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The map is not the territory: rethinking cryptography as an asset class

Sid Kalla, CFA and Bradley Miles are co-founders of Roll, an open social money standard on the blockchain ethereum.

The following is an exclusive contribution for the 2018 year of CoinDesk under consideration.

2018 years in review

For long periods of time, bitcoin returns were not related to equity, bond or commodity markets.

Even though bitcoin has been highly volatile, adding a small amount of bitcoins to a portfolio of stocks and bonds can actually improve risk-adjusted returns (improve the Sharpe ratio). The drivers of bitcoin yields are very different from those of other markets and are therefore rightly considered by investors to be an interesting asset class.

However, generalizing this observation to the wider "cryptographic market" can be dangerous for investor returns.

First of all, let's try to understand what it means to talk about "cryptography as a class of resources" in the first place. Investopedia defines an asset class as follows:

"A asset class is a group of securities that has similar characteristics, behaves the same way in the market and is subject to the same laws and regulations."

In reality, these do not need to be securities – for example, real estate and commodities are not securities but commonly thought of as asset classes.

When we look at the "crypto-market" today, does it fit this definition? We maintain that this is not the case.

The case against

The "crypto-market" today consists of cryptographic assets that have fundamentally different characteristics. They are governed by different economic realities, have different market structures and have different performance characteristics. They are simply too varied to be aggregated into a single class of activity.

Unlike ordinary shares that have rather well-defined economies (limited liability, split ownership, voting rights, etc.), this is not the case with cryptographic activities. The economic characteristics of the MakerDAO MKR token are fundamentally different from the Augur REP and both are fundamentally different from Ethereum's ETH.

The metaphor of the philosopher Alfred Korzybski to distinctly separate the "map" (belief system) from the "territory" (reality) is a suitable analogy here. Simply using "crypto" to describe all the tokens mentioned above, despite their respective incentive structures is a mental shortcut – a mental "map" to navigate the space, which does not exactly reflect the "territory".

During the speculative bubbles, like the one we saw at the end of 2013 and again in 2017, all cryptographic resources tend to move together with a strong correlation. For longer periods of time, however, this is not true (in fact, many of the 2017's most popular cryptographic resources do not have a sufficiently long price history).

Here is a snapshot of the December 2013 crypto market as a reference. Out of the first 3, almost no one has survived significantly until today (with the honorable exception of Dogecoin, of course).

Setting expectations

To add a new dimension to this confusion, 2018 saw the clamor around the "security tokens" as a way forward for the crypto industry. A security token is supported by an underlying asset, such as real estate.

If security tokens are the new ICOs, their economic characteristics are not the same. If a luxury resort offers a security token offering, returns will be much more correlated with the luxury resort market, or with the real estate asset class than Bitcoin. As the industry progresses, there will certainly be many other types of cryptographic resources, each with its own crypto-economic design and performance characteristics.

When new projects enter the space – think Filecoin, Grin, Dfinity, Hashgraph, Algorand, etc., Investors would do well to ask themselves the fundamental thesis on which they are buying an encrypted asset.

Investors can easily be misled into believing that they are investing in bitcoin's inconsistent monetary thesis or in the decentralized calculation thesis of Ethereum when they are actually just buying startup shares or local real estate.

Diversification must be done smarter than buying a set of cryptographic assets and crossing fingers: investors need a "map" with finer details to navigate the "territory".

After all, there is no reason to believe that the digital returns of the $ 100,000 digital cat should be strongly correlated with the $ 1 billion dollar Telegram network, even if technically they are both "encrypted".

Do you have an approved opinion of 2018? CoinDesk is looking for proposals for our 2018 under consideration. News via e-mail [at] coindesk.com to learn how to be involved.

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