The Principles of Thermodynamics in Cryptocurrency Investment

The fundamental concept of the first law of thermodynamics, which posits that energy can neither be created nor destroyed, but only altered in form, finds an intriguing parallel in the world of investing. Here, the interplay between risk and return mirrors this principle, with neither being created nor annihilated; instead, they undergo transformation throughout the investment cycle. In crypto circles, you might have come across the meme, “Everyone buys bitcoin at the price that they deserve.” In essence, these two ideas convey the same message using different language: as the structural risks associated with crypto investing evolve over time, so do the opportunities for returns.

In the early days of Bitcoin (BTC), when it first emerged, it was accompanied by numerous risks, chief among them being existential risk. Back in 2014, there was significant uncertainty surrounding Bitcoin’s survival, particularly after the infamous Mt. Gox hack. This was the era of “funny money,” a time when someone unsuspectingly exchanged 10,000 BTC (now valued at around $300 million) for a couple of pizzas. However, as the perception of existential risk gradually diminished within the market, the value of Bitcoin surged, establishing a new price equilibrium that eased the concerns of new investors.

Another substantial risk in crypto’s history was financial and funding risk, which pertained to the question of whether enough capital would flow into this asset class to fuel the envisioned technological revolution. This risk was substantially mitigated by substantial inflows of venture capital, which exceeded $50 billion between 2021 and 2022. As this dimension of the crypto risk landscape faded, prices soared once again. As we enter 2023, regulatory risk appears to be the next significant hurdle to overcome. Despite occasional uncertainties, we believe that the crypto industry will navigate through this risk, much like it has outside the United States, ushering in the next phase of transformation.

While many risks persist, investors continue to have opportunities for substantial returns. However, with each risk mitigated, returns tend to become incrementally smaller. So, if this risk-return dynamic remains unchanged, where does it go? With regulatory risk taking center stage, we witness a continuously evolving landscape for digital alpha investing. Consider the following:

  1. Offshore market makers are reducing trading volumes, impacting quantitative market-making and high-frequency arbitrage strategies.
  2. Government lawsuits targeting altcoins as potential unregistered securities influence the pool of viable tokens for fundamental investors seeking alpha.
  3. Rules regarding qualified custody have repercussions for all on-chain strategies, which currently represent the cutting edge of financial engineering and market structure innovation.

In essence, as the opportunities for crypto beta gradually decrease, the opposite is occurring for crypto alpha. The reduction of these later-stage risks is paving the way for substantial financialization and institutional adoption. However, this transformation presents a dilemma for allocators. Simply investing with the largest funds is no longer a guaranteed path to success. We find ourselves in an exceptional era for smaller, capacity-constrained funds, which have a unique window of opportunity to outperform. Nevertheless, this situation won’t persist indefinitely, as the thermodynamics of crypto investing continue to evolve.

For discerning institutional investors, it’s essential to contemplate the role they want to play in this pivotal moment of transition within the crypto investment landscape.