flowing digital assets in the DeFi and gaming spaces. Multiple expansion will offset any perceived weakness as these concerns are alleviated.
Elsewhere, the approval of the first Bitcoin futures ETF has helped the SEC get comfortable with financial products incorporating digital assets, but market manipulation and arbitrage are still factors that the SEC will naturally need to see addressed in order to authorize the first spot ETF.
#4: Thematic investing will continue to drive the majority of investment gains
From an investment standpoint, Arca remains thematically focused on DeFi, sports and entertainment as it pertains to fan engagement, gaming and NFTs, and web 3. We are further investigating consumer apps, structured products, and systems whereby early users are rewarded.
NFTs will continue to grow and evolve
Minting is the process of creating and solidifying a digital asset on a blockchain.The minting process of NFTs has been ad hoc, though, with the process varying depending on the platform (like Foundation, OpenSea, or Rarible). The different minting structures and smart contract standards have led to cross-platform compatibility issues, which has discouraged many creators. We believe this process will become standardized. A standardized process will enable a new class of entrants to participate in the ecosystem with confidence, knowing that an industry standard exists for minting their new digital assets.
We also expect that NFT value will shift from art and collectibles to intellectual property. Purchasers of collectibles and art-based NFTs achieve inclusion in a community and ownership of an asset, but the asset is theoretically one-dimensional; it lacks character, history, or any narrative context. The community offers an opportunity to enhance NFTs by building out their intellectual property. The creation of a rich backstory supported by books, games, and movies will help increase asset value.Further, NFTs will become increasingly widespread as they are better understood, and will continue to be another on-ramp to digital asset adoption beyond Bitcoin. NFTs are a means toward world digitization. Anything that is unique and non-interchangeable can be a non-fungible token—tax forms, residential property, music and royalty rights, and beyond. NFTs with both monetary and non-monetary value will make the digital migration, following in the footsteps of money, communication, news, and other daily activities.
Finally, we presume that NFTs will begin to fractionalize and financialize. For example, if you can set a floor price for a series of unique NFTs, you can then create indexes and derivatives on the prices of a unique set of assets. Imagine a company similar to Zillow that would calculate yields on metaverse land or NFT collateral with which to use in DeFi protocols. While true adoption of land and metaverses may be years away, the tools that bring us to that inevitable adoption are going to begin in earnest in 2022.
Rewards will continue to drive upward pricing of assets
There will be an overhaul of how projects reward and incentivize users (liquidity mining and retroactive airdrops). In an effort to create sticky users rather than financial mercenaries, many projects have experimented with how to incentivize and bootstrap growth by rewarding users with their native tokens. The data collected over the past year has provided good insights and analysis into what new users are doing with the tokens they receive—if they are long-term holders and if they participate in governance. The data suggests that oftentimes, they do not.
We will see a continued evolution in 2022. As an increasing number of companies and projects introduce rewards via staking, LP’ing, airdrops, and more, the ownership of physical tokens will continue to be more valuable than owning a proxy of that risk via futures or other derivatives.If the market continues to evolve to the point where there is no real juice in the spread, arbitrageurs will end these trades in favor of strong token holders who are willing to take the directional risk. We expect this to be an important element of market structure going forward. This will not impede the growth of the derivatives market, but will create more efficient market dynamics.
The move toward DeFi 2.0 is an effort to solve for this. While this is a very broad term, it encompasses a necessary evolution. Further, while these rewards have largely been driven by “crypto-native” companies within DeFi and gaming, we’re on the precipice of new entrants to the market that are rooted in traditional consumer businesses like restaurants, airlines, telecom, and retail. Just as Domino’s Pizza became an internet company a decade ago, these consumer-facing businesses will become “blockchain companies”, and will find a way to incentivize and reward customers for taking certain revenue-enhancing and customer-stickiness actions.
Wall Street institutions are starting to take notice as well; we may see the emergence of “Institutional DeFi” in 2022. Some early glimpses into what this could look like include Aave Arc and Compound’s Treasury coupled with the MetaMask institutional wallet. These projects are experimenting with innovative Know Your Pool modules that could help evolve the dated KYC processes of today and unlock DeFi for the new institutional inflows.
We believe that decentralized autonomous organizations (DAOs) will begin to unlock value through diversification and value-accretive deployment of their treasuries. Currently, treasuries are incredibly large, but are often held in a single token (the native token of the DAO itself). This dynamic limits the effectiveness of the treasury and restricts growth initiatives. As DAOs find more creative ways to monetize and diversify their treasuries, and turn this balance sheet into a more productive asset, it will unlock the value of the DAO. For example, Ethereum DeFi usage has suffered due to the network’s scaling issues and increasing transaction costs. Now that dozens of layer 2 scaling solutions are ready to deploy on mainnet, the DAO treasury warchests of DeFi projects can be deployed to incentivize users who left for low-cost/high TPS alternatives (such as Solana and Avalanche) to come back and use the network.
However, governance still remains a drag. Fully centralized is not the solution, but a rush to complete decentralization also creates an inefficient internal workflow. There is a spectrum, and project leaders need to tap into centralized processes in an effort to become more decentralized over time. These entities need to establish a better cadence and structure for governance, and they must provide more transparency. For example, one day per month the decentralized project could accept proposals, and one day per month there could be a vote. Similar efforts will be rewarded both in token price appreciation and voter turnout.
While DAOs attempting to be broad companies have had limited success, DAOs structured around single, clear-cut initiatives have proven more successful. For example, ConstitutionDAO rallied people and money around the singular goal of buying a copy of the constitution. While the bid was unsuccessful, it opened our eyes to how decentralization can be applied to other areas-—labor organizations, governments, project finance, and massive open online educational courses. This type of open, accessible structure will develop further to incorporate decentralized governance with ownership tokens. While some DAOs look like for-profit LLCs, they are a small subset of what DAOs ultimately canvass, which includes every form of institution.
Moreover, the growth in DAOs will force change among historically passive investment groups, like venture capital. VCs will need to actively engage in community governance to advance projects. Venture capitalists traditionally receive ownership stakes and influence through capital and management advisory. Decentralized projects on the blockchain have upended this framework by introducing governance tokens that let the user community vote on business decisions, such as product roadmaps, token issuance, and capital disbursements. Digital asset VCs must collaborate with these communities to promote business initiatives and increase network effects.
Play-to-Earn will morph into Learn-to-Earn
The success of Axie Infinity and the play-to-earn model has fostered record amounts of investment into gaming and NFT companies looking to replicate this success; the same methodology can be applied outside of gaming. Blockchain technology grants all individuals equal access to education and provides for an impartial evaluation of talent. Consequently, skilled individuals will be paid to learn, radically upending the current system. Moreover, this dynamic could lead to better hiring practices based on a public blockchain record of excellence. This can be extended further to credit scores based on action, rather than on finances. Currently, most of DeFi is over-collateralized; with the creation of verified, provable credit scores on-chain, lending will move toward under-collateralized unsecured loans based on the credit-worthiness of the borrower.
For example, a decentralized identity (DID) refers to any subject (person, organization, thing, data model, or abstract entity) as determined by the controller of the DID. In contrast to typical, federated identifiers, DIDs have been designed so that they may be decoupled from centralized registries, identity providers, and certificate authorities. Specifically, while other parties might be used to help enable the discovery of information related to a DID, the design enables the controller of a DID to prove control over it without requiring permission from any other party. DIDs are uniform resource identifiers (URI) that associate a DID subject with a DID document allowing trustable interactions associated with that subject. A DID with a decentralized credit score that is composable across all platforms and applications is imminent.
DeFi 1.0 makes a comeback via protocol-owned liquidity (POL)
After getting off to a hot start in January 2021, DeFi 1.0 (AAVE, SUSHI, YFI, COMP, and others) largely underperformed the broader market for the remainder of the year. This was driven by many factors including, reduced APR for liquidity mining incentives, high ETH gas prices, cross chain bridges, and better incentives on other L1s and (IV) DeFi 2.0.
DeFi 2.0 (OHM, TIME, TOKE) introduced the concept of POL and captured the market’s attention by essentially flipping liquidity mining on its head. Liquidity mining incentivizes mercenary capital that both dilutes and devalues the “equity” (the native token) of a protocol—that is: contribute TVL, farm, dump the tokens, take back TVL, and move on.
With POL and bonding, farmers are essentially contributing TVL to protocol equity in the form of non-native tokens (DAI, LUSD, ETH, and others in exchange for OHM) which diversifies the balance sheet and creates a revenue stream for the protocol to earn fees from the bonded pairs.
We think legacy DeFi 1.0 protocols transition to the POL model in order to revive interest in their projects, rebuild their balance sheet, and create more revenue streams for native token holders (lowering P/E creating value). We are already seeing smaller projects (like ALCX and SYN) work with Olympus DAO to sell bonds in exchange for native tokens; we think this trend is worth watching. It may be the change the legacy ETH blue chips need to reinvigorate their investor base.
Robinhood Effect will be the new Coinbase Effect
Currently, Robinhood only allows for trading of 7 assets 5 of which would be deemed undesirable by anyone who does more than 10 minutes of research. As Robinhood expands token offerings, those digital assets listed will benefit as they tap into a large, trade-happy investor base.
The Metaverse will be the gateway for traditional, non-crypto native companies
The metaverse as a concept has captured the attention of many Fortune 500 companies and is the new buzzword to add to any strategy pitch. However, the proliferation and addition of metaverses will be the gateway through which traditional companies begin wading into the digital assets space. For traditional companies, metaverse opportunities offer a way to connect with more customers, and therefore offer new revenue opportunities. Brands can offer virtual shopping that scales far better than brick-and-mortar stores. The metaverse is a new area that can be used for advertisements and promotions, similar to billboards and ads on public transit.
It will be a race to solve the cross-chain problem
2021 gave rise to a new class of layer 1 smart contract platforms, and saw a resurgence of interest in layer 2 solutions for Ethereum as gas costs became exorbitant. In addition, we are beginning to see the rise of layer 0 and multichain ecosystems such as Cosmos and Polkadot. We now have $250b of TVL across over 80 chains. With so much value dispersed in different places, 2022 will be the year that projects race to effectively bridge assets between these chains with the smallest cost and friction to the user. While there are already some solutions, none have developed a seamless bridge.
We will NOT see a broad-based “end of the cycle” decline in digital assets
The past is not indicative of the future, especially when the past is a tiny sample size that no longer comes close to matching today’s ecosystem. We do not believe that there will be a broad-based market decline in digital assets and we do not believe in “4-year market cycles”. In fact, you could argue that 2021 was already a bear market for DeFi, while it was a bull market for NFTs, gaming, metaverse, and layer 1 protocols. 2022 is likely to yield something similar: a bear market in some sectors and a bull market in others. This is no longer a single-attribute asset class, but a technology that underpins all asset classes. As such, some of these sub-asset classes will do well while others perform poorly. We may continue to have steep, quick, highly correlated corrections, but as we’ve seen throughout 2021, certain assets and sectors will bounce back faster and stronger than others. If you’re looking to short “digital assets”, you better do a lot of research into the specific assets you are shorting. A lazy man’s approach to =broad-based, 2018-like declines will not work in 2022.
#5 Expanded investment opportunity set will come from new issuer types
The best investment setup is an expanding and evolving opportunity set without expanded competition. That is why actively managed digital asset funds have outperformed passive strategies by such a wide margin. As new token types and features evolve, a research-based active approach can take best advantage.
The token opportunity set has expanded fast over the past two years into new sectors, new types of tokens, and new types of issuers—including protocols, individuals, and municipalities. We believe we’ll see further expansion in 2022, and presume that municipalities, universities, and small corporations will begin to issue tokens.
- Municipal bonds will replace general obligation bonds and revenue bonds with infrastructure and reward tokens
- Universities will issue tuition tokens, which will replace 529 plans and allow donors and boosters a better medium for donations
- Small corporations will issue pass-through tokens that combine loyalty rewards with quasi-equity. This is more likely to begin with local restaurants, barbers, gyms, and other retail facing establishments before gaining traction with publicly traded companies.
- “Security tokens” will finally enter the scene in a meaningful way. Alternative Trading Systems for digital asset securities are in their infancy; although there are only a handful, many more are currently undergoing the registration process. New listings combined with access to formerly untapped assets will help to increase the digital asset security market cap three-fold in 2022. The demand for liquidity will increase the need for ATSs to support secondary trading of these securities.
- Blue Chip companies and publicly traded institutions will continue to tokenize assets in order to reduce operating costs and gain access to assets with traditionally high barriers to entry
- The tokenization of real estate will be first, followed by equities, as investors seek the benefits that blockchain can deliver: speed, certainty and immutability