I started my investment career a month before the tech wreck in April 2000. If there was one major lesson I learned over the last twenty years, it’s that I should have been more focused on the fundamental changes the internet enabled.
While I avoided the tech wreck, the cost of not paying enough attention long term was significant. I won’t be making this mistake again. Today, this is particularly important as we are entering a significant new phase of technological innovation known as Web 3.0.
Most investors are aware of the first two iterations of the internet. At its birth, we experienced ‘Web 1.0’ where information was shared mostly via websites in a read-only fashion. We then moved into ‘Web 2.0’ through platforms like Google, Facebook, Apple, Amazon, and Alibaba, where we could not just read, but also write, which allowed us to interact with the platform. Web 1.0 democratised information. Web 2.0 enabled social coordination of our various activities on a global scale.
Web 2.0 has created huge value. The world’s seven largest companies provide the essential digital infrastructure of Web 2.0, which has only been enhanced by the accelerated digitisation caused by the Covid-19 pandemic. Holon believes these companies are going to get a lot bigger as a result.
But we now face a problem.
We have placed our data and enormous power into the hands of a few giant companies that is now widely recognised as one of biggest dangers of our new digital lives. For example, whether you agree or disagree with former President Trump’s positions and views, when a sitting US President is censored — as occurred in January 2021 by the major platforms such as Facebook and Twitter — we all implicitly understand the limitations of the current Web 2.0 data model.
But the good news, which few investors may be aware of, is that the internet is entering into a third generation known as Web 3.0. Web 3.0 is essentially solving the data issue of Web 2.0. Web 3.0 shifts us to a model of read and write, but it adds something new: the ability to ‘verify’ without a central authority that allows us to run applications peer-to-peer without the third-party oversight of a Facebook, Google or Twitter.
Unfortunately, traditional equity managers are yet to understand the potential for significant disruption from Web 3.0 innovations. They are blissfully unaware of how their favourite business models could literally be serially disrupted by structural changes in digital infrastructure.
Indeed, we believe the value proposition of Web 3.0 — i.e. solving the data issue of Web 2.0 — has the potential to be worth many multiples of Web 2.0 solutions, i.e., to be worth many tens of trillions of dollars compared to the trillions of Web 2.0.
In this letter we take a deep look at how two Web 3.0 innovations — Bitcoin and Filecoin — are addressing the serious challenges we face around money/financial services and data respectively. If investors can understand these two issues, they will understand the profound ability of Web 3.0 to not only disrupt existing Web 2.0-based portfolios, but to also create significant new investment opportunities in the future.
The Global Digitalisation of Financial Services – Welcome to Web 3.0
Many of us realise that our banking system has fundamental issues. Firstly, as we have seen with various deposit guarantee schemes around the world, as a society we essentially guarantee the banking system.
To avoid the guarantee being used, particularly in a world of falling interest rates, Governments and regulators have forced banks to increase capital and operate with more compliance. But that is hurting returns.
In Australia, banking has transitioned into a period of significantly lower returns on equity (ROE) due to post-Global Financial Crisis (GFC) reforms. Australia’s highest returning bank, CBA, has seen their cash ROE more than halved from 22% in 2007 to just 10.5% in the 1H2021 result.
But are shareholders being compensated for these falling returns with a lower risk to shareholder capital? I would argue they haven’t because of an issue with our current form of money that could see financial services and banks severely disrupted in coming years.
While banks have been our trusted custodians of money, they don’t actually determine ‘what money is’. What is money at its root?
In 1996, in his paper entitled ‘Money is Memory’, Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, makes a case for understanding money as a primitive form of memory of past transactions. There were two key conclusions of the paper:
1. The only thing that money adds to a society is a (limited) ability to keep track of the past: and
2. That money may only be an imperfect substitute for high-quality information storage and access. There could be better ways to achieve this. This real world message serves to underscore that the government’s monopoly on seigniorage (the ability to create money) might be in some jeopardy as information access and storage costs decline.
Due to the permanent and digital form of its ledger, society can now keep track of the past with a high degree of informational certainty while also storing and accessing ‘data’ or ‘memory’ at a much lower cost.
Ross Stevens, the CEO of Stone Ridge Capital, a well known investor in Bitcoin, defines money more simply as as follows:
“Money is and always has been technology. Whether it was seashells or salt or cattle it’s always been technology for making our wealth today available for consumption tomorrow. Throughout history various monies have always co-existed along a continuum of soundness meaning, good money to kind of bad money and they’ve always been subject to competitive network effects like any competition. Given enough time, including right now, no money is absolutely the best money. On all dimensions there are always trade-offs some are better some are worse some are better at this some are better at other things. It also means that all money is temporal, no money has ever been or ever will be forever including bitcoin will not last forever.
Money is just a good like any other good but what makes money as a good unique is that we value it not for its own sake but for its prospective exchange utility. This means we hope the vessel, whatever we choose to store our money in, keeps its value long enough so we can trade it in the future for stuff we actually want. Nobody actually wants green little pieces of paper, nobody actually wants bitcoin either. What we want those things to do is to hopefully allow us to trade them for things in the future we actually want – a vacation, a college education, property, whatever so it’s not that we want the money we don’t want the money, we want what the money can do for us in the future, what we can trade it for.”
In essence, Bitcoin is the strongest form of memory, and thereby money, that currently exists. Bitcoin enables the sound governance of our money because you can’t manipulate the ‘data’ or ‘memory’ of what our money represents, i.e., our hard work and effort over time can be preserved and exchanged in the future.
Today, we are seeing fiat money (and therefore our data and memory) manipulated in unprecedented ways. Central banks have expanded their balance sheets materially since the GFC, and the Covid-19 pandemic only accelerated the trend. There is no doubt that the printing of money in large quantities will distort ‘our memory’ of what money is supposed to represent.
Are interest rates at all time historical lows the consequence of a distorted monetary unit? Nobody can be sure. It’s actually hard to even get a handle on the degree of the distortion because, unlike the Bitcoin ledger which can be verified independently, the current monetary system cannot.
If a Bitcoin Standard underpins the natively digital global financial system, then every asset allocator and financial adviser in the world will need to re-think asset allocation.
Cash in the current fiat-based local financial systems is programmed to lose value each year. If you sit in cash, you won’t maintain your purchasing power. So your financial planner will advise a low cash weighting, particularly in your younger years.
But under a Bitcoin-based global financial system, your purchasing power is maintained, your cash (or Bitcoin) weighting will therefore be much higher. For example, Gold (the analogue version of Bitcoin) returned approximately 5.4% per annum over the 30 years to mid-March 2021.
By comparison, global equity markets, as measured by the Global MSCI All World Total Return Index, delivered approximately 5.8% per annum over the same period. Crazy to think that a little shiny bit of metal that sat in a vault nearly outperformed global equity markets over a 30 year period.
The network value of Bitcoin has the potential to become very large — in the tens of trillions of dollars — as it consumes many traditional ‘store of value assets’. This is because Bitcoin is likely to displace many asset classes that are acting as an inferior ‘store of value’ created as their advisers and investors tried to solve your purchasing power problem in the first place.
For traditional fiat-based local financial services such as Australia’s big banks, this means the potential for significant disruption is being laid in years ahead if they don’t engage with the digital asset ecosystem. Some regions of the world are waking up to this possibility.
We are seeing a new type of bank being established to provide a trusted bridge between fiat and Bitcoin. In Wyoming in the United States, special purpose depository institutions (SPDI) have been enacted in legislation to foster a safe and secure banking environment to provide this bridge.
Avanti Bank is leading the charge in this respect. This new Wyoming bank formed to serve as a compliant bridge to the U.S. dollar payments system and a custodian of digital assets. The Wyoming legislation allows the bank to meet the strictest level of institutional custody standards, creating a new, low risk way of banking in the future.
SPDI banks can accept USD but they can’t lend, thus no fractional reserve banking. In addition, digital assets such as Bitcoin are custodied under a ‘bailment’ arrangement where the bank does the safekeeping on your asset. However, ownership resides with the customer.
In essence, a new era of ‘Banking-as-a-Service’ is being ushered in to support the global digitalisation of financial services. Unlike traditional, local-based fiat banks of today, we expect SPDI’s to be high returning, high growth and low risk. The very opposite of today’s banking model. (We have an insight here for we are a shareholder in Avanti).
As banking is homogenous globally, we wouldn’t be surprised if the model spreads around the world in recognition of the significantly lower risk profile. Avanti is also laying the groundwork to solve the substantive issue of the people guaranteeing the current banking system or the too big to fail issue. The value that could be released by this development, i.e., sound money custodied sound financial institutions is very significant.
If Australia fails to engage in the global digitalisation of financial services, our banks and their shareholders may suffer the same fate as our local media companies in the years to come. In particular, the United States in the last year has started to embrace crypto and digital assets, with one of the major banking regulators, the Office of the Comptroller of the Currency (OCC) giving banking the green light to engage in the global digital ecosystem. In addition, states like Wyoming now enable asset managers (like Holon) to provide institutional grade product solutions for digital assets with legal certainty.
At Holon, we can see the groundwork being laid for the next Google and Facebook equivalents in the global digitalisation of financial services. Unfortunately, Australia is yet to take a step. The problem is financial services is our largest sector at 10% of GDP and to not engage is putting the golden goose at risk. Holon is actively working to change this.
Moving to a trusted model for our data – Privacy and Security assured
The second area where Web 3.0 will have a profound impact is in data.
The Holon Photon Fund today is overweight centralised cloud services, mainly through Amazon, Google, Alibaba and Tencent. These Mega Caps are providing the digital infrastructure of the Web 2.0 age.
While we are positive on the value proposition Mega Caps bring, a centralised service can never solve (in an absolute sense) privacy and security of your data. As soon as your ‘data’ is handed over to a closed third-party platform service, you are putting your trust in that centralised organisation.
Data leaks have become so common that they hardly make headlines anymore. In 2017 an Amazon Web Services S3 bucket was configured to let any AWS Authenticated User download its data, resulting in exposing the personal information of millions of Dow Jones customers.
A 2019 configuration error on Google cloud services disrupted services for up to four and a half hours impacting Snapchat, Vimeo, Shopify and Discord. This represents a single point of failure, where a central controller is compromised, your data could be compromised as well.
Tech giants are also moderating more and more content, raising significant freedom of speech issues. Facebook and Twitter banning Trump content and AWS shutting down Parler in January 2021 at the time of the Capitol Hill attack was the first time the government has been silenced by the media.
However, a new decentralised data model in Web 3.0 is evolving to ensure privacy and security of your data.
For example, San Francisco-based ‘Protocol Labs’ — a lab that develops and deploys research protocols — has developed an ‘Airbnb’ model for data storage through an open-source public network for data storage. Your data is encrypted end-to-end and stored on a public network. This has been achieved by shifting data from location to content-based addressing (a way to store information so it can be retrieved based on its content, not its location) while incentivising participants in the network to store data.
The protocol that enables this shift (from HTTP location- based addressing) is the ‘InterPlanetary File System’ (IPFS). The decentralised storage network — ‘Filecoin’ — provides the economic incentive to do so by creating a marketplace based on Filecoin tokens (FIL).
The economics of the Filecoin network are designed to achieve two main things: increase speed and lower the cost of data storage and retrieval on the internet. The FIL tokens turn what is effectively an over-the-counter market in centralised data storage today into a global commodity market supporting the most secure and cost effective way of storing and accessing our data.
Today’s cloud players are the largest companies on Earth. Each of them have committed to investing tens of billions to support the shift into centralised cloud services.
So how does a decentralised cloud network acquire the resources to compete with these established networks, even if the value proposition (privacy and security) is vastly superior? By providing a community-based incentive model for global participants to build upon an open source model for data.
Under the Filecoin network protocol, up to two billion FIL will be issued by the network over the years ahead to incentivise participants. At US$80 per token in today’s prices, the Filecoin network would be valued notionally at US$160bn, if all tokens were issued today.
Approximately 70% of all the FIL tokens will be issued to providers of the decentralised cloud storage over time. In the first few years (5-7 years), approximately US$32-40bn in FIL block rewards will be earned by cloud storage providers proportional to their storage capacity on the network.
Currently, there are nearly 1,486 cloud storage providers (or storage miners), 100+ organisations, 200+ new Web 3.0 projects and 5,581 developers contributing to Github [a code hosting platform for version control and collaboration that lets you and others work together on projects from anywhere] on the Filecoin ecosystem. Many of the cloud storage providers are also contributing capital and time, matching the block rewards.
When you add up the contributions from the global community supporting the ecosystem’s development, you start to realise the resources employed have the potential to easily match the centralised cloud systems at an early stage.
The incentives enable the network to establish a significant baseline of useful data storage for Web 3.0 developers to build upon. Longer term, the Filecoin ecosystem is aiming to establish a Yottabyte of storage, which is approximately 1,000 times larger than the data storage within all existing centralised cloud providers (albeit growing rapidly) today.
In the Web 3.0 age of native digitalisation, we are going to need as much cost-effective, privacy-assured data storage as possible. Autonomous vehicles, for example, may end up consuming most of this storage alone. Given the value proposition and the size of the market, it is not surprising that the IPFS/Filecoin ecosystem is probably the largest early stage ecosystem in the world.
Engaging with Web 3.0 is important for your future wealth
The Filecoin/IPFS protocols for data, like the Bitcoin protocol for money, solve fundamental coordination challenges for human interaction at scale. In both cases, the protocols (or Web 3.0 internet infrastructure) enables trust when dealing with our data and money. Both solutions are fundamentally very valuable for humanity and significant innovations.
Both Bitcoin and Filecoin directly or indirectly have the potential to benefit or significantly disrupt investment portfolios within a typical investor time horizon (5-7 years).
Bitcoin has the potential to disrupt global financial services, while Filecoin/IPFS infrastructure enables a more natively digital infrastructure where your data is owned by you, not Facebook, Twitter or Google. This has the potential to significantly change search, online advertising and other core internet services today.
Five years ago the network value of Bitcoin was less than US$10bn, compared to the near US$1 trillion value today. In total, today’s digital asset markets are trading close to US$1.8 trillion, or the size of all companies listed on the Australian Stock Exchange (US$1.7 trillion).
Holon believes digital markets will be significantly larger in the next 5-7 years as the value propositions are translated into easy to use customer interfaces. We see this happening with Bitcoin today, and the rest of the space will start to follow.
At Holon, we believe this is coming much faster than expected due to the natively digital implementation to which the public is now very familiar. After spending significant time and effort on the Web 3.0 space, you realise all the business models and value propositions are picking apart Web 2.0 in addition to the old world economy. As a result we have a saying Holon; “If you are not over Web 3.0, you don’t understand Web 2.0”.
When I entered into investment management in 2000, markets were excited (think tech bubble) about the prospects for the internet. However, the infrastructure was yet to be built. Fast forward twenty years, the digital infrastructure is now essential for home, work and play.
Today’s Mega Caps provide that infrastructure that are the new ‘defensives’ of the digital age. However, Web 3.0, just like Web 2.0, has the potential to accelerate the pace of change once again, with even larger game-changing innovations.
Given the strength of the value propositions (we highlighted just two important ones), we believe digital markets underpinned by Web 3.0 innovation will be substantially larger in the future. The opportunities and disruption that can result has the potential to materially impact your portfolio.
I wish you good investing!
Managing Director & Portfolio Manager
Holon Global Investments