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Crypto Investing Dynamics: Navigating the Thermodynamics of Risk and Return

Aug 24, 2023 at 12:37 pm

The fundamental principle of the first law of thermodynamics, which states that energy cannot be created nor destroyed but only changed in its form, finds resonance in the realm of investing. This analogy holds true as risk and return undergo a constant cycle of transformation within the investing landscape. You might also be familiar with the popular crypto saying, "Everyone buys bitcoin at the price that they deserve." These two concepts essentially convey the same notion, albeit using slightly different terminology: as the structural risks associated with crypto investments evolve over time, so do the opportunities for potential returns.

In the early days of bitcoin's emergence, a multitude of risks existed. One of the initial and most prominent risks was "existential risk." This uncertainty lingered particularly in 2014, given the Mt. Gox hack and the uncertainty around bitcoin's survival. This marked the era of perplexing transactions, like the instance when a pizza enthusiast spent 10,000 BTC (now valued at around $300 million) for a couple of pizzas. As the market gradually reevaluated the existential risk, the value of bitcoin surged, establishing a new price equilibrium for new investors who no longer needed to be concerned about that specific risk.

Another risk in the spotlight was "financial/funding risk," revolving around whether sufficient capital would flow into this asset class to propel the envisioned technological revolution. This risk was mitigated by significant inflows of venture capital, reaching over $50 billion between 2021 and 2022. With each removal of a layer in crypto's multifaceted risk landscape, the price experienced further upswings. In the current year, we contend that regulatory risk is poised to be the next factor to be addressed. While progress might occasionally be obscured, we hold the belief that crypto will navigate through this risk (as seen in instances outside the U.S.) and pave the way for the next evolution in risk dynamics.

The Transformation of Crypto Returns Across Structural RisksThe Transformation of Crypto Returns Across Structural Risks 

Naturally, various risks still persist, which is why investors continue to have the potential for significant returns. However, as each risk diminishes, the potential returns tend to become more incremental in nature.

So, if this energy of risk and return isn't destroyed, how does it transform? With regulatory risk assuming a central role, we observe a dynamic shift in the landscape of digital alpha investing:

1. Offshore market makers are witnessing reduced trading volume, impacting quantitative market-making strategies and high-frequency arbitrage trading.

2. Government lawsuits targeting altcoins as potentially unregistered securities cast a shadow on the range of viable tokens for fundamental investors seeking alpha.

3. Regulations surrounding qualified custody exert influence on all on-chain strategies, where the forefront of financial innovation and market structure resides today.

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