Welcome to the third edition of the Analyst of the Month.
This month we highlight Cosmo Jiang, Portfolio Manager at Pantera Capital where he is responsible for their liquid token strategies.
Cosmo was previously Founder & Managing Partner of Nova River, a web3 crypto investment fund, and before that Managing Director at Hitchwood Capital Management, a fundamental, directional, thesis-driven long/short equity hedge fund.
There are a ton of lessons to be learned from Cosmo's 10+ years in hedge funds, private equity, investment banking and running his own crypto investment fund.
Without further ado, please meet Cosmo Jiang!
To start from the very beginning, I grew up in the small town of Cupertino in the heart of Silicon Valley, so I’ve always been around innovation and tech. The Apple headquarters was visible from my backyard when it was still that rainbow-colored logo. I left California to go to Harvard for college where I studied applied math. At that point I still didn’t know anything about investing, but what I did know was that I liked learning and surrounding myself with smart, growth-oriented people and a natural place to channel that energy is finance.
I started my career with a two-year investment banking “bootcamp” at Evercore, where I focused on M&A for financial companies. More than anything else, I think investment banking is an important stepping stone for developing basic technical skills, work ethic and attention to detail, and I am grateful to have done so at one of the most competitive groups. I then joined the private equity group at Apollo, where I really learned the basic toolkit of being an investor – forming investment theses grounded in fundamental value-based analysis, building relationships with management teams and industry experts, and identifying investible long-term trends. I brought that with me when I joined Hitchwood, a multi-billion dollar public equities hedge fund with a culture of doing in-depth research. Investing is an apprenticeship business and those were the most formative years of my career, where I learned from great mentors with decades of experience including James Crichton and Guy Baron. I was at Hitchwood for seven years where I was a Managing Director responsible for our consumer, internet and media investments - which includes everything from retailers like Nike or Costco to established media giants like Google or Netflix to high-growth eCommerce like Doordash or Carvana.
Now, bridging that today to crypto. I’ve personally been invested since early 2017 when Ethereum caught my eye. My thesis then was that Ethereum had the potential to be a new software platform, which are great businesses. Standing here in 2023 the thesis remains the same, only now there’s more evidence to back it. Crypto would not become relevant to my day job until late 2020, when with the backdrop of COVID accelerating digital penetration across all facets of our lives it was becoming clearer that blockchain-enabled businesses were gaining traction and could become increasingly disruptive.
As I dug in, I came to the realization that there were actually real businesses being built - something that wasn’t true as recently as one or two years prior. There were an increasing number of protocols with product use cases, revenue models, and trackable fundamentals. Moreover, I came to the realization that tokens were a new form of capital formation. Many of these blockchain-based businesses would never have a New-York Stock Exchange listed equity, and instead used tokens to align incentives with management team, employees, tokenholders and, uniquely to digital assets, potentially other stakeholders like customers. These businesses are ones that I can underwrite using the fundamental investor toolkit I’ve built over the last few years.
Whether you call it confidence or hubris, one of my goals was to eventually build my own investment firm. I had originally thought this would be a long/short equity fund focused on consumer internet, until I saw the greenfield opportunity in digital assets.
As an investor, one of the hardest parts of the job is optimizing for the highest ROI on time. There are uncountably many interesting investment ideas in the world but a finite amount of time. My framework for filtering has always been three things, (1) where is the highest potential secular growth, (2) where is there the greatest amount of misunderstanding, and (3) where is there the least amount of competition. The answer to all three is so clearly crypto. From a growth perspective, crypto could go from millions of users today to billions of users over time. From a misunderstanding perspective, even amongst people with the same investing background as me there is a high degree of disagreement on whether or not blockchain technology will ever amount to anything. And finally from a competition perspective, due to the way the industry has grown over time, there are countably few investment firms that use a fundamental lens to invest in digital assets as opposed to the hundreds of new long/short equity launches every year.
I left Hitchwood at the beginning of 2022 and launched Nova River later that year to validate this thesis - that tokens are a new form of capital formation and fundamental investing will be the best approach to long-term compounding returns in this asset class going forward. At Nova River, I am grateful to have met many long-term oriented partners who trusted me with their hard earned capital. These investors had to underwrite both the strategy’s potential in digital assets as well as my skill as a capital allocator. Being a steward of that capital is a privilege that I do not take for granted and seek to earn every day.
After a year of managing the Nova River partnership, I decided to join forces with Pantera Capital to increase the probability of long-term investment success. Pantera is the most established investment manager focused exclusively on blockchain with over $3 billion of assets under management across various venture and liquid investment vehicles. With all my decisions, I ask myself how I can be the best steward of my investors’ capital, and I knew this was a great opportunity to reap the benefits that come with being part of a larger platform.
In some respects, this does not represent much of a change from the status quo. As Portfolio Manager of Pantera’s liquid token strategies, in partnership with Pantera founder Dan Morehead, I am responsible for directing the investment strategy, which is largely the same as that of Nova River. Pantera has a philosophy of genuinely investing in the long-term future of the digital assets industry. This means finding investment opportunities in high quality businesses or protocols with great growth prospects, profitable unit economics, and trustworthy long-term oriented management teams. There are few in the digital assets industry that implement this fundamentals-based strategy today, let alone at scale.
Being part of the Pantera platform has three major benefits for investors over a smaller fund like Nova River. The first and most meaningful is increased resources to invest in research and data analytics efforts, which includes attracting high quality investment talent and partnering with data providers like Artemis. The second benefit is materially deeper industry connectivity, management access and information flow. I am confident these two benefits greatly augment our ability to identify and evaluate attractive investment opportunities. The third benefit is less obvious if all goes well, and that is the institutional-grade infrastructure. Digital asset industry mishaps of the last year highlight the importance of working with experienced, responsible parties and being a trusted partner with the highest quality processes and procedures in place. Pantera has an impressive, seasoned team that manages operations in areas such as legal and compliance, fund administration, asset custody, and vendor due diligence (e.g. audit, trading)
Being an investor is a constant work in progress. You have to balance a “history doesn’t repeat but it rhymes” mantra, because there are universal truths about human nature, with an “adapt or die” attitude, because what worked yesterday will get competed away by tomorrow. Moving into an entirely new asset class like digital assets in particular requires a greater level of open-mindedness and playfulness. My investment approach is similar to what has worked for decades in traditional equities, but adapted for the unique attributes of digital assets.
On the side of universal truths, the core of the investment process is the same as what I’ve practiced in the past. It’s all about being grounded in fundamentals and doing differentiated, in-depth research to form views about the long-term trajectory of the industry, its businesses and the management teams behind them. I have learned that the best way to compound returns over a long time horizon is to focus on quality and growth. This means I am most interested in protocols that have demonstrable product market fit, strong management teams at the helm, and a path to attractive and defensible unit economics.
The tools of the trade have parallels to those in traditional finance. I’m still tracking fundamental data but instead of SEC filings, Bloomberg and M-Science there is Artemis, Dune, Etherscan and Token Terminal. I’m still interacting with management teams but instead of in conference rooms I’m doing it over open community calls and DAO governance forums. I’m still doing field research but instead of doing it over the phone through expert networks I’m interacting through Discord and Twitter.
On the side of adaptation, it is also clear there are some concepts that are entirely novel for digital assets.
Bootstrapping growth through token issuance is disruptive. Users can now share in the equity upside of a protocol. As the saying goes, show me the incentives and I’ll show you the outcome. This is an incredibly powerful way to incentivize early user adoption that doesn’t exist in equities.
Capital structures are also more nuanced. Companies may issue separate equity and tokens, each with different rights, and even within tokens there can be separate governance and utility tokens. This can be extraordinarily confusing to navigate and requires careful reading of fine print, which is oftentimes not even printed.
Governance in DAOs is also new. All of a sudden stakeholders have a voice, and the level of engagement and discourse is certainly much higher. Some governance forums have hundreds of new posts a week. This compares to the nearly empty conference rooms that characterize the typical annual shareholder meeting for a public company, of which I have attended many.
All that said, at the end of the day the question I seek to answer is the same - what is the long term earnings power of this protocol and how will that value be returned to capital providers? How I get to that answer is just slightly different.
As a fundamental value focused investor, I am most interested in areas where there is product market fit and large growth potential. There are three areas I see that fit this characterization:
- Blockspace: In order to transact on a blockchain, users need to pay transaction fees to ensure their actions are picked up by validators and included in the next block - this is paying for blockspace, and it is a big business at the core of blockchain. Ethereum has proven there is meaningful demand for its blockspace, to the tune of over $1bn of annualized revenue (and over $20bn at peak). Layer 2s built on top of Ethereum open up more blockspace, and demand for that has resulted in annualized revenues of over $120mm on Arbitrum and $65mm on Optimism at peak this year. If one believes that blockchains will see increasing usage, that will translate into growing revenue from selling blockspace.
-Trading: the most frequently used blockchain applications today relate to trading, whether on centralized exchanges like Coinbase and Binance or decentralized exchanges like Uniswap and DYDX. Trading, or more cynically gambling, is a core human activity that has been around for millenia with inevitable demand. Even in this period of low volatility, these trading venues are generating meaningful revenue. In the latest quarter, on an annualized basis Coinbase generated $1.2bn of trading fees, Uniswap over $600mm and DYDX over $75mm.
-Stablecoins: the demand for storing and transferring value, primarily denominated in USD, has proven to be critical to the financial plumbing across crypto and in emerging markets with less stable governments and currencies. Stablecoin issuers are effectively banks that earn a spread based on what they pay to attract deposits and the yield they can earn on those deposits. Tether is the largest stablecoin issuer with over $80bn USDT issued and reported $3.4bn of annualized profit in the latest quarter. Maker is the largest decentralized stablecoin issuer with $5bn DAI issued and is generating over $50mm of annualized profit.
Within the second category I laid out, DYDX is a great example of a protocol with attractive fundamentals that can be evaluated using a traditional investment framework. DYDX is an on-chain decentralized exchange (“DEX”) for trading perpetual futures (“perps”).
Market share leader within a category that is taking share in an attractive end market:
- DYDX is the market share leader within perps DEXs with ~55% volume share in 2023 year-to-date. I believe its market share dominance will continue because of the quality and differentiation of its product - the user interface is familiar to anyone who has traded on a centralized exchange, and it is the only DEX at scale with a central limit orderbook model. The upcoming v4 upgrade is expected to further improve the user experience with better latency.
- Within exchanges, DEXs as a category have been share takers from CEXs, as evidenced by DEX share of the futures market increasing to 2.5% in the latest quarter from 1.7% last year. This is a secular shift I believe will continue as CEXs continue to suffer from user trust issues and regulatory pressure while at the same time the DEX user experience improves. There is still more room to take share, if it follows a similar upward trajectory as the spot markets where spot DEXs now have 15% market share.
- As discussed previously, so as long as you believe crypto will grow as an asset class, trading is intrinsic human nature and this end market will grow alongside.
Profitable unit economic inflection:
- The business model is straightforward - DYDX collects trading commissions (roughly 2.5 basis points of volume) and pays for customer acquisition in the form of rewards and rebates.
- DYDX was previously paying out more in rebates than it was collecting in trading commissions because it was trying to incentivize growth. It has since shifted its focus to profitability this year with great success.
- DYDX has gone from loss making to profitable this year and now earns roughly 1 basis point of volume in profit.
Capital allocation inflection:
- DYDX plans to begin returning capital to tokenholders in conjunction with its upcoming v4 upgrade. A portion of revenues would be distributed to tokenholders who stake their tokens on the new DYDX chain, directly tying token value to the protocol’s profitability.
-At today’s valuation and assuming ~50% of circulating tokens opt-in for staking, the dividend yield could be >10% based on trailing 90 day volumes.
Putting this all together, over the next couple years you can pencil out a reasonable scenario where DYDX could be worth over $10bn or 5x upside versus today’s market cap. This assumes overall trading activity grows from prior peak, DEX market penetration doubles within perps, and DYDX maintains its market share and margins.
Artemis is an indispensable tool in my research process. I live in Excel, and having an Artemis plug-in that can pull in prices and fundamental data series in a similar fashion as the Bloomberg plug-in is incredible. Whenever I’m looking at a new sector or just want a quick snapshot of key trends, it’s easy to reference the Artemis web app’s pre-made dashboards.
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