2023 Annual Investor Letter

This below is an excerpt from ParaFi's 2023 Investor Letter (the "Letter"). The Letter was originally drafted for ParaFi investors and parts of this letter have been redacted and/or amended for public distribution. Please see Important Disclaimers at the end of the Letter for additional information.

Dear Partners,

In a couple months, we will celebrate ParaFi's 6 year anniversary.

We often say that crypto moves in "dog years". Not only does this reflect the frenetic news cycle, the turbulent volatility, and the provocative characters. It's also simple mathematics. Crypto markets trade 24/7/365, so there is a 5.16x multiplier on time the market is open relative to traditional markets (168 hours per week versus 32.5 hours per week for US public equities).

Using that rubric, ParaFi isn't turning 6. It's turning 30.

I remember turning 30 (in human years) almost a decade ago. It was a transition point in my life. I had just gotten engaged to my wife and had started a new role with KKR. I felt a sense of growing up and appreciation for my past. Yet I also sensed that my best days were ahead.

As I reflect on ParaFi's evolution, I sense that we currently sit at a similar juncture. We started from humble beginnings in 2018 as one of the first investment firms in the digital asset space. Over our 6 years, we have grown into a leading firm with $930mm+ AUM across multiple investment strategies, a 20 person team, and a global base of 400+ investors². Yet it's clear to me that we are still early on our journey.

Our path has been anything but linear, and certainly we have taken some wrong turns and learned countless lessons along the way. Navigating these twists and turns is table stakes for investing in a frontier and contrarian asset class. Through the market cycles, I am proud of our team's resilience and focus, and have conviction that ParaFi as a firm, as well as the industry at large, is better positioned than we've ever been.

When I set out to build ParaFi, I aimed to build not simply a fund, but an investment firm that could stand the test of time. Architecting a great investment firm isn't easy. Great investment firms organize people and ideas into a culture and set of processes that deliver strong and repeatable performance. This is a tough formula to nail. And one that ParaFi continues to strive towards. Nonetheless, I take pride in what we've built - a rigorous investing culture, long term partnerships with our investors, hands-on support for our portfolio companies, and a team that genuinely loves working together.

As a firm in 2023, we had over 1,000 meetings with crypto founders and portfolio companies and we completed 21 private investments across ParaFi Digital Opportunities and Venture Funds. We scaled ParaFi Technologies into a leading builder of blockchain infrastructure, which helps drive hands-on insights to our investment team (ParaFi Technologies is now validating ~ 1% of all blocks on Ethereum!).

We hosted quarterly calls for our investors diving into the regulatory environment, the venture capital landscape, and emerging real world use cases for blockchain technology. We traveled around the globe to hackathons, hosted webinars covering topics like Ethereum's Technical Roadmap, and spoke on numerous panels and podcasts.

But amidst these milestones, we pause to ask ourselves a straightforward question, a question that's often lost in the never-ending blizzard of zoom calls, portfolio meetings, and the 24/7 crypto macro news cycle. A question that a 6-year old (or perhaps a 30-year-old) may ask. Or frankly anyone that is exploring a new frontier. Simply put: Why are we here?

Without grounding in the "why", it's difficult to contextualize the journey. We know all too well that the path over the past six years has been anything but linear. The road less traveled often is. The best way to understand the "why" is often to remember how a journey began.

The Beginning

It is Summer 2015.

At the time I was working in the credit business of KKR. I had gotten involved on my nights and weekends as a hobbyist in bitcoin. I studied the mechanics of proof-of-work consensus, attended meetups with other r/btc subredditors in the Mission neighborhood of San Francisco, and occasionally would grab lunch in the Coinbase offices when it was a fledging early stage start-up.

Bitcoin was trading sideways between $200-300 that summer, after a blow-off top in December 2013 catalyzed by the Cyprus banking crisis. The entire crypto market at the time was valued at approximately $5bn with only eight total digital assets with market caps of greater than $10mm (versus today a market cap of $2.3 trillion with 1,000+ tokens >$10mm). Stablecoins had just started with Tether standing at ~$400k outstanding (vs. $98+bn today).

Yet despite the niche scale, it was clear to me that something special was brewing.

Six years prior, in 2009, during the depths of the global financial crisis, bitcoin was born in an obscure corner of the internet. Bitcoin's pseudoanonymous creator, Satoshi Nakamoto, designed a peer-to-peer payment system and store of value that did not rely on central banks or financial intermediaries. Instead, the system was built on game theory and cryptographic proof. Simply put, bitcoin could serve as "money without counterparty risk". Its blockchain, an immutable ledger that kept track of transactions, was auditable and transparent to anyone with an internet connection. Instead of trusting banks and governments, bitcoin was designed as a system that trusted solely in math.

In the Summer of 2015, the promise of blockchain technology wasn't dead. In fact, the ecosystem of companies and infrastructure was larger than it had ever been. Somehow it had spawned from a white paper in a chat room and survived against all odds, now quietly growing like a virus across technology, libertarian, cryptopunk, and financial communities in the Bay Area and abroad. Yet it was still largely out of the purview of Wall Street and the mainstream conscious.

With the help of an analyst, I put together an 86 page deck titled: "Intro to Cryptoassets". The goal was to pitch KKR on acquiring bitcoin and actively pursuing other investments in the blockchain space. This required a first principles revisiting of many foundational topics -- the history of money, the centralization of existing internet services, the architecture of distributed systems, etc. This was a mix of liberal arts and hard science and the most fascinating work I'd ever done.

Bright-eyed and bushy tailed, I expected the investment pitch to KKR management would be a slam dunk. This was groundbreaking technology with a deeply asymmetric payoff. But I was wrong. Their response was one of deep skepticism. "Is there a way to short bitcoin?" my colleagues asked. The blunted response was not an anomaly. It was the same reaction I heard from peers at other investments firms, family, and friends. My pitch had fallen flat. I was missing the why.

What is a blockchain good for?

In the first ParaFi investor letter from Q3 2018, we described why a blockchain is useful:

It's helpful to start from the beginning and examine "blockchain" on a first principles basis. Blockchain is merely a data structure. The only difference between a database and a blockchain is that a blockchain is a computer application run simultaneously on computers around the world, rather than a database which is typically run on a central server. With a blockchain, anyone can run the application and see the data.

But what do blockchains enable that couldn't be done before? Simply put, blockchains facilitate the transfer of value over the internet without a third-party intermediary. They accomplish this by enabling digital scarcity. A simple analogy is the internet. The internet is a network that enables the transfer of information. When information is sent over the internet (whether an email, photo, or text), the sender retains a copy. As a result, both the sender and recipient have copies. Information can exist in more than one place at a time.

However, value and information are different. Value can only exist in one place at a time. If a digital $100 bill could be spent multiple times, it wouldn't have value. This is known as the double spending problem.

The double spending problem is precisely what blockchain technology solved. Using advances in cryptography and a distributed network of computers, blockchain ensures that value can be transferred from party A to party B in such a way that 1) party A does not retain a copy and 2) the transaction does not rely on a trusted third-party. This is significant. Blockchain technology can be applied to track and send anything of value – money, stocks, bonds, intellectual property, software licenses, votes in an election – without the need for a centralized third-party.

Why does this matter? Today, value transfer over the internet flows through intermediaries. Today, the world relies on Dropbox to store photos, JP Morgan to transfer money, Fidelity to custody stocks, and Spotify to access music. The internet has evolved into a highly centralized hierarchy – Amazon owns 50% of e-commerce purchases, the Amazon/Google/Microsoft trio controls 90% of the cloud computing market, and Apple controls 50% of the global smartphone market. While these companies perform valuable services, they also pose systemic risks. They have the power to (i) extract a meaningful economic cut of routine transactions, (ii) expose and monetize user data, and (iii) censor who uses their service. Examples include Facebook's Cambridge Analytica breach, Apple's restriction of content in its App Store, and Visa's hefty fees it charges merchants.

Blockchain technology has the potential to rebuild value transfer over the internet without reliance on centralized intermediaries. This future world holds radical promise for a more equitable, private, and inclusive internet.

That's the why.

Where Are We Now

In the evolution of great technologies, often the "why" comes before the "what" or the "how".

The internet in its earliest incarnation, deemed ARPANET, was launched in 1969 by the Department of Defense for academic and research purposes. Developers and venture capitalists began to grasp the potential of this technology in the '80s and '90s. Yet it largely remained off the public radar. It wasn't until the early 1990s that the web browser had its "Netscape" moment, kicking off the past three decades of growth. The perplexed look on Katie Couric's face when she asked "What is the Internet, Anyways?" on the Today show in 1994 demonstrates how the internet has gone from obscure to ubiquitous over the past 30 years.

Most technological adoption follows this arc of "gradually, then suddenly". Early adopters and builders work in earnest for years or decades until one morning the world wakes up to the first consumer use case. Case in point, artificial intelligence has been a burgeoning industry for the past couple decades, but it wasn't until ChatGPT launched in 2022 that it entered the public zeitgeist.

We believe blockchain is going through a similar evolution. If you ask 100 people what blockchains are useful for today, you will likely still encounter confusion and skepticism from the preponderance of responses. Crypto is a less "consumer-y" use case than AI. Most can appreciate the power of chatGPT as it is a skeumorphic, incremental improvement over the search engine. (Of course, AI is much more than a better search engine, but this is first order popular thinking).

Crypto on the other hand is a bit more difficult to comprehend. It completely re-invents a new base layer on which applications and businesses operate. One confounding factor is its heterogeneity – blockchain touches money, governance, finance, identity, gaming, physical networks, creative economies, etc. Another is blockchain's abstractness – most use cases are only comprehensible to developers and techno-hobbyists (despite the fact that many consumers use blockchains today without knowing they're using them). And up until the past couple years, blockchain infrastructure was virtually unusable due to high costs, high latency, terrible UX/UI, value leakage via Maximal Extractable Value ("MEV")⁴, outages, confusing public/private key cryptography, etc.

Undeniable Progress

Yet in the 15 years since Satoshi's whitepaper and six years since founding ParaFi, the digital asset ecosystem has unequivocally made tremendous leaps forward. Progress that is almost unimaginable if you were to step back to October 2008.

Bitcoin has established itself as an institutional macro asset. Blackrock and Fidelity's Bitcoin spot ETFs have accumulated nearly 1% of all Bitcoin in existence only 1 month after approval. Ethereum, Layer 2s ("L2s") and other Layer 1s ("L1s") have evolved into a cornucopia of applications from gaming to finance to real world asset ("RWA") tokenization to platforms for AI agents. On Ethereum alone, approximately 4mm ETH (~$11.6bn) have been burned and paid in fees over the past 2.5 years (since EIP 1559). Stablecoin transfers are now run-rating at over $15 trillion per year, driven by B2B payments and remittance use cases where they're already cheaper than alternatives (see Visa's USDC payment launch on Solana, Mastercard's comments claiming 1/3 of LatAm customers have used stablecoins for purchases, or Bitso now accounting for 4% of remittances in the US-Mexico corridor).

Tokeneconomics are bootstrapping networks from geolocation to WiFi hotspots to car data; for example, Hivemapper has built real-time mapping data for 13% of the entire earth. Decentralized finance ("DeFi") networks have endured for nearly half a decade with on-chain lending platforms like MakerDAO generating >$100mm+ of free cash flow per year. Decentralized Social platforms like Farcaster have reached >100k Monthly Active Users ("MAUs") while mitigating censorship risk and weaving payments into their core architecture. Decentralized Prediction Markets like Polymarket have already seen ~$60mm in open interest on the 2024 US Presidential Election.

Pages could be filled with the novel use cases we are seeing proliferate on-chain across the industry. Crypto has entered the Overton Window – it has moved from unthinkable to radical to acceptable to sensible… and, we believe, soon to be: popular. How the rest of this decade unfolds for the blockchain ecosystem is filled with questions and uncertainty, but what's unquestionable to us is that this industry is going to reshape and disrupt trillion dollar markets. Gradually, then suddenly.

Many refer to crypto as a new technology, which is true, but it's also something else – a brand new asset class. New asset classes come along every decade or so (e.g., private equity in the 70s, high yield credit in the 80s, etc.) Nascent asset classes are often "alpha rich". At their inception, competitive intensity is low (i.e., few sophisticated investors) and return dispersion is high (i.e., owning the best assets delivers a non-linear disproportionate outcome versus owning the average asset). Nascent asset classes tend to offer high returns on rigorous due diligence and quality asset selection. It's the reward markets deliver for sorting through the complexity.

With "2 million" unique tokens reported on Coinmarketcap and a $2.3 trillion market at the time of this writing, crypto is a paradigmatic nascent asset class. Our prevailing view is >99% of tokens will converge towards zero in the coming years, but the remaining <1% offer asymmetric upside. Counterintuitively, we hold the following two views contemporaneously: 1) that 99% of tokens will be worthless and 2) that crypto, in aggregate, is significantly undervalued. We believe this presents a prime opportunity to sort the wheat from the chaff.

We often hear from newcomers and skeptics to the industry that "there are no fundamentals in crypto" and "there aren't any real use cases". These cursory proclamations have stubbornly persisted during bear markets, despite the myriad of activity. Many leading web3 protocols were designed and launched in bear markets after a period of heads down building for 18-24 months. A few examples of strong growth in underlying KPIs and usage include:

• MakerDAO, a decentralized credit protocol launched in 2017 and built on Ethereum, is generating $225mm of on-chain revenue and $108mm of free cash flow at the time of this writing.
• Polymarket, a prediction marketplace for sports, politics, and culture, reached an all time high of $54mm in volume in January 2024 alone. Major media publications, political parties, and candidates themselves have cited and shared Polymarket.⁷
• Farcaster, a sufficiently decentralized social media platform, has nearly 30,000 daily active users ("DAUs") after a staggering ~15x growth in DAUs since December 2023. Farcaster has introduced Frames, enabling any post to be turned into an interactive environment for NFT mints, payments, and games natively through the Farcaster UI.⁸
• Hivemapper, a decentralized global mapping business, has already geospatially mapped 13% of the entire world's global road network in less than 18 months.⁹
• Parcl, a platform to speculate on real estate prices using stablecoins and a proprietary pricing index, has seen $170mm in total volume traded since November 2023.¹⁰
• Helium, a decentralized wireless protocol, has onboarded 50k users to its mobile plan. Separately, Solana's new web3 phone generated 100k pre-orders in one month. Many applications are now airdropping tokens to Solana phone users and building mobile support from day one.¹¹

There is a significant uptick in stablecoin usage, re-staking marketplaces, decentralized social, creator economy applications, on-chain identity, KYC'd DeFi environments and more.

Kevin Yedid-Botton, Portfolio Manager and Partner

Wayne Gretzky famously said: "Skate to where the puck is going, not where it has been."

During my 13-year international ice hockey career, I once met Wayne Gretzky and took a page out of his playbook. While his advice didn't play out for my hockey career, I found his philosophy to be unconventionally applicable to financial markets, where things have turned out for the better.

If you've watched or played hockey, you may agree that it's one of the fastest team sports. "Skating to where the puck is going" is not just a method of increasing your shots on goal. It's also a framework for identifying the evolution of the game in real-time and getting into the right position to score and win. Consistently being one step ahead of the game is the winning formula.

What learnings could Wayne Gretzky teach us about quantitative strategies?

Since 2019, we have made the choice to run an alpha-hungry strategy in one of the fastest-moving markets in the world: crypto. What has been the winning formula? Being one step ahead of the rest of the market – skating to where the puck is going.

So, what have we learned from Wayne Gretzky? Quantitative alpha is like a puck: it continues to weigh 5.5oz, is 3 inches in diameter, is made of black rubber, and moves very quickly across the rink. In order to score, you need to be in the right position.

The way we've played the game has changed, but the objective of the game has not.

Sincerely,

The ParaFi Team

Sources

² As of December 31, 2023.

⁷ Source: https://dune.com/rchen8/polymarket

⁸ Source: https://dune.com/pixelhack/farcaster

⁹ Source: https://x.com/aseidman/status/1753486209572376585?s=20

¹⁰ Source: https://app.parcl.co/

¹¹ Source: https://dune.com/rawrmaan/helium-mobile

Important Disclaimers

This Letter is provided by ParaFi solely for informational purposes and is not financial, legal, tax or investment advice. Through this Letter, ParaFi is not recommending any particular security, protocol, token, financial instrument, or other tradeable asset ("Asset") or any investment strategy and is not offering to sell, or soliciting to buy any Asset, including those of any investment fund advised by ParaFi. This Letter is not personalized for your particular circumstances or investment needs. You should independently evaluate and judge the matters referred to in this Letter.

Unless otherwise noted, the information and opinions contained in this Letter are provided as of the date given in this Letter and is subject to change without notice. ParaFi does not represent or warranty as to the accuracy or completeness of the information and opinions contained herein. ParaFi is under no obligation to update, revise, or correct any information contained herein. Specifically:

• Certain information contained herein is based on or derived from information provided by independent third-party sources. ParaFi believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.
• Opinions, beliefs, intentions, assessments, estimates, and projections, including, among other things, estimates of valuations, targeted characteristics of a Fund, and anticipated management of risks (collectively, "Statements") are subject to error, involve inherent risks and uncertainties, many of which cannot be predicted or quantified and that are beyond the control of ParaFi, and are based upon certain assumptions, which may not be reasonable or may not be likely to occur. Any price inferences presented in the Letter are for illustrative purposes only. Future evidence and actual results (including actual composition and investment characteristics of the investment portfolio) could differ materially from those set forth in, contemplated by, or underlying these Statements. Statements expressed herein may not necessarily be shared by all personnel of ParaFi.
• The links and related articles herein are provided as a convenience. The inclusion of any link does not constitute an endorsement, authorization, sponsorship, affiliation or monitoring by ParaFi with respect to such linked site or its owners. Accessing any linked sites is at the user's own risk.