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‘Tokenomics’, incentive structures, red flags: How a pro-crypto investor finds value with Pratik Kala from DigitalX
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Special Report: In this Stockhead interview, Kala breaks down the investment process behind the only ASX-listed digital asset funds manager. DigitalX Asset Management is a Subsidiary of DigitalX Limited.
For Pratik Kala, digital asset investment analyst at ASX fintech DigitalX (ASX:DCC), modern crypto investing requires the same rigorous due diligence as traditional asset classes.
And in a recent interview with Stockhead, Kala discussed how the DigitalX Funds investment team builds positions within a sophisticated investor framework that adheres to the regulatory requirements of an ASX company.
An early mover in the space, DigitalX was the first ASX company to report Bitcoin holdings on its balance sheet.
The company now runs two crypto investment funds for sophisticated investors – a dedicated Bitcoin fund and the DigitalX fund, which returned over 238% for its investors in 2021. With the DigitalX Fund incorporating a broader basket of digital assets.
So, what kind of crypto assets make the cut?
Kala detailed the fund’s DD process; what attributes the team looks for, along with some of the red flags common to the still-burgeoning crypto sector.
Fund filters
The DigitalX Fund generally holds positions in 8-12 crypto assets in the Top 20 by market cap at any one time.
As a starting point, it excludes stable or wrapped coins – digital assets that are pegged to either fiat currency (such as USD) or other crypto assets (most commonly Bitcoin), respectively.
Before starting its due diligence process, the fund only assesses assets in the Top 20 by market capitalisation (not including stable/wrapped coins) on the crypto listing website CoinMarketCap.
“Obviously crypto is still a volatile asset class, so we only consider an asset for inclusion if it has stayed in the top 20 for a minimum of six weeks,” Kala says.
“It’s common for an asset to move into the Top 20 before falling back out, so we’re looking for that consistency.”
“Once an asset meets that criteria, then we go into a rigorous due diligence process to determine its inclusion in the fund.”
Stage 1: Asset analysis
Tokenomics
Typically, the DD process starts with a detailed appraisal of the asset’s whitepaper, which has some similarities to an ASX prospectus. The whitepaper outlines what problem the project is trying to solve and its strategy to achieve it.
“Many tokens are issued without sound emission schedules. So we place a great deal of importance on tokenomics,” Kala said.
Tokenomics (or token economics) describes how tokens are issued for a given asset.
The simplest example is Bitcoin, which is well known for having a fixed supply of 21m coins.
Conversely, the crypto asset Cosmos (ATOM) was established with an unlimited supply.
“If there’s an infinite supply then we ask, what does that actually mean? For example, if a coin supply is inflating by 20% or more per annum, then it raises questions about whether we should even consider it as an investment,” Kala says.
As an example of sound tokenomics, Kala cited the Ethereum network.
“That’s a structure where the more the network is used, the more deflationary supply becomes. So the more the network is used, the more tokens are burned and removed out of circulation, but that process is flexible and it’s constantly adjusting to find the right balance,” he said.
“So different protocols have different methodologies, and it’s a case by case basis where we look at that, comparing each to its sector peers.”
Governance
Another key factor tied to tokenomics is the governance structure of a given project.
Broadly speaking, crypto is focused on decentralised solutions.
“There’s no traditional board of directors with many of these protocols. It’s all community based, so that puts the onus of strategic decisions on participants from within the community of the protocol,” Kala said.
“One important question is, how do participants vote on protocol changes and what are the thresholds for a vote to pass? We analyse the governance mechanism– whether it allows for efficacy in governance or whether it creates unnecessary complexity or introduces risk.”
Incentives
Another core aspect of any crypto project is the incentive structure it establishes to bring more participants onto its network in order to create those important network effects.
On a longer timeline, the crypto sector is in its relative infancy which means it still attracts “a lot of mercenary capital”.
“What we’re looking at is, how is the community or extraneous business interests being incentivised to use or build on the protocol? Are there sustainable staking, yields or ecosystem incentives to keep users/developers around or short term bonuses like airdrops?”
That’s important, otherwise, you can have an exciting new project that has a lot of money thrown at it, but it doesn’t last because there’s no incentive structure for users or developers.”
Stage 2: Engaging with the network
If the right boxes are ticked in the first stage of DD, Kala moves onto Stage 2: engaging with the network.
“We don’t believe in just reading whitepapers before we invest,” Kala says.
“So the next step is to set up wallets and interact with the protocol.”
Actually participating in a network is the best way to determine if aspects of a whitepaper are marketing spin, or if the technology really works in practice.
“By now in the crypto space, most people would be aware of all the projects with fancy marketing hype,” Kala said.
“So joining the network helps us understand if it works well.”
For example, some products may work well with a smaller user base.
“But if it scales from 1-2,000 users to 100-200,000, can it still function? We also want to know if the protocol’s interface is user friendly, and to do that you have to use it,” Kala says.
“A lot of people still make their decisions by reading research of dubious origins or marketing decks, but they don’t jump in and actually try to use it.”
“Recently we’ve rejected investments in several protocols after we actually tried the product.”
Stage 3: On-chain metrics
As part of that direct interaction with the network protocol, Kala and his team also take advantage of the ‘transparent transactions’ unique to the crypto sector.
“Blockchains don’t lie, everything is publicly visible and that’s one of the great things about this entire space,” Kala says.
“So when we’re looking at a protocol, there’s a lot of information on our checklist which is all publicly available if you know where and how to look.”
For a network such as Ethereum, that means data such as daily transactions, the average ‘gas’ price, network utilisation, and how much revenue is being generated by the protocol – all of which are updated in real-time.
“So on-chain metrics are a key part of our investment process because they show us if a network is vibrant and growing in the right direction, or slowly dying.
Public information on a blockchain network also includes the number of developers and coders that are active within that protocol – another sign of the strength (or weakness) of a project. If there are no developers there is no product. If there is no product there is nothing to buy.
“We dive deep into on-chain metrics before we make the decision that an asset makes the grade for a potential allocation”,” Kala said.
Red flags
Because market volatility is still a central aspect of crypto investing, knowing what to avoid is also just as important as knowing where to allocate capital.
Kala also provided some context around how DigitalX manages risk, given the more regulated framework that it operates in as an ASX -listed manager.
The fund does not participate as a liquidity provider in DeFi projects, given the ongoing risks around hacks and project bugs. The risk is just not worth it at this stage of the cycle.
“We do stake a small portion of our coins on established networks because that’s an extremely safe way of generating yield,” Kala said.
“You can offer computing power and get a yield on the back of that, so we view that as a very safe investment.”
But in terms of early red flags, it mainly comes to whether projects breach the fund’s initial due diligence criteria – particularly around governance.
“One red flag relates to the distribution of tokens,” Kala says.
“So you could have, say, 100m tokens at inception, and 80m are held by a group of only four or five people.”
“They could be people working remotely, with known or unknown identities, so where you have a small group that controls the majority of the tokens, any small disagreement could destroy the value of the token immediately.
Another red flag is where the proposed governance mechanism in the whitepaper leaves grey areas in areas such as tokenomics.
“If the governance structure is vulnerable to changes, that could leave critical decisions such as whether to inflate the supply of tokens in the hands of just a small group of decision-makers,” Kala says.
“So it’s crucial the projects are set up with the right amount of checks and balances, while also creating a platform that can scale and grow. That balance isn’t easy to get right and the projects that have executed well have already found an advantage in the market.”
Lastly, and most importantly; does the project have a viable way to accrue actual dollar value?
“Technically anyone can create a Shiba Inu coin or something like it, which is based simply on marketing and hype and has no clear mechanism through which coins will actually accrue value,” Kala said.
In contrast, networks such as Ethereum have demonstrated an ability to add real value.
“We can see the value in its entire dev ecosystem,” Kala said.
“There’s a lot of brainpower building all kinds of projects – DeFi through smart contracts, NFTs, automating new industries such as the music business.”
“One of the central ideas behind crypto is that users could be anywhere and still access the same financial infrastructure as a banker sitting in Manhattan.
“The use cases are certainly there and network effects are a part of what gives these projects real value. While there is strong demand and continued improvement at a protocol level, providing developers with tangible utility these protocols will continue accruing value through ongoing demand for their native tokens.”
