Given the recent volatility in digital assets, it’s natural to question future opportunities in this space – but regardless of volatility, they are there. To better understand the potential of what’s to come in the wide-open landscape of digital assets and blockchain technology in a Web3 context, turn the dial of your time machine just a few clicks to the left and set it to “1990 “. Few people understood what could become of the Internet. The timely exchange of information relied on fax machines. Smartphones and internet-bound mobility? Not even a twinkle in Steve Jobs’ eyes.
“Today we are in the early days of a likely 30-year, decade-long investment opportunity that is Web3 blockchain technology,” said Scott Army, managing director and CIO of Galaxy Vision Hill, the multi-manager fund of funds offering at Galaxy Digital . “In the 1990s it would have been very difficult to capture any of the entire industries that would grow out of the internet. Whole app ecosystems still had to be designed. Today, in many ways, we are at the base level of redesigning this entire technology stack and are just scratching the surface.”
Many institutional investors — veteran observers and long-game players — share Army’s perspective. Venture capital firms invested more than $33 billion in crypto/blockchain in 2021 – more than all other years combined. Additionally, in Q4 2021, valuations in the space were 141% higher than the rest of the VC space.1 In short, institutional investors largely believe in and are making allocations to support the growth of blockchain technology and the space at large. Such investments are likely to lead to an improvement in the quality of the investment process. Maybe they feel that way because they see it in prison, for example.
“Asset safety has always been important to institutional investors,” says Army. “Over the past five years, custody solutions have improved significantly, not just for Bitcoin and Ethereum, but for many mid- and small-cap assets. Hedge funds and venture funds can securely own and custodian these digital assets in an institutional manner. Many traditional custodians in the wealth management world are partnering with crypto-native custodians because they know there is a need and their clients are asking for it.”
Evolving need for specialization
A common misconception about crypto is that there is only one thing that can be attributed to anything and that everything is the same as everything else. Indeed, there is considerable segmentation and specialization, much of which results from old-school relationship building.
“Digital assets are a global asset class and we invest globally, but localized deal flow is important, especially in the early stages,” says Army. “We like local relationships at an early entrepreneurial stage where you really incubate and work closely with the founders and help them recruit and hire the team. If you are practical, we will be very valuable as a venture investor.”
Institutional interest in digital assets is likely to increase as the space matures to offer more robust companies to invest in – real returns from specific stocks in the space and venture investments make it more familiar and easier to compare to a traditional valuation framework . This is being observed to some extent as digital assets begin to disrupt other sectors such as gaming, healthcare, wireless and data storage. Some non-traditional aspects of the investment process also need to be adjusted.
“The importance of operational due diligence in crypto and digital assets is very different than in traditional ones,” says Army. “Crypto is a new instrument, so operational due diligence is complex in terms of new providers, trading counterparties, counterparty risk, the instruments being traded, and so on. Many in-house teams cannot perform the required level of operational due diligence in this area, so we are often asked to do this for clients. Investment due diligence and operational due diligence are dual in our team and have been from the start due to the importance of a comprehensive focus on both parts of the diligence process.”
Another area that requires a shift in perception is the context in which risks are viewed. “Institutional investors aren’t going to change the way they aggregate risk assets, so you tend to see the teams that are looking at digital assets in a similar way,” Army says. “A venture group looking to invest in emerging technologies, for example, can look at blockchain technology from a similar perspective and allocate a portion of their normal venture allocation to the space. This has been the easiest route for institutions to enter the market because it’s the clearest route — and often, a multi-decade technology iteration aligns well with this venture allocation. A hedge fund team that focuses on absolute return will look at digital assets and question whether there is relative value and might see it as a potential proxy for stock volatility or equity absolute return.”
The net result of this has been increasingly specialized products for different types of investors. For example, a nimble multi-family office with a higher risk tolerance may want to move aggressively into certain parts of the directional market. Larger, more risk-averse institutions not only want to classify risks correctly, but also want to understand volatility and liquidity parameters, among other things.
“We have a market-neutral fund that appeals to those who are more risk-averse,” Army says. “Our venture fund works well for people who are comfortable with investing for a longer period of time and don’t want more market risk. We see that the questions are becoming more nuanced and the demand for 24/7/365 expertise in this area is very high. Many of our partners consider us a de facto OCIO alongside our role as a multi-management fund manager.”
With new investors entering the digital assets space amid the movement toward decentralized finance, investors often wonder when exactly this decentralization will happen. In short, it won’t happen overnight.
“Societies have been centralized for thousands of years,” says Army. “There is a role for trust and centralization. Not everything has to be decentralized. We’re going to evolve to a Web3 world, but there’s a 2.5 in between that might have some decentralized protocols as the base layer with some centralized business models on top that can add a trust layer if needed. Then the process improvement can be done at the protocol level.”
This type of insight is pervasive in an investment approach that is a broad expression of the thesis that is crypto and blockchain technology.
“We seek to attract the emerging category winners of the future, maximizing opportunity and minimizing individual risk—whether it’s with a single project or a single manager,” says Army. “How do we do that? Through high-quality allocations to top crypto venture managers – both aspiring and marquee-type managers.”
1Galaxy Digital Research, 2022.