Venture Capital Investing in Crypto

EMS:
Absolutely. So to kick off the conversation, tell us a little about the firm and how you got to where you are today.
WR:
Sure. So Pantera Capital was originally founded by Dan Morehead in 2003 as a global macro hedge fund. Dan was originally the head of global macro trading at Tiger Management of Julian Robertson's era. He pivoted the funds nine years later in 2012 to become the first institutional asset manager in the US that focused exclusively on blockchain and crypto assets.
So our first fund was a Bitcoin fund that exclusively invested in Bitcoin. At the time, that was a useful vehicle for investors to have available to them. And we've since launched a series of venture funds that invest in early-stage crypto protocols and businesses, as well as a liquid token fund that invests in publicly traded cryptocurrencies. So our latest fund, which is our fourth fund, was the blockchain fund, was a wrapper for all of our strategies. So that's early stage crypto, venture equity, and liquid token strategies.
EMS:
Great. Well, so given your focus on VC investing in crypto, love to hear your outlook for the space. Obviously, it's a very interesting time currently.
WR:
Yeah, no, it is an interesting time. So we released our 2023 Year Ahead Blockchain Letter in January, and we've had a bunch of insights into our sort of longer term VCs for 2023, and I'd encourage your listeners to check it out if they haven't already. I covered blockchain and crypto infrastructure in the letter, so I'll outline a few of my terms from that here.
So we've known that Ethereum scaling solutions, which are known as Layer-2s in the community, are probably the most critical sector to be tracking the progress of the ecosystem in 2023. So how do you track that progress? Well, typically people use metrics like TVL, which stands for total value locked and refers to the amount of capital currently invested into the smart contracts of a crypto project, and also DAUs or daily active users. However, for several reasons that I'll skip over here, which you can find more info on in our blockchain letter, TVL and DAUs can be somewhat easily gained. And so we don't think that they're great metrics for giving clear insights into the progressive ecosystem.
Instead, we think watching for specific tactical milestones will help determine the longer-term trajectory projects. And again, we outline what we think those are, the infrastructure section of our letter. Where traditional metrics may be helpful is in tracking the inflows of capital from non-DeFi or decentralized finance verticals like gaming, NFTs or Web2 corporate partnerships.
So the final piece of Layer-2s comes down to an important Ethereum base layer protocol upgrade known as EIP-4844. EIP stands for Ethereum improvement proposal, and EIP-4844 is also known as "Proto-Danksharding," and it's a critical and pretty highly anticipated part of the Ethereum scaling roadmap that Vitalik Buterin, Ethereum's founder, has outlined. So EIP-4844 will lower the costs of rollups, which are the tech that most Layer-2s are built on, by a factor of 10 to 100X, so multiple orders of magnitude. We think this is both a blessing and a curse. So it could provide a big tailwind, so higher volume transaction fee verticals like gaming, but could pose problems for the monetization of the current Layer-2 bread-and-butter business model, which is DeFi.
EMS:
Great. Well, so given that, what are some of the greatest specific opportunities you see looking ahead and why?
WR:
So we're excited about a lot in the space, and again, I direct your listeners to our blockchain letter for a more comprehensive view from all of our team, but I'll outline a couple of things that I'm excited about. So the emerging Ethereum middleware sector is made up of several players who are building infrastructure to help secure and scale the core Ethereum blockchain. So our Eigenlayer, and, full disclosure, Pantera is not an investor at Eigenlayer, is building a restaking protocol that allows for the extension of Ethereum's base security layer to other products and services in the space. So we're inside different projects that could be enabled by this new premise, and we'll be watching for any projects that are using restaking in 2023.
Another Ethereum middleware layer is Obol Network. This is one of our most recent investments that we made in January of this year. So Obol is essentially building a technology called Distributed Validator Technology or DVT, which allows for multiple Ethereum validators to run a single Ethereum validator node. And what that means is that each node has a significantly reduced risk of slashing, which is when validators either intentionally or unintentionally act in a way that they're not supposed to and risk losing some or all of their stake deeper. So slashing is a pretty major problem in the staking community and it was at one point considered such a material risk that Lido DAO, who are the current largest E-staking service, was spending 25% of their revenue on slashing insurance. So it wasn't surprising to us when we found out that Lido are currently finalizing their testing in DVT and intend to incorporate the tech into their stack as a measure to significantly reduce or do away with insurance payments as well as improve the user experience of staking.
The other benefit of DVT is that it reduces the risk of staking award losses due to validated downside, which has the effect of increasing average staking yields over time. And so what all this means is that not only will staking become better for sale users, but institutional onboarding should be a lot easier with risk management protocols like DVT in place.
Finally, DVT is a composable technology, so we think it can integrate pretty closely a piece, other pieces of it there in middleware, and so we think that pretty substantial network effects exists, which is why we are excited about the Obol, the Obol investment.
Finally, DVT was considered such important part of the Ethereum roadmap that Vitalik included it as a standalone section in the Merge, and you can find Vitalik roadmap diagram if you just Google Vitalik Ethereum roadmap.
Finally, the other area that we're starting to look into more of is the emergence of trustless bridging protocols. So most crypto bridges today are the sort of trusted design, which means you have to trust a third party to take custody of and execute your transactions where you're bridging between blockchains. These have been shown to be pretty high risk. There are over $2 billion lost in bridge hacks in 2022, which accounted for about 70% of the total crypto hacks for that year. Thankfully, there are several trusted bridge models they're starting to develop which allow for the math and cryptography alone to determine the bridging of your assets, and we're excited to see how that space develops as bridges are critical to enabling the multi-chain future that most investors and participants in the space envisage.
EMS:
Great. Well, and on the other hand, what are some of the greatest challenges you face looking ahead and why?
WR:
Sure. So I think one of the biggest challenges the space continues to face is bringing in non-crypto native users during a bear market. So we've seen some projects be very successful in making client profile Web2 partnerships, and I think it's now up to them to grade these partnerships and prove their value to traditional non-crypto native businesses. I also think that one of the biggest growth factors in terms of user numbers for crypto over the next five years could be the gaming vertical. So the problem is that so far most crypto games are not that great compared with the most popular traditional games. So I think it's now up to either the Web2 gaming incumbents to begin running tests on blockchain rails. Also, crypto native game developers to start designing games that have a longer-term vision and narratives to keep users involved for several years to come. And all of that should be done in such a way that the token design and token mechanics are used in a way that enhances the game experience rather than just being somewhat of a gimmick, which some crypto gamers have experienced so far.
EMS:
Great. Well, we've covered a lot of ground today, so I wanted to see what your future plans are.
WR:
So our mission at Pantera is to continue to fund and help build the best projects in crypto which are contributing towards the development of the economic layer of the internet. We've continued building out our team entirely despite the bear market, including bringing on several critical members to our portfolio support team, including most recently Dr. Matt Stephenson, who's our most recent edition as Head of Cryptoeconomics. And we'll continue to review in interims our internal processes for finding, investigate, and supporting the best founders in crypto and Web3.
EMS:
Will, I wanted to thank you so much for sharing your perspective with our listeners.
WR:
Thanks for having me, Elana.
EMS:
Absolutely. And thank you for listening to the EisnerAmper Podcast series. Visit eisneramper.com for more information on this and a host of other topics, and join us for our next EisnerAmper Podcast when we get down to business.
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