GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE - PNC
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INVESTMENT STRATEGY
August 2021
GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
In this white paper, our aim is to help
When you hear the word cryptocurrency, do you immediately think “bitcoin”?
arm investors with knowledge of the If so, you’re not alone. The cryptocurrency (crypto) world has evolved
cryptocurrency investment landscape dramatically since an anonymous author(s), under the pseudonym
and provide tools to evaluate the myriad Satoshi Nakamoto, penned a brief white paper in 2008 detailing the
digital asset options. mechanics of what we’d soon come to know as bitcoin. While bitcoin is still
the largest crypto by market capitalization, there are now some 6,000 cryptos
Daniel J. Brady in existence today.
Chief Investment Strategist
Rebekah M. McCahan For some, the crypto universe has evolved beyond its origins as a new
Investment & Portfolio Strategist payment technology and is instead viewed as an investment opportunity.
Bitcoin reached an all-time high of more than $61,000 on March 12, achieving
John W. Moore a 300% annualized return over the last 10 years. Given this impressive return,
Investment & Portfolio Strategist it’s natural to see increased investor interest. However, in the short history
Bethany A. Stein, CFA of bitcoin, we have seen its price reach euphoric highs, only to be followed
Director, Investment Strategy by dramatic crashes. So, while it’s understandable that investors may be
asking if “this time is different” given the extreme volatility and uncertainty in
determining appropriate valuations, we still view bitcoin and other cryptos as
speculative investments and not suitable for all investors.
If that’s the case, what is this publication all about? Well, despite our views
on crypto as a highly speculative investment, we believe the world of digital
assets has reached a critical mass that gives us confidence that it’s more
than just a passing fad. Therefore, our aim in this white paper is to help arm
investors with knowledge of the crypto landscape and provide tools to evaluate
the myriad crypto options.
1GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
Furthermore, we want investors to understand there’s A common analogy for investors new to the world of crypto
more to the crypto story than just bitcoin. What’s often is the scene in Alice’s Adventures in Wonderland where
excluded from mainstream discussions is the growing Alice follows the rabbit down a rabbit hole and into the
adoption of blockchain technology, the underpinning upside-down world of Wonderland. The analogy works so
capability that not only makes crypto possible, but also well because when an investor learns of the technological
enables the broader movement towards decentralized concepts behind crypto, it can feel like they stumbled into
finance (DeFi), the secular force that we think is driving an upside-down world of make-believe. If you’re interested
the advent of digital currencies. If crypto is to be taken in learning about digital assets, where we believe the
seriously as an asset class and is not just a means to industry is headed and the truly upside-down world of DeFi
speculate on digital art or sports videos, we believe in plain language, this is for you. And, if after all that you end
investors should focus on opportunities within DeFi up exiting the rabbit hole, that is ok! Even Alice eventually
alongside bitcoin. woke up from her Wonderland dream.
Crypto GLOSSARY
Learn the Lingo
DeFi Decentralized Finance; any blockchain technology Mining Solving cryptographic equations using high-
that does not rely on a centralized point of control powered computers to generate new coins on a
and is instead executed through pre-programmed specific network.
software.
dApp Decentralized Application; a computer application NFT Non-fungible Token; a wholly unique digital file that
that runs on a distributed computing system. is stored on a blockchain.
Fork An iteration of an existing crypto (e.g., bitcoin) that Nuked Slang for when a crypto price declines swiftly,
is created when a group of users wants to make a abruptly stopping upward price momentum.
significant modification to the software to the point
where they leave the original crypto network and
form a new one.
FUD Fear, Uncertainty and Doubt; for example, when a Rekt Slang for “wrecked,” as in a permanent loss
person has views against digital assets in general of capital.
or against a specific crypto, they usually include
some degree of FUD in their argument.
HODL Hold on for Dear Life; the mindset of longer-term Whale An investor that owns a relatively significant
crypto investors due to periods of significant price amount of a specific crypto asset.
volatility and high downside risks.
ICO Initial Coin Offering; akin to an initial public offering When Lambo A light-hearted question crypto investors ask,
(IPO) of stock. referring to when their coins will be worth enough
to afford a Lamborghini.
“Despite initially getting nuked on a DeFi ICO, the whale avoided getting
completely rekt by ignoring the FUD and remaining a HODLer.”
2GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
TABLE OF
CONTENTS
Crypto 101, Putting It Into
Crypto History the Abridged Version Practice
A Condensed Timeline The Building Blocks of Crypto Business Cycle Analysis
Crypto Categories Valuation Analysis
Page 4
Gold by Any Other Name Technical Analysis
The Upside-down World of DeFi
Page 13
Stablecoins: Digital Fiat Currency
Page 6
Investment The End of the
Attributes Ways to Invest Rabbit Hole
Key Investment Merits & Risks Public Options Page 21
Cryptocurrency Asset Allocation Private Options
Yield Farming
Page 19
Page 17
3GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
Bitcoin Price
A Condensed Timeline of the July 19, 2010* - March 15, 2021
History of Cryptocurrency $60K
Blockchain technology has a
unique, global grassroots history; $40K
it was not the invention of Silicon
Valley, nor did it originate from
Wall Street. $20K
Even within the crypto community
there are numerous views on
the path forward. For example, 2009 - 2014 2015 - 2017 2018 – 2019 2020+
not every crypto maximalist is a
bitcoin maximalist!
We are very early in the
development of blockchain
technology, so it is important to
understand how we got to this
point in order to find the next MAGIC INTERNET BLOCKCHAIN NOT CRYPTO ACCEPTANCE?
investment opportunities within MONEY BITCOIN WINTER
digital assets. *Although bitcoin began trading in January 2009, accurate pricing data did not exist until 2010.
Source: Bloomberg L.P., PNC
2009 – 2014 MAGIC INTERNET MONEY
OCT Nine-page bitcoin white paper is published OCT The Silk Road “darknet” website is shut down.
2008 under the pseudonym Satoshi Nakamoto. 2013 Its creator, Ross Ulbricht, is sentenced to
The author(s) remain unknown. life in prison without parole for non-violent
crimes. Ulbricht has become a polarizing figure
JAN The first block of 50 bitcoins is “mined”
between “no coiners” and “maximalists.”
2009 on January 9. At current prices, that is
approximately equivalent to $2 million. DEC The price of bitcoin rises above $1,000, and
2013 market capitalization tops $1 billion for the
JUL Mt. Gox launched. It would become the largest
first time.
2010 bitcoin exchange, handling an estimated 70%
of all bitcoin transactions at its peak. JAN Winklevoss twins’ Bitcoin ETF filing is
2014 rejected.
OCT The first “fork” from bitcoin (Litecoin) launches.
2011 It is a copy of bitcoin’s code, except transactions FEB Mt. Gox goes bankrupt amid fraud allegations.
are faster and complex computational power is 2014 The price of bitcoin crashes 50% and would
required. By 2021, there would be more than 30 not rise above $1,000 again until 2017.
“forks” of the original bitcoin code.
OCT Joe Lubin, former VP of Technology in Private
JUL Tyler and Cameron Winklevoss (the 2014 Wealth Management at Goldman Sachs,
2013 Winklevoss twins) register for the first-ever founds blockchain company ConsenSys.
bitcoin exchange-traded fund (ETF).
4GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
2015 – 2017 BLOCKCHAIN, NOT BITCOIN 2018 – 2019 CRYPTO WINTER
JUL The Ethereum blockchain platform Following the 2017 peak:
2015 is created by a group of developers • After rising 3x in two months in 2017, bitcoin crashed
including Vitalik Buterin, Gavin Wood, 50% in two months.
Charles Hoskinson and Lubin. Similar • What about ether? It crashed over 90% in 2018.
to bitcoin forks, both Wood and
Hoskinson would leave to develop their • What really hurt crypto investors was in
own blockchain platforms, Polkadot and November 2018 when bitcoin fell another 50% and
Cardano, respectively. would not recover that drawdown for six months.
AUG The state of New York orders digital asset • FUD crept in as many assumed the wild story of
2015 firms to register their business with a bitcoin and DeFi was over. Thus the “crypto winter”
“BitLicense,” causing many crypto start-ups began…
to cease operations in the state.
MAY Warren Buffett calls bitcoin “rat poison
FEB IBM announces plans to create a
2018 squared.”
2016 blockchain-as-a-service offering
(shut down in 2021). DEC ConsenSys lays off about 60% of its staff.
2018
MAY Crypto exchange BitMEX is credited with
2016 creating the perpetual swap — trading futures JUN Facebook/Libra announcement in June sparks
with no contract expiration (founders would be 2019 renewed interest in cryptocurrencies.
arrested in 2020 for U.S. rules violations).
2017 DeFi token mania — nearly 1,000 ICOs launch
throughout the year. 2020+ ACCEPTANCE?
MAR A second bitcoin ETF filing by the Winklevoss
AUG JPMorgan acquires a minority position in
2017 twins is rejected.
2020 ConsenSys.
DEC Bitcoin price climbs by 3 times (x) in two
NOV U.S. regulators partner with software firm
2017 months, reaching just under $20,000.
2020 Circle to use the stablecoin USD Coin as an
international payment system in Venezuela.
DEC Bitcoin recovers to a new all-time high.
2020
JAN Ether recovers to a new all-time high.
2021
JAN Crypto total market cap tops $1 trillion,
2021 making it larger than the entire S&P Small
Cap 600®.
JAN BlackRock registers to allow bitcoin futures as
2021 an eligible investment in two mutual funds.
FEB Largest U.S. crypto exchange Coinbase files
2021 for a direct public listing; estimated valuation
is between $80-100 billion.
5GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
Crypto 101, the Abridged Version Remember the early days of the internet when all
we did was check email and visit AOL chat rooms?
Cryptocurrencies are a relatively recent phenomenon The technology that enabled those functions was called
that began in 2008 with Satoshi’s white paper. As with Web1. Obviously we’ve come a long way since then,
other technological breakthroughs, bitcoin was born but the more interesting subtext to this timeline is that
out of a technological revolution much longer in the somewhere along the way, the internet took a detour
making, specifically the dramatic evolution of the to become dominated by a few advertisement-driven
internet toward decentralization and the application behemoths (e.g., Alphabet and Facebook) in the period
of blockchain technology. commonly called Web2. Needless to say, applications
from ridesharing to social media on a global scale
The concept of decentralization is likely new to most would not have been possible without Web2. However,
investors, and yet it is a key differentiator between the centralized control exercised by these behemoths
logging information using a common spreadsheet has become problematic enough for a growing number
versus enabling the unique, complex features of crypto. of users due to rising privacy concerns. In our view,
With a decentralized computer network, data is not the momentum is starting to shift back to the original
stored in a central location, and there is no central point decentralized, user-controlled experience of Web1.
of control. Any user can tap into the network anywhere, Thus, we believe we are at the early stages of the
at any time. The concept is similar to Linux open source next iteration of the internet, taking concepts such as
software or Wikipedia. the Internet of Things (IoT), artificial intelligence and
decentralization and calling it Web3 (Exhibit 1).
Decentralization is what enables the lynchpin of crypto —
blockchain technology — to come to life. So how The Building Blocks of Crypto
did we get here? The story of crypto and blockchain
technology goes hand-in-hand with the evolution of When the bitcoin white paper came out, it did not even
the internet itself. mention the word blockchain; however, the concept
Exhibit 1
The Evolution of the Internet
1990s 2000s-Current Future?
Web1 Web2 Web3
The Birth of the Internet The Rise of Oligopolies Decentralization
Email E-commerce Cryptocurrencies
Personal web pages Smartphones Smart contracts
AOL chat rooms Apps Decentralized finance (DeFi)
Online bookstores Social media corporations Decentralized apps (dApps)
Fintech corporations Blockchain gaming
Virtual economies
Online gaming
Source: PNC
6GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
quickly evolved into the technological backbone of how of digital assets. Whereas physical assets, such as
digital assets work. What is blockchain? It is an innovative currency or even a physical gift card, can only be spent
technology consisting of complex cryptography and once, before Satoshi’s white paper it was difficult to
software that creates an immutable, decentralized prevent digital information from being duplicated or
database for whatever its application may be. In other falsified, potentially allowing it to be used multiple
words, the data cannot be changed, and there is no times. Because blockchain cryptography supports a
central authority over the records. The concept of ledger that is decentralized and unalterable, once a
blockchain technology dates back to the early 1990s cryptocurrency transaction is recorded, it cannot be
(i.e., the early days of Web1), but it was not until the erased, which provides a strong defense against the
invention of bitcoin as a peer-to-peer payment network possibility of double spending.
that it found a real-world use case (Exhibit 2).
We’ve covered the building blocks (pun intended) of the
While we could digress into a deep dive on blockchain’s what behind blockchain, but who keeps the decentralized
underpinning technology, in our view it would be akin to network operational? Since no one is in charge per se,
an investment paper on the aerospace industry describing the decentralized system provides an incentive to users
how an airplane is assembled instead of focusing on to self-regulate. In short, a crypto network’s security is
the bigger picture of which aerospace companies have supported by two highly important user groups: miners
attractive long-term growth prospects. Yes, it is important and node operators. Without these two groups working
to understand what blockchain technology is, just as it is as a symbiotic, “trustless” community, the security of a
also important to appreciate that machines can fly without decentralized blockchain could become vulnerable.
first having to study aerodynamics!
Crypto miners are not out panning for gold in the
Blockchain technology is essential to crypto because Yukon River; rather, these groups and enterprises
it eliminates what’s called the double-spend problem use some of the most high-powered computers on
Exhibit 2
Cryptocurrency Blockchain Illustration
$
Transaction requested. Transaction request Node operators validate
distributed to node operators. transaction using known
algorithms.
Once verified, the transaction is
The transaction is complete. combined with other transactions to
form a block, and that block is added
to an existing blockchain.
Source: PNC
7GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
the planet to solve complex cryptography problems To assess the strength of this soft infrastructure,
to generate new coins. In competition with one investors should turn to a common technology
another to mine coins quickly, they also have a industry measure: network effects. Think about how
direct financial incentive to keep the blockchain Facebook surpassed MySpace, or Google replaced
functioning and validate existing coins (or blocks) as Yahoo; there was a clear winner between these similar
transactions occur. As the adage goes, there is no applications because one had better scalability and
such thing as a free lunch. It is no different in crypto stronger network effects. There are various ways to
transactions, as miners earn transaction fees for quantify network effects, including the Lindy Effect,
validating each transaction on a network (the average Metcalfe’s Law and S-curve adoption.1 Also, similar
bitcoin transaction fee over the last 12 months was to commonplace software applications, crypto
approximately $20, which does not include service fees networks can be measured by growth in their monthly
from custodians or exchanges). active users.
Node operators are the referees of the network, We believe these concepts are the bedrock of
ensuring the accuracy and security of transactions. crypto fundamental analysis. Without a committed
Most computers have enough power to run a node, community of miners and node operators validating
but as this is the upside-down world of decentralization, transactions, a blockchain network could easily
there is no financial gain for this task. In other words, become susceptible to theft or fraud, which could
node operators are incentivized purely by their render the cryptocurrency worthless in short order.
commitment to the cause. In fact, we believe one of the key differentiators
between one cryptocurrency versus another is the
Thus, a complete crypto network has traders and perceived strength of its network effect. Therefore,
investors: miners all racing to find the next coin, it is imperative to know what you own in terms of the
and the volunteer node operators. In an internet- underlying network strength of a blockchain. Prices
based system, none of these groups have to actually might be rising in the short term, while network
know one another, and yet they all have a common activity — the most basic value in crypto — is flashing
interest to secure and maintain the network. warnings signs of long-term instability.
Table 1
Traditional vs. Digital Currencies
TRADITIONAL DIGITAL
Example U.S. Dollar Gold Bitcoin Ether Dai
Category Fiat Currency Store-of-Value Digital Gold DeFi Token Stablecoin
Inception Date 1971 ~600 BC 2009 2015 2017
Price Fluctuation N/A Yes Yes Yes N/A
Source: PNC
1
Lindy Effect is the theory that the longer a technology stays in use, the longer its life cycle is extended. Metcalfe’s Law is a common valuation
practice for social media companies where the value of an internet network is proportional to the square of its number of users. S-curve
Adoption is a model for the phases of new technology (research and development, growth, maturity and decline/obsolescence).
8GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
Crypto Categories did not intend for bitcoin to be used for daily consumer
transactions. The technology has only been around for
Before cryptos arrived on the scene, there were two 12 years, with limited use as an actual payment system
generally accepted mediums of exchange: fiat currencies for most of that time. Even now, while some companies
and store-of-value assets such as gold. Bitcoin and accept bitcoin as payment, the average bitcoin transaction
other competing crypto coins are more akin to gold than takes about 10 minutes to complete. Thus, using bitcoin
fiat currency, in our view. In fact, bitcoin and the like for simple purchases like paying for a cup of coffee is
often assume the moniker of “digital gold” due to their far from a practical use case. As such, the term “digital
similarities with the yellow metal. In the crypto world, there asset” is probably a more apt description than the “digital
are also two other types of digital assets — DeFi tokens and currency” nomenclature put forth by early adopters to
stablecoins — that have their own unique characteristics describe their groundbreaking invention.
that set them apart from digital gold (Table 1, page 8).
We discuss all three in more detail in the following sections. For bitcoin in particular, another similarity with gold is
its “often imitated, never duplicated” status. There are
Gold by Any Other Name
thousands of minerals, and yet gold has remained the
Similar to gold, bitcoin is a finite resource, as the source primary store-of-value asset globally. Likewise, there
code is programmed to stop generating coins after are more than 30 cryptocurrency forks derived directly
21 million coins have been mined. With approximately from the original bitcoin code, but bitcoin remains the
18.5 million coins already mined, at the current rate it is dominant crypto coin. So, in the universe of more than
expected miners will reach 21 million by the year 2140. 6,000 cryptos and 30-plus bitcoin forks, what separates
Similarly, other competing crypto coins also have limits bitcoin from the pack? How can an investor feel confident
in place. that bitcoin isn’t just the MySpace of crypto and some
sleek blockchain in the future will replace it? It comes
Also, like gold (and unlike fiat currencies), bitcoin back to the strength of the network. While many of
and the like are not practical for routine payments. these digital-gold competitors have a loyal user base of
Despite Satoshi’s description of the bitcoin concept as a miners, users and node operators, their networks pale in
peer-to-peer payment system, we believe the author(s) comparison to the bitcoin network (Table 2).
Table 2
Bitcoin vs. Select Bitcoin Forks
As of 3/15/2021
MARKET CAPITALIZATION ($ billions) NODE OPERATORS
Bitcoin $1,112 10,505
Litecoin $13 1,421
October 2011*
Bitcoin Cash $10 1,206
August 2017*
Bitcoin SV $4 270
November 2018*
Dogecoin $7 1,103
December 2013*
*Date of fork from bitcoin.
Source: coingecko.com, PNC
9GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
The simplest method to compare network strength
between coins that have similar properties is by the
Cryptocurrency: Select Environmental,
number of node operators, since they are performing
their task for the love of the coin. For example, bitcoin Social and Governance Considerations
cash and bitcoin SV have very similar technological
characteristics. However, the differences in their
Environmental
market capitalization versus number of current node
operators should be an initial warning flag to investors
that a coin might have strong price momentum, but its
network strength is subpar. Fortunately for investors,
+ Largely paperless.
due to the nature of cryptos’ open source software and
decentralized blockchains, their underlying network Running the network requires a lot of power;
data is freely available to view and analyze at any time.
- however, it could be argued that fiat currencies
do as well, but it’s impossible to definitively
Typically, a coin’s network and market capitalization quantify.
are positively correlated; but, there are a few rare
circumstances where a coin has a strong network that’s
not reflected by its market capitalization. For example, Social
one of the oldest cryptos is a coin called Monero, but it
is not even a top-20 coin by market capitalization. Does Provides fair financial access to the unbanked
that mean Monero has weak fundamentals relative to
other cryptos? For users of Monero, quite the opposite
+ and those living in countries with oppressive
regimes.
is true, in our view. In fact, we believe Monero has one
of the strongest networks within the crypto universe Potential for illegal activity, although all
despite its size, as a primary feature of the coin is transactions can be tracked. Various reports
enhanced transaction privacy, which has limited its
adoption. Thus, a key differentiator between coins is not
- estimate less than 1% of crypto transactions
are for illegal means compared to 2-5% of
only the strength of the network but also whether it is global GDP using fiat currencies.
growing faster than others. After all, even MySpace still
has a committed user base!
Governance
The Upside-down World of DeFi
As we mentioned in the introduction, if investors solely
focus on bitcoin and other digital gold coins, we believe
+ Decentralized blockchain technology is quite
possibly the nirvana of operational governance.
they could miss out on the larger secular trend toward
decentralized finance (DeFi) networks. Similar to how we Some digital asset projects claim to be
decentralized when in fact they are significantly
-
believe the nomenclature cryptocurrency is somewhat
misleading, the term “DeFi” is also ambiguous in that influenced by a small group or coalition of
it is not specific to just the finance industry. And yet the users that own a majority of the coins in
name has already stuck. Thus, when we refer to DeFi, circulation.
we mean any blockchain technology or application that
Source: PNC
does not rely on intermediaries such as custodians,
exchanges and others to control the network.
DeFi runs on smart contracts, which is a term used to
describe a program that is coded to operate without
the need for human intervention. Remember how we
10GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
mentioned the IoT and artificial intelligence? This is blockchain technology, if its management team still
where blockchain technology intersects with those maintains control and can — even theoretically —
concepts and forms the upside-down world of DeFi. make material changes to the smart contract code,
IoT has struggled to gain traction in part because of then it is not really a blockchain in the DeFi sense of
security risks involved with internet-native applications. the term.
The potential of Web3 and the creation of secure
platforms using blockchain technology could help solve Because the DeFi industry is still in its nascent phase,
those concerns. we believe investors should view DeFi opportunities
as analogous to venture capital investing, but without
Most smart contract innovation is currently focused accredited investor restrictions, and with projects
on the financial industry; however, wide-ranging that are priced in real time. The industry is highly
applications, from decentralized prediction markets fragmented, and as one would also expect from venture
to decentralized wireless networks, are beginning capital, pricing is volatile.
to emerge. Additionally, DeFi and smart contract
innovation has opened the door to collector items How do investors gain access to this burgeoning
in the form of non-fungible tokens (NFTs). Through industry? Investment opportunities in DeFi are
blockchain technology, NFTs such as cryptokitties, most easily accomplished through the purchase
NBA Top Shots and even digital art that sells for of DeFi tokens, which are somewhat analogous to
millions of dollars, have seen significant interest, in owning a share of stock in a company. As the life cycle
part because of the reduced risk of duplication or theft. of a DeFi project matures from development through
the operational phase, the developers and early
Corporations can utilize blockchain technology investors typically issue governance tokens through an
to make improvements to what may be outdated initial ICO, somewhat similar to an equity IPO. The key
applications. However, even if a corporation employs difference with an ICO is that as investors and users
Chart 1
Network Comparison
As of 3/15/2021
$1,200
$1,112
$780
$800
Market Cap (Billions)
$400
$200
$32 $33
$4
$-
Bitcoin Facebook Ethereum Polkadot Cardano EOS
Number of (d)Apps on Network 2 -10 2,000+ -50 TBD -50
Inception Date 2009 2004 2015 2020 2017 2017
Source: coingecko.com, Bloomberg L.P., PNC
11GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
buy tokens to establish widespread ownership of the NFTs reside on the Ethereum network). Based on
project, the founders no longer have control. After Ethereum’s market capitalization, compared to other
all, the project is designed to be fully decentralized, networks such as bitcoin or even Facebook, its growth
running on smart contracts, once it is operational. rate has been stunning (Chart 1, page 11). Similar to
bitcoin’s digital gold competitors, there are plenty of
All the concepts involving miners, nodes and network “eth killers,” as they are kindly referred to, looking to
activity within the digital gold discussion in the prior become the network of choice for dApp developers.
section also apply to DeFi, including the process for A few examples include Polkadot, Cardano and EOS.
properly analyzing the fundamental merits of a DeFi However, most have either struggled to build a network
investment opportunity. An additional necessary effect, or have only recently gone live despite already
step that may seem counterintuitive to the concept lofty valuations.
of decentralization, given DeFi is predicated on
decentralized control, is the need to perform a Within a DeFi network are the dApps themselves,
qualitative analysis of the developers themselves. which are smart contract applications ranging from
This would be akin to assessing a company’s automated trading exchanges to securities lending.
management team. What is their experience with Again, we believe dApps should be assessed through
software development or their reputation within a similar lens as venture capital projects. Growth in
the DeFi community? Did the project get early stage investor interest has been tremendous in the last year
investments from prominent venture capital firms or despite most dApps having only been around one to
was raising capital a challenge? These are important two years at most. We believe the growth potential
additional questions in analyzing the appropriateness in this area is quite promising; however, we caution
of a DeFi investment opportunity. it is still in its very early days. Like venture capital
investments, not all dApps will survive. However,
Currently, the largest DeFi network by far is Ethereum, the ones that are successful have the chance to be
which was actually founded by a group of bitcoin extremely disruptive, while keeping in mind the one
enthusiasts looking to create additional blockchain use thing dApps all have in common is extreme price
cases beyond digital gold (and yes, most of the popular volatility (Table 3).
Table 3
DeFi Market Performance Comparison
As of 3/15/2021
Trailing
Developer Market Cap 12 Months (TTM) TTM Max
dApp Launch Date ICO ($ billions) Primary Use Case Performance* Drawdown
Chainlink Jun 2017 Jun 2019 11 Data feed 1196% -60%
Uniswap* Nov 2018 Sept 2020 15 Automated trading exchange 902% -73%
Compound* Sept 2018 June 2020 2 Securities lending 562% -74%
Bitcoin Oct 2008 Jan 2009 1,112 Cryptocurrency 929% -53%
Ether Jul 2015 Aug 2015 200 Cryptocurrency 1529% -61%
*Performance for Uniswap and Compound is since inception.
Source: coingecko.com, PNC
12GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
Stablecoins: Digital Fiat Currency or so. Stablecoins such as Tether, USD Coin and Dai
collectively have a market cap of nearly $50 billion
Investors frequently inquire about the third type of as of February 28, compared to less than $5 billion
cryptocurrency known as stablecoins. These cryptos a year ago — a 10x growth rate (Table 4). We believe
are pegged to a fiat currency, thus making them stable such astonishing growth highlights the demand for fast
while still operating on a blockchain network. As such, and secure international payments. Stablecoins are
stablecoins’ primary use case is international money also used as digital cash reserves that stay in a DeFi
transfers and payments and are therefore of limited blockchain rather than in a traditional deposit account.
value for investors seeking price appreciation. Crypto miners also use stablecoins to hedge price
volatility and exposure to the coins they are mining.
That being said, the use of stablecoins for payments has In short, we view stablecoins as a novel method of
grown just as swiftly as crypto prices in the last year sending money, not making it.
Table 4
Stablecoins Comparison
As of 3/15/2021
Central
Bank Digital
Example Tether USD Coin Dai Currencies JPM* Coin Libra/Diem
Digital Fiat
Concept Stablecoin Stablecoin Stablecoin Internal Token Stablecoin
Currency
Crypto trading International DeFi project Internal payments/
Primary Uses TBD TBD
reserves payments reserves transfers
“Basket of
U.S. dollar peg 1:1 1:1 1:1 N/A 1:1
currencies”
Market Cap $39 billion $10 billion $3 billion TBD N/A TBD
*JPMorgan
Source: coingecko.com, PNC
Putting It All into Practice some of the approaches may seem unorthodox —
our sympathies to students of The Intelligent Investor —
As we mentioned at the outset, we currently view this is the upside-down world of crypto!
bitcoin and other cryptos as speculative investments
and not suitable for all investors. As such, crypto is Business Cycle Analysis: Where Have We Been,
not appropriate for a broad, formal asset allocation Where Are We Going?
recommendation. However, adoption of cryptocurrency
and DeFi applications is continuing to build, so we think In our traditional approach to investment analysis,
it’s worthwhile to examine the world of crypto through we view the business cycle as having four phases:
an investor’s lens. slowing expansion, contraction, recovery and
accelerating expansion. How does this apply to crypto?
Given the short time crypto has existed, is it even Instead of examining measures like GDP growth,
possible to implement our traditional investment industrial production or retail sales, we believe the
analysis process? In our view, absolutely! Admittedly crypto business cycle is centered on the all-important
13GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
network effect. Since all transactions on a decentralized it is typically a signal of a weakening network in which
blockchain are observable to anyone, investors can longer-term investors — and potentially miners or
analyze how long users are holding onto their coins, node operators — have left the network for better
analogous to stock turnover. opportunities elsewhere. That is why network effects
are critical to a decentralized blockchain for investors:
Crypto investors can use holding period data to growth in the number of long-term users leads to a
assess the strength of the network, and in turn, it stronger network, which should help maintain value in
becomes a potential gauge of trends in its value and the network over time. (Chart 2). While it’s important to
price. For example, the early part of a crypto business understand crypto follows a business cycle just like any
cycle starts with the “HODlers,” that is, zealous other investment, the available metrics are coincident
crypto believers, followed by long-term investors, indicators at best. However, the chart does denote a
and finally the speculative short-term traders. As the relatively strong group of long-term investors maintain
speculators take more market share of the network, the majority of the bitcoin network.
Chart 2
Bitcoin Age Distribution vs. Price
7/19/2010 - 3/15/2021
100 $100,000
90
$10,000
80 10 Years+
7 Years - 10 Years
$1,000
70 5 Years - 7 Years
3 Years - 5 Years
60 2 Years - 3 Years
$100
1 Year - 2 Years
Percent
50 6 Months - 1 Year
3 Months - 6 Months
$10
40 1 Month - 3 Months
1 Week - 1 Month
30 1 Day - 1 Week
$1
24 Hours
20 Price (log-scale)
$0
10
0 $0
7/2010 7/2011 7/2012 7/2013 7/2014 7/2015 7/2016 7/2017 7/2018 7/2019 7/2020
Source: glassnode.com, Bloomberg L.P., PNC
14GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
Valuation Analysis: Attractiveness Relative to Chart 3
History and Peers Bitcoin Price vs. RVT Ratio
4/28/2013 – 3/15/2021
Some investors may be skeptical of crypto in large part 13.0x $100,000
because of perceived valuation limitations. Can an asset
that derives value from a network effect really have 11.0x
quantifiable value? While one may not be able to pull $10,000
up an income statement and plug a few numbers into 9.0x
a spreadsheet, the open source nature of crypto and
$1,000
DeFi provides a wealth of data that can be analyzed in a 7.0x
similar way to traditional valuation analysis, albeit with
a little more creativity. For example, crypto investors 5.0x
$100
can look at a network’s realized value to transaction
3.0x
volume (RVT) ratio. This ratio is simply the network’s
market capitalization divided by its daily transaction $10
1.0x
fees and can be viewed similarly to a price-to-earnings
ratio for stocks. Chart 3 depicts bitcoin’s price versus its -1.0x $1
RVT ratio, which has risen to 6x recently, well above its 4/2013 4/2014 4/2015 4/2016 4/2017 4/2018 4/2019 4/2020
1.6x historical average. RVT Ratio (L) Bitcoin Price (R, log-scale)
Table 5 illustrates a few other common valuation methods. Source: glassnode.com, PNC
Table 5
Select Cryptocurrency Valuation Methods
Valuation Method Description Pros Cons
Precious Metals Theory that as bitcoin is Easy to explain Specific to bitcoin and other
Analogy accepted as digital gold, “digital gold” competitors only
it will take market share as
No quantifiable method to
a store of value
measure or model this forecast
Stock-to-flow Popular theory that the price High correlation to the price of Specific to bitcoin
of bitcoin follows a four-year bitcoin so far
High correlation may be spurious
cycle, positively impacted by
mining “halvings”*
Realized Value/ Similar to a price/earnings Data is readily available Given the still-volatile nature of
Transaction Volume for stocks crypto projects, forecasting ability
Network effect indicator
(RVT) Ratio is limited
(Market cap of network/daily
Better served as a backward-
network transaction fees)
looking indicator
Total Value Locked Measures the amount Network effect indicator Not relevant for bitcoin and other
(TVL) Ratio users have “locked” into a “digital gold” competitors
DeFi protocol for lending
Depending on the source of the
purposes
data, it may be double-counted
*Bitcoin halving is an event that takes place every four years where the mining reward gets cut in half. In the beginning, 50 coins could be mined at a
time, then after four years it dropped to 25, and then 12.5, to 6.25 today. The next halving is expected to take place in 2024.
Source: PNC
15GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
Technical Analysis: Charting One of the Most Volatile Asset for professional traders, giving rise to the term “HODL”
Classes in History in the crypto community, meaning “Hold on for Dear
Life.” Buy-and-hold HODLers have come to expect a
Crypto markets are fraught with volatility, which highly volatile asset class as par for the course, which
presents a challenge to technical analysis. obviously is not an appropriate investment for all.
Furthermore, in the upside-down world of crypto,
what would appear to be a sell signal using traditional Table 6 highlights a few technical measures that
technical analysis can often be confirmation of an examine transaction activity as a momentum indicator.
uptrend and vice versa. For example, the notion of As an example, Chart 4 shows bitcoin’s relative strength
trying to “buy the dip” in crypto has proven costly even indicator (RSI) has positive momentum.
Table 6
Select Cryptocurrency Technical Analysis Metrics
Technical Analysis Method Description Pros Cons
Coin Days Destroyed (CDD) Monitors coin movement Correlates with network Specific to bitcoin and other
(or lack thereof) on a effect indicators “digital gold” competitors only
given day
No quantifiable method to
measure or model this forecast
Relative Strength Measures the magnitude Historically positive signal An RSI above 70 for equities
Indicator (RSI) of the change in prices when RSI is above 70 usually means it is overbought
Pairs Trading Tracks the change in Gauge for momentum shifts Prices can still be moving lower
the price relationship between bitcoin, the other in general, even if the momentum
between two coins, such “digital gold ex-bitcoin” coins, shift is correct
as ether / bitcoin and “DeFi tokens”
Source: PNC
Chart 4
Bitcoin Price vs. RSI
$60,000 Bitcoin Price
9/30/2011 – 3/15/2021
$50,000
$40,000
$30,000
$20,000
$10,000
$0
110
90 Bitcoin RSI
9/30/2011 – 3/15/2021
70
50
30
9/2011 9/2012 9/2013 9/2014 9/2015 9/2016 9/2017 9/2018 9/2019 9/2020
Source: Bloomberg L.P., PNC
16GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
Key Investment Merits and Risks of Cryptocurrency
With that framework or lens on how to view crypto through a traditional investment process, we highlight what we
believe are the key merits and risks of investing in crypto.
MERITS RISKS
Growth Potential: Decentralized blockchain Regulation: If the Securities and Exchange Commission
technology is a breakthrough disruptor for numerous (SEC) or other global regulatory body classifies a digital
industries and offers significant growth potential for asset as a security (rather than a commodity), there will
years to come. be numerous challenges to growth and adoption.
Rapid Adoption: The bitcoin blockchain in particular Volatility: Given the nature of a nascent technology
has a very strong network effect. Even when the price priced in real-time, digital asset volatility is well above
declines significantly, the user base remains stable. traditional securities like equities.
Transparency: Valuation metrics, while unorthodox, Going Concern: Given the early stage of DeFi,
are rather easy to obtain since all blockchain data is projects could lose significant market share as
freely available to investors. new and improved projects are developed.
Access: A unique feature of DeFi investing is direct Security: Investors face the risk of a breach from
access to venture capital-like projects without hackers on intermediary platforms (e.g., custodians
accredited investor requirements. or exchanges). This is in contrast with the blockchain
networks themselves, such as the bitcoin network or
the Ethereum network, which have not been hacked
to date due to their decentralized nature.
17GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
Classification of Crypto Assets both bitcoin and ether as commodities. According
to the CFA Institute, a commodity is a physical good
An asset class is defined as a grouping of investments
attributable to a natural resource that is tradable
that exhibit similar characteristics and are subject to
and supplied without substantial differentiation by
the same laws and regulations. Asset classes comprise
the general public.2 We believe the latter part of the
instruments which often behave similarly to one
another in the marketplace. Historically, the main asset definition clearly describes the essence of crypto
classes broadly have been equities and fixed income, assets, and thus the commodity label is appropriate.
spanning both public and private markets, as well
as traditional cash equivalent and money market Using our multi-asset class framework, the primary
instruments. asset classification for cryptos starts with the realm
of alternative investments. The sub-asset class of real
Crypto assets fit none of these descriptions, so from assets includes areas such as timber/land, inflation-
a multi-asset class allocation framework, where do linked securities and commodities. Therefore, from an
we go from here? Fortunately, investors have already asset allocation perspective, crypto would be a subset
received guidance, as U.S. regulators have classified within the commodity exposure (Table 7).
Table 7
Alternative Investment Asset Classes
Leveraged Buyout
Oil & Gas
Private Equity Secondary
Venture
Infrastructure
Distressed
Private Debt
Mezzanine
Public
Real Estate
Private
Commodities
Real Assets Land/Timber
Inflation Linked
Long/Short Equity/Credit
Event Driven Activist, Merger Arbitrage
Hedge Funds Equity Market Neutral, Arbitrage,
Relative Value
Relative Value Credit
Macro, Global Tactical Asset Allocation,
Directional
Commodity Trading Advisor
Source: PNC
2
Managing Investment Portfolios: A Dynamic Process. Third Edition. CFA Institute, 2007.
18GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
Ways to Invest
One of the challenges with crypto, given we are current environment, investors’ options are somewhat
still in its nascent days, is the limited availability limited. However, following are some of the most
of traditional investment vehicles like actively readily available options for investing in crypto and
managed mutual funds or ETFs. Therefore, in the related assets.
010001010111
101010100101
010101010101
111011101100
010101001010
CRYPTOCURRENCY
INVESTING
PUBLIC PRIVATE
Direct (DIY) Direct (Passive) Indirect Venture Capital Hedge Funds
Direct Exposure — Do It Yourself Indirect Exposure —Public Equities
• Buy cryptocurrencies or DeFi governance tokens • Invest in the equity of publicly traded crypto industry
directly, as there are currently no actively managed companies (miners, crypto asset managers,
crypto strategies aside from hedge funds. exchanges that offer crypto trading), but most of these
companies are still either small- or micro-cap stocks.
• Investors can buy less than a full coin. The smallest
bitcoin denomination for example is a “satoshi,” which • Invest in semiconductors, hardware and software
is one one-millionth of a full coin, and most exchanges companies that make crypto products such as
allow trading one one-hundredth of a coin. mining equipment, but where it is typically a small
percentage of the firm’s overall revenue.
• Decentralized markets are open all day, every day.
Direct Exposure — Passive Vehicle, Professionally Managed Venture Capital
• The SEC has yet to approve a digital asset ETF, thus • Similar to a traditional venture capital fund, these
there are alternative investment vehicles in existence professional investors provide early stage funding to
that are designed to be buy-and-hold strategies, but new DeFi projects. This provides access to pre-ICO
typically charge 1-2% management fees. As bitcoin governance tokens before they are publicly available.
is by far the biggest coin, the majority of passive • These funds also act as active managers in trading
vehicles are bitcoin-only strategies.
cryptocurrencies and DeFi tokens, looking for
• The largest of these is the Grayscale Bitcoin projects deemed to have significant growth potential,
Trust. It charges a 2% annual fee, and over the a development team that is on the cusp of a major
last 12 months traded at a 16% premium to the improvement in the existing technology or even
underlying price of bitcoin. Over that timeframe its deep-value projects that have the potential to unlock
correlation to bitcoin is just 0.872 compared to 0.999 growth and just need additional funding to continue
for the typical ETF tracking the S&P 500®. operations.
19GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
Table 8
Hedge Funds
Performance Comparison
As of 2/28/2021
• Due to the uncorrelated nature of cryptocurrencies,
coupled with their high volatility, hedge funds have Annualized
been attracted to the asset class for a number of
years. In fact, according to Hedge Fund Research, YTD* 1Y 3Y 5Y
Inc., when there was a net closure of hedge funds
HFR Crypto Index 72.3% 427.0% 51.2% 155.8%
overall in 2019, the only style that saw an increase in
new funds was crypto.
Bitcoin 56.0% 929.0% 189.8% 267.1%
• Table 8 shows a performance comparison of the HFR
Cryptocurrency Index with the two largest cryptos. Ether 91.6% 1529.1% 191.9% 270.2%
Based on the performance dispersion, it shows how
difficult it is for the average hedge fund to outperform. Source: coingecko.com, Bloomberg L.P.
A Quick Note on Yield Farming
With much of the earliest DeFi projects focused on In the nascent stage of DeFi, some yield farming can
financial services smart contracts, naturally that produce income comparable to that of CCC-rated bonds
has led to some new and unusual lending concepts. (8-10%). However, while that yield may sound enticing
One example is the concept of “yield farming,” where in a growth- and yield-seeking world, in our view DeFi
an investor owns a token, but is willing to lock it on a tokens should in no way be compared to traditional debt
network for an extended period of time. instruments. The yield from DeFi lending is dependent
on the price of the coin, which can be incredibly volatile.
Why would an investor lock their tokens on the In other words, the investors may receive that 8-10%
network? To help promote growth of the network with yield, but the price of the coin could depreciate rapidly
an improved sense of permanence. As a reward for to the point they earn a materially negative total return.
effectively depositing their tokens within the network, The concept of yield farming is interesting, but we
miners subsequently give a percentage of the fees they expect meaningful yield capture will be arbitraged
earn to those investors. quickly as DeFi projects mature.
20GOING DOWN THE CRYPTOCURRENCY RABBIT HOLE
The End of the Rabbit Hole and users get comfortable with how DeFi works,
we expect decentralized blockchain technology
As the digital asset universe has a total market cap use cases to continue growing rapidly. At the same
of over $1 trillion, larger than the S&P 600 Small time, we acknowledge the real-time pricing of these
Cap Index, it is difficult to dismiss digital assets venture-capital-like assets could lead to significant
as a passing fad. We believe if the evolution of the performance volatility, which is why digital assets are
internet shifts to Web3, the use of decentralized just not suitable for all investors.
blockchain technology will increase, and thus investors
should focus on those long-term opportunities If by now you’re not sold on the upside-down world
within DeFi. The mainstream narrative continues of cryptocurrencies, that’s ok! Our goal was to take
to focus on bitcoin because digital gold is easier to readers (and maybe some new HODLers?) on a
explain, in our view, than a decentralized flash loan journey down the rabbit hole to think about crypto
smart contract. However, some of the largest DeFi from an investor’s perspective, rather than one that is
projects already generate more transaction fees full of FUD or leaving readers asking “when lambo,”
than bitcoin despite having a market cap that is 99% when either of those lines of thinking usually ends in
smaller. As NFTs like digital art grow in popularity, speculators getting rekt.
For definitions of indexes used in this publication, please refer to pnc.com/indexdefinitions.
The PNC Financial Services Group, Inc. (“PNC”) provides investment and wealth management, fiduciary services, FDIC-insured banking products and services,
and lending of funds through its subsidiary, PNC Bank, National Association (“PNC Bank”), which is a Member FDIC, and provides specific fiduciary and agency
services through PNC Delaware Trust Company or PNC Ohio Trust Company. This report is furnished for the use of PNC and its clients and does not constitute
the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation, or particular needs of
any specific person. Use of this report is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client’s
individual account circumstances. Persons reading this report should consult with their PNC account representative regarding the appropriateness of investing
in any securities or adopting any investment strategies discussed or recommended in this report and should understand that statements regarding future
prospects may not be realized. The information contained in this report was obtained from sources deemed reliable. Such information is not guaranteed as to its
accuracy, timeliness, or completeness by PNC. The information contained in this report and the opinions expressed herein are subject to change without notice.
Past performance is no guarantee of future results. Neither the information in this report nor any opinion expressed herein constitutes an offer to buy or sell, nor a
recommendation to buy or sell, any security or financial instrument. Accounts managed by PNC and its affiliates may take positions from time to time in securities
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are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the
FDIC or the Federal Reserve Board. Securities involve investment risks, including possible loss of principal.
Investments in cryptocurrencies or digital assets are speculative investments that involve high degrees of risk, including a partial or total loss of invested funds.
Investments in this area are not suitable for any investor that cannot afford loss of the entire investment.
DIGITAL ASSET INVESTMENTS SUCH AS DIGITAL CURRENCIES MAY BE SUBJECT TO LEGISLATIVE AND REGULATORY CHANGES OR ACTIONS AT THE STATE,
FEDERAL, OR INTERNATIONAL LEVEL WHICH MAY ADVERSELY AFFECT THE USE, TRANSFER, EXCHANGE, AND VALUE OF DIGITAL/CRYPTO ASSETS. Depending
on its characteristics, a digital asset may be considered a “security” under the federal securities laws. The test for determining whether a particular digital asset
is a “security” is complex and difficult to apply, and the outcome is difficult to predict. Accordingly, digital assets and exchanges are not regulated with the same
controls or customer protections available in equity, option, futures, or foreign exchange investing.
Investors should conduct extensive research into the legitimacy of each individual digital asset before investing. The features, functions, characteristics, operation,
use and other properties of the specific digital asset may be complex, technical, or difficult to understand or evaluate. The digital asset may be vulnerable to
attacks on the security, integrity or operation, including attacks using computing power sufficient to overwhelm the normal operation of the digital asset’s
blockchain or other underlying technology.
Blockchain is a nascent and rapidly changing technology and there remains relatively small use of blockchain networks and blockchain assets. The development of
blockchain networks is a new and rapidly evolving industry that is subject to a high degree of uncertainty.
Factors affecting the further development of the blockchain industry include: continued worldwide growth in the adoption and use of blockchain networks and
assets; the maintenance and development of the open-source software protocol of blockchain networks; changes in consumer demographics and public tastes
and preferences; the popularity or acceptance of the Bitcoin or Ethereum networks; the availability and popularity of other forms or methods of buying and selling
goods and services, including new means of using fiat currencies; government and quasi-government regulation of blockchain networks and assets, including any
restrictions on access, operation and use of blockchain networks and assets.
The application of distributed ledger technology is novel and untested and may contain inherent flaws or limitations. Blockchain is an emerging technology that
offers new capabilities which are not fully proven in use. There are limited examples of the application of distributed ledger technology.
The creation and operation of digital platforms for the public trading of blockchain assets will be subject to potential technical, legal and regulatory constraints.
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