Will liquidity venture capital shape a more efficient cryptocurrency market?

Original Title: "Liquid Venture Investing in Crypto"

*Original Author: * Arthur0x, DeFiance Capital

*Translated by: Qianwen, * ChainCatcher

In recent years, no frontier market has captured investors' interest more than the cryptocurrency market.

Cryptographic assets are still in their early stages, and there is currently no recognized valuation framework for investors to reference. The crypto market is filled with price speculation and hype, with little attention paid to fundamentals—an example being meme coins with zero utility achieving billions in market capitalization in a short time. Unlike traditional markets, early projects/protocols are akin to startups still in seed or Series A rounds, often launching tokens on public markets. At the same time, injecting liquidity into newly created cryptocurrencies on decentralized exchanges is quite easy, and various factors combine to make the cryptocurrency market one of the most vibrant yet challenging investment markets today.

Imbalance in Capital Flows Leads to Market Structure Distortion

Currently, there are four main types of participants in the cryptocurrency market: retail investors, cryptocurrency trading firms/hedge funds, large corporations (such as Tesla, Tether, and Microstrategy), and venture capital (VC).

Many retail investors do not conduct serious research and analysis when considering cryptocurrency investments—this explains why meme coins and many undelivered cryptocurrencies trade in the top 10 by market capitalization.

Cryptocurrency hedge funds/trading firms generally tend to trade based on short-term market trends. Large corporations have yet to venture beyond Bitcoin, and even with Bitcoin, they only occasionally engage.

Venture capital has been the primary way for most institutional capital to invest in the cryptocurrency space in recent years, as evidenced by the massive funding received by native crypto VCs and traditional VCs. In 2021 and 2022, venture capital firms invested over $37.7 billion and $31 billion in cryptocurrency startups, significantly surpassing the total investment in all previous years.

Source: The Block Research

In contrast, there are very few structural buyers in the liquidity market for cryptocurrencies, as long-term institutional capital flows are dominated by venture capital. This issue is not unique to the cryptocurrency market. The long-term participation of other categories of market participants also varies based on market conditions. Even if some venture capital firms can operate flexibly and directly invest in liquid cryptocurrencies, they are often constrained by their expertise and the structure of their risk funds, typically focusing on risk trades in the primary market. Even when they invest in liquid cryptocurrencies, it is usually handled as individual trades, with little active management based on the latest fundamental conditions. They rarely double down on project investments, even if prices may be lower than when they bought in and the product's market fit has been further validated.

Market Structure Distortion Creates Huge Opportunities

For those investors willing to navigate the liquidity cryptocurrency market and understand how to do so, this market structure distortion presents an excellent opportunity for substantial risk-adjusted returns. Although Kyle and Tushar from Multicoin Capital succinctly explained this concept six years ago, it remains applicable today. Most cryptocurrencies are essentially liquid venture capital (except for Bitcoin), and since the field is still in its early stages, most cryptocurrencies are young, having been around for less than five years, with high potential returns and a fat-tailed distribution.

For most investors with limited capital, considering the dynamic developments in the field, investing in cryptocurrencies through liquid venture capital will yield the best risk-adjusted returns. This approach allows investors to achieve venture-like returns while managing their investments as assets with public market liquidity. There are many such cases where most of the returns from these cryptocurrencies come from the liquidity market after token generation events (TGE). This is important because cryptocurrency networks also exhibit a power law, where market leaders can maintain their lead and dominance, as evidenced by the current dominance of large tech companies in U.S. stock market capitalization.

Source: CoinGecko, ICODrops as of March 27, 2023

Because liquid venture cryptocurrency investors can adjust their position sizes and manage investment risks in real-time based on changes in fundamentals, they do not need to cast a wide net across hundreds of projects to offset underperforming stocks in their portfolios with a few 50x to 100x returns. Instead, they can focus their investments on 10-20 higher-return projects, generating substantial risk-adjusted returns.

At the same time, this strategy allows investors to better manage investment risks, as they can wait for the relevant cryptocurrency's protocol/product to gain more market validation before adding to their investments. Conversely, if a cryptocurrency does not meet initial expectations, they can reduce their investment.

As Kai Wu from Sparkline Capital states:

"Investing in early-stage innovative projects carries very high implied volatility. Due to the existence of the power law, the range of outcomes presented by startups is very broad. Cryptocurrency tokens allow us to directly observe this volatility, which can often reach annualized levels of 100%."

"Therefore, innovative investors should pay close attention to liquidity. Technological trends can shift rapidly, and today's best startups may not maintain momentum tomorrow. Liquidity enables investors to change direction as the environment evolves."

Fundamental Investors Are Key to Developing an Effective Cryptocurrency Market

From a broad perspective, liquidity venture investors can play a crucial role in establishing a strong culture of shared ownership in the Web3 ecosystem, where token economics and governance align the incentives of product users, startups, and investors. For example, capital and liquidity support from investors can help address the cold start problem of DeFi protocols, facilitating protocol adoption. These investors can also play a practical role in the development of protocols, such as actively participating in governance and providing input on the strategic direction of protocols/products.

Ultimately, the emergence of more liquidity venture investors focused on fundamentals in the market will help improve market efficiency in the cryptocurrency public market, aiding cryptocurrencies in achieving their fair value, balancing out the excessive private venture capital investors.