Crypto vs Junk Bond Market: The Right Financial Mental Model Will Make or Break

Original: https://moneromr.substack.com/p/crypto-as-junk-equity-a-mental-model?sd=pf

The crypto world’s aversion to financial services is palpable. Calling Aave contributors bankers and watching the blood drain from their faces faster than Sam Bankman-Fried can exit DeFi in November 2021 is understandable. Cryptocurrency is undoubtedly the hottest subject of 2021, but it has the potential to become notorious given the constant stream of bankruptcies and failures reminiscent of the 2008 financial crisis. My senior managing director at Goldman Sachs once summed up the burden of notoriety well:

"Be careful when hot industries become notorious. Banking used to be a no-brainer for anyone looking to live a comfortable life, but the size of the bonus made it hot back then. Lack of discipline And lack of focus led to a catastrophic turnaround in the industry from hotness to notoriety. And once you’re notorious, you only go downhill.”

Notoriously few benefits, and token-based cryptoeconomic systems are not among them. Remember that in the short run the market is driven by social factors (voting machines), but in the long run it is always dominated by financial factors (weighing machines), and fear of missing out blurs the time frame. Market performance in 2022 tells us that investor attention has shifted. Strikingly, the number of Google queries for "what is EBITDA" has increased nearly five-fold compared to last June. Hope those Googlers get their answers, because it might be a long time before we see the bottom.

A number of mental models have emerged in the last year attempting to explain the explosiveness and staying power of token-based models: mostly around social capital dynamics. Cryptocurrencies (money), utilities (digital goods), and brands (NFTs) are all fascinating narratives to understand this asset class, albeit mostly around public dynamics rather than market fundamentals. Some might argue that on purpose, each of these frameworks evaded the SEC's attention under the Howey test.

But cryptocurrencies are a financial revolution first and foremost, and financial dynamics will clearly drive future valuations for the industry. Developing the right financial mental model will make the difference between success and failure for investors. First, we need to delve into what makes tokens and equity similar:

Through this lens, we can understand cryptocurrencies as an evolution of corporate equity, resulting in a model with greater flexibility and risk, less certainty and standardization, and higher expected returns. In other words, the business model at the time encouraged semi-speculative investments in assets whose legal rights and returns were opaque. While the uninformed may lose everything, the diligent will reap digital fortunes.

Given that financial capital dynamics drive long-term crypto markets, we propose a junk equity model: understanding the role of tokens in capital structures as lightweight equity. Like equity, tokens can capture residual value, but unlike equity, its rights are more opaque and limited by design. The core source of cash flow is usually subsidized rewards funded by inflationary tokens, and investors must rely on token economics backed by the incentive system to understand financial valuations. Understood this way, it is less clear whether tokens should be securities. If the business is successful, there is less of an expectation of profit than a loose promise of returns. In short, tokens and equity are skeuomorphic, but you get far more uncertainty.

This isn't the first time new financing vehicles have emerged that resemble existing ones: the debt market underwent a similar revolution in the '80s, and Mike Milken ushered in the junk-bond era. While the innocuous name of junk bonds might suggest a closed niche in the financial services world, junk bonds have become a trillion-dollar asset class. Milken himself built his Drexel Burnham Lambert bank into a behemoth with about $1.5 billion in capital in 1988, but it then collapsed.

Junk bonds came about because a small group of smart financiers realized that the expansion of the Fed's balance sheet after the stagflation of the 1970s would allow companies to support more, riskier debt. This is more apparent to some than others: The entire debt investing industry has emerged around conservative principles, with few pushing the envelope for fear of mounting losses. Yet at certain moments in history, circumstances have even overturned the commonly held belief that the American corporate system can support more leverage than conservative thinkers honed in the 1970s could comprehend. In this case, there are a few factors that make the junk bond explosion so obvious in retrospect, including:

• Balanced Budget Leads to U.S. Balance Sheet Expansion Leads to Continued Headline Yield Falls
• Restructuring of the banking system in the 1970s gave more power to borrowers
• 'Private equity' investors weaponize knowledge of funding markets

Milken's key insight that higher yields offset the default risk of speculative-grade firms was powerful, but was significantly amplified by structural innovations of the time: most notably the emergence of mortgage-debt structures. A CDO is a new financing structure that can multiply demand for bonds, democratizing the diversification benefits of large credit portfolios to small companies or investors, rather than just the large banks that previously benefited only. With it, risky loans could be packaged together and financially designed to "lower" the overall risk: in retrospect, given the high correlations, we know that diversification payoffs are much lower than advertised, but the end consequences may require It will take years to become clear. Structure and speculation give way to true innovation and evolution.

Today’s cryptocurrencies share many characteristics with the junk bond revolution, especially building a bridge between speculation and technological development. Similar to junk bonds, the axiom on which cryptocurrency investing theory is based won’t be acknowledged for another decade, but it’s pretty simple:

1. Programmable financial assets are more powerful
2. Automation and an active user community can deliver better margins and asset efficiency
3. Trust-minimized coordination system operating at scale increases economic productivity

This revolution was accompanied by a structural evolution of its own: the DAO, which cemented decentralized ownership as a business model and increased community participation in how the protocol was run. DAOs have done a lot to make tokens equivalent, creating skeuomorphic governance rights, cash flow rights, and control parameters. DAOs brought some structure and predictability to the otherwise lawless crypto jungle, and the paradigm shift was driven by the intersection of financial and structural innovation.

In addition to encouraging speculation and innovation, cryptocurrencies and junk bonds share many characteristics: They differ from traditional bonds in similar ways. Tokens are a good match for the strengths and weaknesses of junk bonds in terms of return profile, investor rights, and accepted understanding.

The most important similarity between tokens and junk bonds is that they allow non-standard businesses to flourish, and this is done by paring down the elements of standardization and indexation. Financial markets are very structured, partly because of a legacy of standard information distribution. SEC filing requirements may be updated to reflect the fact that people can now post online. A lack of structure and consensus creates incredible opportunities for risk-seeking investors to profit from their differentiated knowledge, while a lack of standardization confuses the rest of the world with knowledge that may be a common understanding.

The origins of more than one large alternative asset manager can be traced entirely to this paradigm: notably, Apollo Global Management was founded on the basis of Leon Black's use of differentiated underwriting to buy distressed junk bond books. There is no accepted framework for evaluating them, so any real bid is a winning bid. Leon understood the background that led the market to misunderstand junk bonds and bought them as quickly as possible. He leveraged this strength to build the world's second largest alternative investment manager, today with over $500 billion in assets under management, and exceptional expertise in credit investing.

Buffett and Graham also pioneered the practice of corporate investing based on working capital. In the 1960s, what other people didn't know was that you could go to the SEC office and get a company's balance sheet and trade on that information advantage. That might sound like a dirty word today, but there are always rewards, and those who work hard to find them in the non-standard world. However, once standardization enters the competition, information advantage is created by deceit, not courage.

We predict that financially inclined token investors will significantly outperform in the next bull market, as only fundamentals can anchor investors in the internet’s hype machine. Financial models, when strictly enforced, can provide high-fidelity analysis of probabilistic outcomes. Digging into models of token inflation, understanding the size and longevity of subsidies, is an easy way to rule out bad investments. After all, these are just companies counting on their lifetime source of equity financing. Mismanagement should be as easy to detect as decisions recorded on-chain, and where value creation is unclear, the market will relentlessly zero projects. So we gave the founders more freedom to control their lifetime funding, but built a market valuation mechanism where the market checks for waste in real time. Like junk bonds, mistakes in token structure are punished swiftly and relentlessly, as market participants can amass controlling shares and easily enforce their will, as Ohm Protocol did with all its forks during the crash like that. Just like Milken did in the 80's, today we are ready to give entrepreneurs more leeway to build a business that lasts for generations. But founders excited about this new paradigm should be wary that, like the aftermath of the junk bond boom, the cryptocurrency boom will also allow financiers of all stripes to weaponize analysis to profit massively from the pain. Founders won't be able to get bailouts from white-shoe lawyers with decades of knowledge of institutional structures.

Of course, the junk equity model doesn't work in every situation. Tokens like ETH also fit the crypto-as-money and crypto-as-utility models. These mental models are not mutually exclusive. However, the junk equity model is more applicable in the following situations: usually when the company raises both equity and token financing. For example FTX, which has a free floating token FTT. The stake is entitled to cash flow, the token is only a fee discount, but the token still trades at a diluted cap of about $10 billion. Why? Because investors are betting that as FTX grows, parts of the business will become decentralized and begin to be managed by tokens, possibly even generating cash flow. Many corporate-trained investors would look at the token and reject it, but those who understand Sam's vision know that once regulation is clear, he will likely drive the value of the token. Tokens are option value on the network: it is lightweight equity.

The history of finance in the United States is such a history: new, efficient markets emerged, and savvy financiers used mental models to understand their correlations before corporate academics defended them years later. By definition, the middle period is an intense period of highs and lows as the rest of the world chooses its side.

But remember, only 4% of the world owns cryptocurrency today, and it already feels like this side might win. Imagine what the next billion people will do.