• Bianca Chen

Anticipating the Boom-bust Cycle in Cryptocurrencies: When does an Ecosystem Become an Echo-chamber

Updated: Oct 6, 2018

The cryptocurrency market experienced its best year ever in 2017. A number of people became rich overnight by being smart or just plain lucky. The boom also made several new funds the new darlings of the industry. Olaf Carlson-Wee and his crypto fund Polychain were undoubtedly among the biggest winners. After turning $4 million into $10 billion, Olaf set a sample for the crypto investment world. However, according to a WSJ article published last month, following the crypto market crash this year, Olaf’s legend may well be short-lived.

However, without hearing from many of the investors who pulled their money out of Polychain directly, we are still not quite sure of their version of the story. Although Polychain is a relative latecomer, many backers were some of the fund industry's most seasoned veterans. Their view on this emerging asset class is still unclear to the public.

Here, I would like to share an exclusive interview with Jeffrey Tarrant, the founder of Protégé Partners and Mov37, also a guest on my docuseries “Next: Blockchain”, by our contributor Niki Natarajan, the founder of In Ink and an asset management journalist with more than 20 years’ experience. In this piece, they discuss Tarrant’s investment experience in crypto funds including Polychain and his view on cryptocurrencies and blockchain.

Jeffrey Tarrant, the founder of Protégé Partners and Mov37

Niki: We first met 16 years ago, when you were pioneering the emerging hedge fund manager space, today one of your latest fascinations is blockchain. How did you get here?

Jeffrey: I spent four years ‘hanging out’ with tech-savvy innovative youngsters in places like Silicon Valley, MIT Media Lab, Oxford, Cambridge and University College London and became convinced that the next generation investment manager would run money at the confluence of data, data science, artificial intelligence, crowdsourcing and blockchain.

Dubbed ‘The Third Wave’ by Wired magazine, this intersection of man plus machine, now known as autonomous learning investment strategies (ALIS), led me to found MOV37 in 2017, where we have recently created a new fund to incubate ALIS managers and blockchain-related ventures.

The archetypal money manager of this new genre is Richard Craib. He is a 30-year old South African, Cornell mathematics major, who founded Numerai. Last year, Numerai, which I and a few others including Paul Tudor Jones, Union Square Ventures and Fred Wilson have backed, became the first hedge fund to launch its own cryptocurrency.

Numeraire, the cryptographic token is aimed at incentivizing data scientists around the world to contribute artificial intelligence to the Numerai hedge fund. Numeraire, which was a free option granted to me and my investors when we co-invested with Union Square into the GP, was deployed, and 1.2 million tokens of the maximum 21 million tokens were sent to 19,000 data scientists around the world.

Niki: How does the crypto mania compare to the dot-com bubble?

Jeffrey: It has become fashionable to compare the rise, and subsequent fall, of cryptocurrencies to the tulip mania in the 17th century and Wall Street’s crash of 1929. Crypto’s recent 80% plunge is now worse than the burst of the dot-com bubble in 2000.

The one upside of the fall in value of cryptocurrencies, however, is that unlike the dot-com bubble, which saw the Bloomberg Internet Index of 280 internet stocks go down $1.7 trillion from a 52-week high towards the end of 2000, they are unlikely to take the global economy down with them.

A Brief History of Bubbles

(Source: Bloomberg, International Center for Finance at Yale School of Management, Peter Garber. Starting price is the price three years prior to each asset’s high, or the earlier available price in cases with fewer than three years of data.)

Today, there are close to 2,000 cryptocurrencies. By market capitalization, Bitcoin is still the largest blockchain network, followed by Ethereum, Ripple, Bitcoin Cash, Litecoin and EOS.

The cryptocurrency froth came in the form of high net worth investors bypassing the venture capitalists to create a feeding frenzy for Initial Coin Offerings (ICOs) and Simple Agreement for Future Tokens (SAFTs), a market that was swamped by more than 2,000 agreements.

In the mid-90s, long/short technology focused hedge funds used to hold private equity pockets of ‘pre-IPO’ holdings. Unlike ‘pre-IPO’ holdings, where investors owned a stake in a company that could survive and eventually create value, ICOs are based on white papers, often written by charitable organisations, that may or may not have any substance, let alone any intrinsic value.

Niki: How did you first get involved in cryptocurrencies in the first place?

Jeffrey: Peter Gabriel.

Niki: Peter Gabriel of Genesis fame?

Jeffrey: Yes. Would you believe that my singer, song-writing childhood hero, the sound track to my youth, became the portal to my blockchain fascination? On top of his successful solo music career, since 1992, Peter has been running human rights organisation, WITNESS, and it was through being on the board of it that I first met internet and technology entrepreneur Joi Ito a decade ago.

Joi went on to become director of MIT Media Lab, which CBS’ 60 Minutes called ‘The Future Factory’ and, together with entrepreneurs such as LinkedIn co-founder Reid Hoffman and venture capitalist Fred Wilson, we helped to endow the Digital Currency Initiative, created to foster an independent academic exploration of blockchain technology and cryptocurrencies.

It was set up to provide financial support for the work of Bitcoin developers Gavin Andresen, Cory Fields and Wladimir van der Laan, who had previously been supported financially by the Bitcoin Foundation at a time when Bitcoin’s ecosystem reputation had taken a bashing thanks to scandals such as Silk Road, the online marketplace for the illegal, and Japanese Bitcoin exchange Mt. Gox, which saw some $450 million of the cryptocurrency fraudulently ‘disappear’.

Niki: How has your cryptocurrency experience compared to The Greatest Trade Ever?

Jeffrey: In October 2016, before the bubble became apparent, I invested day one in Olaf Carlson-Wee’s fund that became the largest crypto hedge fund at approximately $1 billion. At the time, Olaf was a 27-year old Vassar College graduate whose senior thesis was on Bitcoin and a former employee of cryptocurrency exchange Coinbase.

Despite his having no formal training in financial analysis or track record of managing money, I also took a stake in the General Partner of PolyChain Capital. My 30 years of allocating to emerging talent might have helped me make the decision to invest, but it was more useful to see the signal to exit.

When smart people start over hyping and intellectualizing, and the egos start to match the oversized returns, the time to exit is usually close behind. There were numerous blogs all interviewing and quoting Olaf, who even made it as a Forbes cover star.

To me this was a sign that what had once been a technology-driven financial ecosystem had now become an echo-chamber of self-congratulation and one-upmanship. But to be honest, the real clincher to exit was an email from Olaf changing the fund’s terms.

In my world there are two types of money managers: ones that understand the difference between luck and skill, and those that don’t. If a money manager says it is all about [their] skill it’s time to leave. On 31 December 2017, I was cashed out.

To put the timing into context, exiting at this point meant that I had crystalized 25 times my original investment in just 14 months. Let’s just say, by way of comparison, a decade before, my clients and I had made nine times our original investment over two years when we backed John Paulson with $60 million for his fund that bet against bonds backed by subprime mortgages using credit default swaps.

Niki: Can you put the crypto bubble into context?

Jeffrey: Naysayers question how a concept that has no tangible backing can even become a bubble. The reality is economically simpler: investors are looking for a non-sovereign currency alternative. The top six central banks have been buying long dated fixed income, government bonds and equities in a process of quantitative easing, flooding the market with unlimited paper money.

Over the past decade that means these six central banks hold close to $20 trillion of QE assets, which, in some cases, is more than has ever been held in an environment of never before seen negative nominal yields in sovereign bonds. Since this has never happened before, the data on this scenario does not exist, so models and hypotheses cannot accurately predict what will happen.

The interesting part of this history lesson is that the central banks purchased these assets by issuing wampum in the form of “fiat” currencies, an unlimited supply of paper with no direct physical gold or otherwise backing. These currencies were issued by the same governments that let the great financial crisis develop and nearly devastate the global financial system.

But as Carmen Reinhart and Kenneth Rogoff wrote in This Time is Different: Eight Centuries of Financial Folly, all fiat currency systems have eventually failed. As people have been looking for other assets to own, bonds, equities and property have appreciated greatly, possibly due to such reasons.

Bitcoin, with its mathematically finite 21 million units (as opposed to limitless supply of paper), has become the new ‘currency’ alternative for the wealthy Silicon Valley intelligentsia, further fueling the shift from ecosystem to echo-chamber. But whether or not cryptocurrencies survive another 10 years, misses the point of the real paradigm shifting technology: blockchain.

I personally believe that blockchain is a game changer not only in finance but in other industries. Since the invention of double entry accounting, which dates back to the Renaissance, blockchain, or more specifically the distributable, immutable consensus ledger combined with homomorphic encryption, will transform secure data processing to allow financial services, and numerous other industries, to move to a whole new level.

Contributor: Niki Natarajan

With more than 20 years’ experience as an asset management journalist, Niki Natarajan founded In Ink (London) to specialise in creative content in 2014. For 12 years, Niki ran InvestHedge, a monthly publication dedicated to the fund of hedge funds community, which is where she first met Jeffrey Tarrant as he was founding Protégé Partners. In this role, she organised and hosted the InvestHedge Forum and FoHF awards, an event that this year is honouring Jeffrey Tarrant by inducting him into The Hall of Fame. Prior to this, Niki worked for Financial News and Institutional Investor, where she was launch editor of Global Fund News, editor of Foreign Exchange Letter and reporter on Global Money Management.