I want to focus on the fundamentals of Ethereum (ETH). Although the core of our investment process is quant, it is still important for us to understand the fundamentals of the assets we trade in. As George Soros and Stan Druckenmiller used to teach me, when looking at an investment opportunity in the public markets, you should analyse it from three perspectives: 1) fundamentals, 2) quantitative / technicals and 3) news flow. When these three factors are aligned, you need to “back up the truck and go big” in hedge fund parlance. This is how these hedge fund titans have generated best-in-class returns consistently over past decades.

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A similar framework can also be used to identify big opportunities in cryptocurrencies. We believe ETH has considerable upside potential based on fundamentals and news flow drivers. With two of the three drivers above now supportive of a price rise, we have prepared more algorithms to trade ETH.

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ETH Background

ETH is the second biggest cryptocurrency based on market capitalisation ($25bn). ETH is a decentralised, open-sourced blockchain that offers smart contracts functionality. ETH has a much wider capability than Bitcoin. For example, it has its own programming language (Solidity) and allows users to build and deploy applications on top of the Ethereum blockchain.

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Ethereum and ICOs

Several years ago, the biggest use case for the Ethereum blockchain was Initial Coin Offerings (ICOs). The mechanism of action is similar to that of an IPO. To conduct these ICOs, entrepreneurs would create smart contracts on the Ethereum platform to raise money. Investors would need to buy ETH and send them to wallet addresses of ICO projects to participate. Investors would receive project tokens in return. In the heydays of ICOs, tokens would go up 2x, 5x, 20x and 100x in a few weeks. This drew in more investors, driving a colossal surge in demand for ETH. This was the craziest speculative fever that I have ever witnessed in my career. During this period, ETH price increased $8 per coin to $1,400 at the peak (170x increase). Putting this into perspective, ETH’s market cap reached $130bn at the peak in 2017, putting it in the same league as companies like Toyota, McDonald’s,

AstraZeneca and Nike. This boom was followed by a bust. As ICO projects failed to generate returns in the real world, investors started selling project tokens. Projects also started selling ETH. ETH price fell to the trough of around $85 in 2018 (a 94% drop from the peak). The reason for bringing up the ICO boom and bust is because I

believe this could happen again. There are two catalysts that could drive this:

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1) ETH 2.0

ETH will go through a major transition to ETH 2.0 later this year / early 2021. This change will make the network much faster (100,000 transactions per second), allowing ETH-based applications to scale. In addition, ETH will change the consensus mechanism from Proof-of-Work to Proof-of-Stake; instead of solving a mathematical problem to earn fees (Proof-of-Work), validators will be required to stake (lock-up) ETH in order to vote to earn fees. Locked up ETH will receive a reward of 3%-15% per year. Investors who want to participate would need to buy ETH coins and lock them up in the system.

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2) DeFi

DeFi is short for decentralised finance. These are financial applications built on the blockchain. Similar to ICOs, most DeFi applications are built on Ethereum. With DeFi, users can conduct the same activities as they do in traditional finance but in the digital space. Key applications of DeFi include: lending / borrowing (a platform called Compound behaves like a bank in the digital world), trading on exchanges (similar to stock exchanges) and derivatives (users of Synthetix can tokenise anything in the real world e.g. gold, Tesla stock). While this sounds complicated, think of these applications as digital analogues to what happens in the real world. The DeFi sector has grown by 800% in the past year and the top-100 DeFi tokens market cap is now $6.2bn. Because most DeFi projects are built on ETH, one needs to use ETH coins to transact. These coins will need to be locked up as collateral and used as fees to operate in the digital world. ETH 2.0 and DeFi will drive higher demand for ETH coins. But both also require ETH to be locked up, thus reducing supply. In any market, a reduction in supply in the face of surging demand usually results in explosive price increases. We think ETH could revisit previous highs ($1400 or 6.2x increase from current levels) in the next 24 months.

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Risks

Aside from the usual macro concerns / COVID-19 risks, we see two major risks to our bullish thesis on ETH. 1) Delay of ETH 2.0: The crypto community expects ETH 2.0 to be launched this year or early next year. But given the scale of the change, the launch could be delayed and 2) Quantitative / technical signals are not showing signs of a new bull market yet: Based on the framework above, the quantitative signals are not indicative of a start in a new bull market just yet. However, quant / technical signals could easily change in a short period of time.