Cryptocurrency Asset Management Company Arca: Five Major Development Trends and Nine Investment Themes in 2022

Author: Jeff Dorman

Original Title: "Arca 2022 Outlook: Themes & Narratives We're Bullish On"

Compiled by: Dong Yiming, Chain Catcher

In the past few years, we have published annual and mid-year forecasts focusing on the sources of growth in digital assets. At times, we have also had the right understanding of some important ideas, such as:

• At the beginning of 2020, we wrote about the growth of DeFi and incentives.
• In mid-2020, we discussed the rise of NFTs.
• At the beginning of 2021, we discussed the growth of social/sports tokens.

Arca's fundamental investment process begins with a top-down thematic approach, which continues to drive Arca's focus, time, and investments.

We believe that 2022 will be another incredible year of growth in specific areas of the digital asset ecosystem. We reached out to members of Arca's legal, compliance, marketing, business development, and labs/innovation teams; we also tapped into our venture capital and liquid investment teams. Here are the themes we will emphasize in 2022 and beyond.

1. Despite some periods of instability, the macro backdrop will be positive

The macro landscape in 2022 will be mixed, but ultimately, the development of digital assets will still be supported. First, inflationary pressures may ease. When inflation is low and moderate, it fuels the wheels of a productive capitalist system. Problems arise when inflation begins to erode real purchasing power, which turns into a tax on people.

Some try to ignore inflation, while others go to extremes, calling for hyperinflation. Of course, the reality lies somewhere in between. The inflation we see today is real, persistent, and damaging to people's wallets. On the other hand, in a country with an aging population, heavy debt burdens, a highly diversified and vibrant economy, and control over the global reserve currency, hyperinflation is not a real risk. Additionally, comparing price changes to 2021 rather than the 2020 recession (albeit briefly) will make year-on-year comparisons more challenging.

We acknowledge that current inflation is a problem. From an investment perspective, we are likely in an "inflation-induced false prosperity" economic quadrant, which is a risk-friendly environment. While this may change by mid-2022, it will not be catastrophic. Low interest rates, sustained but moderate inflation, strong growth, and the long-term shift from analog to digital will continue to provide a favorable backdrop for broad investments in digital assets.

Perhaps more importantly, excessive money printing, instability of central governments, and widespread distrust of financial institutions are leading to a continuous deterioration of confidence in our traditional systems. The blockchain-based economy offers alternatives to the dollar and TradFi in certain respects. Furthermore, the increasingly prevalent technological flaws of traditional financial institutions will continue to undermine their authority.

While digital assets will still be a growth asset in 2022, other parts of the ecosystem are likely to begin maturing and evolving into safe havens.

2. Growth of institutional capital will lead to a rise in Bitcoin prices

This year, we have seen news about institutional investors buying Bitcoin or Ethereum for the first time. Behind the scenes, institutions managing the vast majority of global investable assets have shifted from disinterest to exploration, and recently into deeper due diligence. As billions of dollars of new capital flow into the digital asset market, we will begin to see the results of this due diligence.

As institutional capital enters the market exponentially, marginal buyers will far outnumber marginal sellers. 2022 will further prove that digital assets are part of a long-term transformation rather than short-term trading. The complexity of institutional digital asset exposure has surpassed the previous binary "yes, I have risk exposure" or "no, I do not have risk exposure" portfolios. Investors are already studying how digital assets fit into their existing frameworks, and this trend will accelerate in 2022. Investors may not immediately dive into all areas of the ecosystem, but they will move beyond binary exposure.

Due to the results of education and distribution, anyone who still believes that the world of digital assets is dominated by Bitcoin will be left behind as the industry becomes more comprehensive. As more sophisticated capital enters the market, terms like "altcoin" (used indiscriminately to describe anything that is not Bitcoin) and "Bitcoin dominance" (to show the percentage of total market capitalization represented by Bitcoin) will be phased out. Moreover, as digital assets now represent characteristics of currencies, stocks, fixed income, real estate, and commodities, we believe that digital assets will not just be seen as the sixth asset class. Instead, digital assets will be viewed as the next generation of value and the digital packaging of all existing asset classes.

The value of Bitcoin against the dollar may continue to rise, but true institutional investors do not view this space as a macro or test game; rather, they see it as an investment allocation across a continuously evolving technology spanning various sectors and industries. This will lead us to adopt terminology and classifications that fit our existing investment landscape. According to a recent crypto literacy survey, only 2% of respondents in the U.S., Mexico, and Brazil failed to score 60% or higher on a quiz covering basic concepts related to Bitcoin, stablecoins, and NFTs. When companies prioritize educational programs, they eliminate barriers to entry and lead to rapid growth.

3. Regulatory progress will be slow

Recently, the most direct and reasonable forms of regulation surrounding stablecoins and centralized exchanges should emerge and may be constrained by existing laws and frameworks. This may initially seem harsh, but ultimately it will lead to trillions of dollars of new capital entering the system, which should offset any price weakness. However, existing laws do not fit all digital assets or decentralized finance (DeFi) applications. New frameworks that encompass these areas will require new legislation, which will take years to develop.

This will be heavily influenced by newly crypto-friendly lawmakers and strong digital asset lobbying. Therefore, as indicated by the low multiples of actual cash flow digital assets in today's DeFi and gaming sectors, regulation may continue to impact digital asset prices. As these concerns are alleviated, multiple expansions will offset any apparent weaknesses.

The approval of the first Bitcoin futures ETF helped the SEC accept financial products that include digital assets, but market manipulation and arbitrage remain issues that the SEC naturally needs to address before they approve the first spot ETF.

4. Thematic investing will continue to drive most investment returns

From an investment perspective, Arca remains focused on DeFi, sports, and entertainment, as it relates to fan engagement, gaming, NFTs, and web 3. We are further exploring consumer applications, structured products, and systems that reward early users.

1. NFTs will continue to grow and evolve

Minting is the process of creating and solidifying digital assets on the blockchain. However, the minting process for NFTs is unique and varies by platform (such as Foundation, OpenSea, or Rarible). Different minting structures and smart contract standards lead to cross-platform compatibility issues, which deter many creators. We believe this process will become standardized. A standardized process will enable new entrants to confidently participate in the ecosystem, knowing that there are industry standards for minting new digital assets.

We also expect the value of NFTs to shift from art and collectibles to intellectual property. Purchasing collectibles and art-based NFTs allows buyers to achieve community recognition and ownership of the asset, but this asset is theoretically one-dimensional—it lacks character, history, or any narrative context. The community provides an opportunity to enhance the value of NFTs by building their intellectual property—creating rich backstories supported by books, games, and movies will help increase asset value. Furthermore, as people better understand NFTs, they will become increasingly common and will continue to serve as another entry point for people to understand and embrace digital assets beyond Bitcoin.

NFTs are a means of realizing a digital world. Anything unique and non-fungible can be an NFT, such as tax forms, residential properties, music, and royalties. NFTs with monetary and non-monetary value will follow the digital migration of currency, communication, news, and other everyday activities.

Finally, we assume that NFTs will begin to be segmented and financialized. For example, if you can set a floor price for a series of unique NFTs, you can create indices and derivatives based on the price of that unique set of assets. Imagine a company similar to Zillow that calculates the yield on Metaverse land or NFT collateral used for DeFi protocols. While it may take years for humans to truly adopt the Metaverse and Metaverse land, we will begin to encounter these inevitable adoption tools in early 2022.

2. Rewards will continue to drive asset prices up

There will be a complete overhaul of how projects reward and incentivize users (liquidity mining and retroactive airdrops). To create sticky users rather than financial mercenaries, many projects have attempted to incentivize and guide growth by rewarding users with their native tokens. Data collected over the past year provides great insights and analyses on how new users are using the tokens they receive, whether they are long-term holders, and whether they participate in governance. The data suggests that, generally, they do not. We will see continued development in 2022.

As more companies and projects introduce rewards through staking, LP, airdrops, etc., owning physical tokens will continue to be more valuable than owning the risk through futures or other derivatives. If the market continues to develop to a point where there are no price differences, arbitrageurs will end these trades in favor of strong token holders willing to take directional risks. We expect this to become an important component of future market structure. This will not hinder the growth of the derivatives market but will create more efficient market dynamics.

Moving towards DeFi 2.0 is about addressing this issue. While this is a very broad term, it encompasses the necessary evolution. Additionally, while these rewards are primarily driven by crypto-native companies in DeFi and gaming, we are on the brink of new entrants rooted in traditional consumer businesses such as restaurants, airlines, telecommunications, and retail. Just as Domino's Pizza became an internet company a decade ago, these consumer-facing businesses will become "blockchain companies" and will take actions to increase revenue and enhance customer stickiness.

Wall Street institutions are also beginning to take notice. We may see the emergence of "institutional DeFi" in 2022. If you want an early understanding of what this might look like, you can look at projects including Aave Arc, Compound's treasury, and MetaMask institutional wallet. These projects are experimenting with innovative "Know your pool" modules that can help evolve today's outdated KYC processes and allow new institutional entrants to unlock DeFi.

3. DAOs and governance will continue to innovate but will struggle

We believe that DAOs will begin to unlock value through the diversity of their treasury and value-added deployments. Currently, the treasury is very large but is typically held in a single token (the native token of the DAO itself). This dynamic limits the effectiveness of the treasury and constrains growth initiatives. As DAOs find more creative ways to monetize and diversify their treasury and transform this balance sheet into more productive assets, it will unlock the value of the DAO.

For example, the use of Ethereum DeFi has been impacted by network expansion issues and rising transaction costs. Now, dozens of Layer 2 scaling solutions are ready to deploy on the mainnet, and the funds in the treasury of DeFi projects can be used to incentivize users to choose low-cost, high TPS alternatives (such as Solana and Avalanche) to return to the mainnet.

However, governance remains a problem to be solved. Complete centralization is not the solution, but rushing to decentralize can also lead to inefficiencies in internal workflows. There is a range where project leaders need to leverage centralized processes to become more decentralized over time. These entities need to establish better governance rhythms and structures and must provide greater transparency. For example, decentralized projects could have one day a month to accept proposals and one day a month for voting. Similar efforts will be rewarded in terms of token price appreciation and voter turnout.

Attempts to become a broad company DAO have not seen much success, but it has proven easier for DAOs built around a single, clear initiative to succeed. For example, ConstitutionDAO rallied people and money around the single goal of purchasing a copy of the Constitution. While the bid was unsuccessful, it showed us how decentralization can apply to other areas—labor organizing, government, project financing, and massive open online education courses. This open, accessible structure will further evolve to combine decentralized governance with ownership tokens. While some DAOs may resemble for-profit limited liability companies, they are just a small part of the forms that DAOs will ultimately explore, which will include various forms of institutions.

Moreover, the growth of DAOs will force traditionally passive investment groups like venture capital to change. VCs need to actively participate in community governance to advance projects. Traditionally, venture capitalists gained ownership and influence through capital and management consulting. Decentralized projects on the blockchain introduce governance tokens that allow user communities to vote on business decisions such as product roadmaps, token issuance, and capital expenditures, thereby disrupting this framework. VCs investing in digital assets must collaborate with these communities to promote business plans and increase network effects.

4. "Play-to-Earn" will evolve into "Learn-to-Earn"

The success of Axie Infinity and the play-to-earn model has led to record investments from gaming and NFT companies hoping to replicate this success; the same approach can be applied beyond gaming. Blockchain technology provides everyone with equal access to education and offers a fair assessment of talent. Therefore, capable individuals will earn rewards through learning, fundamentally disrupting the current system. Additionally, this dynamic may lead to better hiring practices based on the excellent record-keeping capabilities of public blockchains. This could further extend to credit scoring based on actions rather than finances. Currently, most DeFi is over-collateralized; as verified, provable credit scores are created on-chain, lending will shift towards low-collateral, unsecured loans based on borrower credit.

For example, Decentralized Identity (DID) refers to any subject (person, organization, thing, data model, or abstract entity) determined by the controller of the DID. Compared to typical federated identifiers, the design of DIDs allows them to be separated from centralized registries, identity providers, and certificate authorities. Specifically, while other parties may be used to help discover information related to the DID, this design allows the controller of the DID to prove their control over it without the permission of any other third party. DIDs are Uniform Resource Identifiers (URIs) that associate DID subjects with DID documents, allowing for trusted interactions associated with that subject. A DID with a decentralized credit score is about to be integrated across all platforms and applications.

5. DeFi 1.0 will make a comeback through Protocol-Controlled Liquidity (POL)

After exploding in popularity starting in January 2021, DeFi 1.0 projects (AAVE, SUSHI, YFI, COMP, etc.) have significantly underperformed the broader market for the remainder of this year. This has been driven by many factors, including reduced APRs for liquidity mining incentives, high Ethereum gas fees, cross-chain bridges, and better incentives for other L1 and DeFi 2.0 projects.

DeFi 2.0 (OHM, TIME, TOKE) introduced the concept of POL and attracted market attention by completely disrupting liquidity mining. Liquidity mining incentives hire capital, dilute, and devalue the protocol's "equity" (native tokens)—that is: contribute TVL, farm, sell tokens, reclaim TVL, and then move on.

Through POL and bonds, miners essentially contribute TVL to protocol equity in the form of non-native tokens (DAI, LUSD, ETH, etc. in exchange for OHM). This diversifies the balance sheet and creates revenue streams for the protocol.

We believe that the transition of traditional DeFi 1.0 protocols to the POL model is aimed at reviving interest in their projects, rebuilding balance sheets, and creating more revenue streams for native token holders (lowering P/E ratios to create value). We have already seen smaller projects (like ALCX and SYN) partnering with Olympus DAO to sell bonds in exchange for native tokens; we believe this trend is worth watching. This may be the change that traditional ETH blue chips need to revitalize their investor base.

6. The Robinhood Effect will become the new Coinbase Effect

Currently, Robinhood only allows trading of 7 assets, 5 of which are unpopular. As Robinhood expands its token offerings, these listed digital assets will benefit from their large, eager-to-trade investor base.

7. The Metaverse will become an entry point for traditional non-crypto native companies

The Metaverse as a concept has caught the attention of many Fortune 500 companies and is a new buzzword added to any strategic pitch. However, the spread of the Metaverse will become the entry point for traditional companies to begin venturing into the digital asset space. For traditional companies, the Metaverse offers a way to connect with more customers, thus providing them with new revenue opportunities. Brands can offer customers a better virtual shopping experience than physical stores. The Metaverse is a new realm that can be used for advertising and promotions, similar to billboards and ads on public transportation.

8. There will be a race to solve cross-chain issues

In 2021, a new class of layer 1 smart contract platforms emerged, and as gas fees became prohibitively high, interest in Ethereum's layer 2 solutions resurfaced. Additionally, we are beginning to see the rise of layer 0 and multi-chain ecosystems (such as Cosmos and Polkadot). We now have $25 billion in TVL across over 80 chains. With so much value dispersed across different places, 2022 will be a year where projects compete to connect users effectively between these chains with minimal cost and friction. While there are already some solutions, no project has yet developed a seamless bridging solution.

9. We will not see a widespread "cycle-ending" decline in digital assets

The past does not represent the future, especially when the sample size of the past is small and no longer closely matches today's ecosystem. We do not believe that digital assets will experience a widespread market downturn, nor do we believe in a "4-year market cycle." In fact, one could argue that 2021 was already a bear market for DeFi, while it was a bull market for NFTs, gaming, the Metaverse, and Layer 1 protocols. 2022 may yield similar results: some sectors may experience bear markets while others may see bull markets. This is no longer a single-attribute asset class but rather a technology that underpins all asset classes.

Therefore, some of these sub-asset classes will perform well while others will not. We may continue to see steep, rapid, highly correlated corrections, but as we saw throughout 2021, certain assets and sectors will rebound faster and stronger than others. If you want to short "digital assets," it is best to do extensive research on the specific assets you intend to short. A lazy approach similar to the broad bearish method of 2018 will not work in 2022.

5. The expanding investment opportunity set will come from new types of issuers

The best investment setting is one with a collection of opportunities that is not saturated with competition and is constantly expanding and evolving. This is why actively managed digital asset funds have outperformed passive strategies by such a large margin. As new types of tokens and functionalities develop, research-based active investment approaches can leverage the most advantages.

The token opportunity set has rapidly expanded into new fields, new types of tokens, and new types of issuers over the past two years, including protocols, individuals, and municipalities. We believe we will see further expansion in 2022 and assume that municipalities, universities, and small companies will begin issuing tokens.

• Municipal bonds will be replaced by infrastructure and reward tokens instead of general obligation bonds and revenue bonds.
• Universities will issue tuition tokens, replacing "529 plans," allowing donors and boosters to become better donation intermediaries.
• Small companies will issue pass-through tokens that combine loyalty rewards with quasi-equity. This is more likely to start from local restaurants, barbershops, gyms, and other retail-facing venues before gaining the attention of publicly listed companies.
• "Security tokens" will eventually enter the scene in a meaningful way. Alternative trading systems for digital asset securities are still in their infancy; while there are only a few, many more are currently being registered. The combination of new listings with previously undeveloped assets will help triple the market capitalization of digital asset securities in 2022. The demand for liquidity will increase the need for ATSs to support these securities in secondary market trading.
• Blue-chip companies and publicly listed institutions will continue to tokenize assets to reduce operational costs and gain access to traditionally high-barrier assets.
• Tokenization of real estate will be realized first, followed by stocks, as investors seek the benefits that blockchain can bring: speed, certainty, and immutability.