My bets on Blockchain

This is going to be a quick and dirty “here are my thoughts” post because I want to get the idea out there and solicit feedback.  I want to talk about what I have done with blockchain, where I think it might be going, and why I am (cautiously) optimistic that blockchain technology isn’t the bubble that many fear.

Back in May I decided that bitcoin just might be the real deal. I started to look for ways of investing in it.  It was a tough go.

I found that putting money into bitcoin in Canada was somewhat more difficult than the United States.  I cringed at the idea of providing a bunch of personal information to some exchange site, including drivers license and a credit card. I’m a dinosaur in some respects and I get nervous about transferring personal information over the internet.

I also found very few ways of playing the trend via the stock market.  There were basically zero publicly traded company’s that I could find.

I ended up taking only a small position in bitcoin and ethereum (really small).  But I also did another, much smarter thing.  I took a tiny position in Overstock.com.

The size of the position was inconsequential.  I’m not going to pretend I got in before the move or even that I understood what Overstock was doing.  I did it simply so I would have a placeholder in my portfolio and I would be aware of it if something happened.

In mid-September something happened and the stock started to go.

Now fortunately but unfortunately, I was really caught up in the Helios and Matheson story at the time, and so I didn’t pay a lot of attention to Overstock.  My mind doesn’t multitask all that well, and delving into blockchain while I was trying to decipher Moviepass just wasn’t within my capacities.  Its too bad, because if I had I am sure I would have seen what I see now and gotten in about $10-$15 earlier.

Nevertheless, I did get around to looking at both Overstock.com and at other crypto ideas over the last couple of weeks.

A few things have struck me.

Blockchain not Currencies

First, I feel like the real play here is with blockchain, not bitcoin. Getting into crypto-currencies has been a money maker, no question.  But going forward I am of the mind that the winners are going to be companies that have figured out ways to use blockchain technology to eliminate inefficiencies, in particular those associated with the middle man of particular transaction classes.

The most common description I hear of blockchain is that it is a decentralized platform.  That has never really resonated with me.  Maybe the word decentralized is too vague.  After doing much reading and listening on the subject, I have found that the definition that makes more sense to me is to say that blockchain is simply a very effective way of eliminating the middle man.

I know if I was to use that definition publicly I would get a lot of push back: its too narrow, it doesn’t describe all the functionality or possibilities that blockchain can encompass, etc.  But to me, looking for near-term disrupting investment ideas, that is the definition that sticks.

Our world is full of transactions that individuals and companies perform with each other every day.  Each transaction requires a level of trust between the buyer and seller.  In many cases the level of trust required to complete a transaction directly between buyer and seller is not possible.  Maybe its distance, logistics, complexity, could be any number of things.   Whenever we run into this “trust gap” the solution has always been to employ an intermediary that embodies a greater level of trust and through which the transaction can flow.

Of course this middle man takes a cut.  In some cases, especially if its an opaque market, they take a big cut.

The way I look at blockchain is it’s a way of dis-embodying that trust into technology.  The middle man disappears.  The skim shrinks.  Everyone (other then the middle man) benefits.

This makes so much sense to me.  It seems inevitable. It makes me want to go all in.

Overstock

Overstock is the obvious way to play this.  I finally got into Overstock in a more meaningful way in the mid-$30s.  I have added since then.  The stock is parabolic which is frightening and I can just as easily see it going to $35 as $55 in the short run.  I mean who knows when a chart looks like this and is clearly being run around by traders.

In the longer run, I think that what Overstock is doing is fascinating and if it works, the stock will go much higher.

The thing that really jump-started Overstock was their initiative, via their subsidiary tZero, to launch a trading systems for tokens.  That seems to have coincided with when the stock took off.  They also announced their own initial coin offering (ICO) for tZero, which will take place over the next couple of months.

I think these are both great initiatives and are movements in the right direction.   But the most interesting development to me is the blockchain securities lending platform that Overstock’s tZero subsidiary has developed.  Byrnes does a really good job of describing how the platform works on the second quarter conference call.  Start listening at a little after the 20 minute mark.

In this case, the middle man that Overstock is trying to eliminate is the prime broker.  The cut that the prime broker appears to be taking in security lending seems to be abnormally large.  If you want the details of how it works, just listen to the call and do a few google searches.  Its clear that A. this is a very large market and B. there is a lot of waste to be eliminated if the middle man can be removed.

What I also find so interesting about the opportunity, other than that it makes sense, is that even by taking a much smaller piece of the pie than prime brokers currently do Overstock/tZero can make a lot of money because the transaction base is so large.  IHS Markit says that security lending is a $9 billion market.  If this platform can begin by taking even a smidgeon of that, its going to be very significant to the stock.  If the platform goes viral, well then things would get silly.

On the second quarter call Byrnes noted the following about the platform (my underline):

I’ll mention we have about 700 symbols in inventory now. 100 of them are hard to borrow, we have over $100 million in inventory. Another reason I’m in New York is talking to people who have billions or tens of billions of dollars that they want to integrate, they want to provide as inventory. So, we’ll see how this goes, but I’m really quite proud of this system.

So its just starting to scale.  I think it was only 5 weeks old at the time.

I admit I am fuzzy about the economics.  Clearly the play here is to make this advantageous to funds and short sellers by lowering transaction fees and taking a smaller skim than what prime brokers take, and by performing the task with complete transparency.  Byrnes goes on in the call to define the following economics of the platform net to tZero:

This is the best use of blockchain I’ve ever seen, because it addresses exactly the issues that regulators have, that short sellers have, that prime brokers have. I don’t want to be sued if this turns out to be wrong, I think the capacity is 1% of x, if we theoretically got somebody putting in $1 billion, I think we should be generating $10 million through, essentially the bottom line of tZERO, and I think there may be possibilities well beyond that.

None of this is to say that it’s a sure thing that the security lending platform, the ICO platform or any of the other initiatives that Medici (the Overstock subsidiary that owns tZero) has a stake in, are going to pan out.  But I am of the mind that some of them will.

One last thing about Overstock that I think is worth mentioning.  The ICO seems like a really interesting way to raise money to me.  According to the press release that I linked to above, the ICO will give participants a tZero token that has the following attributes:

• The tZERO token will be tradable on tZERO’s U.S.-regulated ATS.
• The tZERO token will incorporate profit-sharing features of a security as well as utility features of an app token, including:
  • Token holders will be able to use the tZERO token to pay for fees on the ATS and payment of such fees using tZERO tokens will grant up to a 25% discount as compared to payments made using U.S. dollars. The tZERO token is expected to have additional functionality and token holder benefits to be announced at a later to date and will be included in the offering memorandum; and
  • tZERO believes its token will be the first to offer a percentage of tZERO’s profits, distributed as a quarterly distribution paid into tZERO token holders’ digital wallets.

My take on this (tell me if you think I am wrong) is that the value intrinsic to the token is not based on ownership.  The beauty of it is that its not really an ownership stake.  In fact I am pretty sure you can’t do a US based ICO right now that generates out right ownership in a company (the SEC hasn’t laid down any structure for this yet but again tell me if I am wrong about this).

Instead the token is more like the right to participate in the success of the platform.  I almost want to say that its like an Amazon Prime membership for blockchain technologies but maybe that’s too cheeky and a bit of a stretch.   Nevertheless, the value of the token is a function of the success of the platforms created by tZero, realized via the discounts and dividends that are derived from their success.  So the benefits are most easily realized by participants in the platforms, in this case those who participate in the ICO exchange and the securities lending exchange (maybe others?).

To use a word I hate to use, it all seems very synergistic.

Think about it.  These tokens, while not offering ownership in tZero, are going to give holders a significant discount on transactions on the platforms and are going to give a dividend based on the success of the platforms.  So the bigger the tZero platforms get, the more valuable the tokens are.  And if you are a fund that is thinking about how it would be nice to lend securities without having to have a prime broker take a big chunk of the interest, it probably makes sense to take on some token exposure so you can make your transactions even more cheaply and even get a dividend kick-back that is a function of your own volume to some degree.

Its easy to see how if this works, it could snowball.

Other ideas

Overstock is my favorite blockchain idea hands down and the only one I have a truly meaningful position in.  But I also took small positions in a few others.

I own two Canadian venture stocks, LeoNovus and Posera, which both made JV’s with the company DLT labs.  I will be the first to admit that the details on what comes of the JV’s are murky but I did some work into DLT Labs and they seemed like a legitimate blockchain development company so I figured each was worth a small stab.  LeoNovus also has a proof of concept agreement with a Canadian bank and was interviewed on Capital Ideas TV here.  Both of these stocks are actually up quite significantly today, and I’ll admit that I have questioned whether their growing market capitalizations are justified on multiple occasions today.

I also took small positions in a couple of Chinese related ideas, Xunlei Limited and Xinyuan Real Estate.

Xinjuan has somewhat of a peripheral blockchain idea.  My original impetus to buy the stock was that it appeared cheap compare to other Chinese real estate developers and we seem to be in a bit of a China bull market at the moment.  But its also had a blockchain platform for property financing live for over a year now and that gave me some added reason to take a small spec.  I came across the stock from this youtube video.

Xunlei has a blockchain based product called OneCloud and has recently had an ICO, which is not easy to do for a Chinese company.  The company also has over $5 in cash and investments per ADS, so it appears relatively cheap and thus I figured it was worth a tiny punt.

Again none of these four stocks are significant in size for me. Way less than 1%.  Overstock is the only one I have any real conviction in so far.

Conclusions

I am not going to pretend I have some amazing insights that project the success of any of these companies.  I’ll be clear about this, and I include Overstock in the statement.  This is to a large degree a speculation.  The technology makes sense to me, and in the case of Overstock the applications they have identified make sense to me, but I don’t really know if it pans out in the end.

It is a bit like Helios and Matheson in the sense that while I don’t know how it all plays out, my thinking is this:  I suspect that for foreseeable future the money wanting into blockchain technology assets is going to far exceed the number of available avenues to invest in.  This happens all the time and when it does it floats a bunch of little companies along with it.  A few of these companies turn out to be winners.  Many turn out to be flops.  But getting from here to there can make you a lot of money if you are agile.  So for the time being, picking the eventual winners kind of takes a back seat.  That’s why I was willing to take some bets on the smaller basket outside of Overstock.

And like I said, I don’t even know if Overstock will be a winner here.  Maybe no one will adopt their initiatives and tZero will crash and burn.  I’m certainly no expert in the field.  What I do know is that while Byrnes seems to be more than mildly hated by many, which I think is great, when I listen to what he has to say (for example as the 2014 key note at this Bitcoin conference) I think he makes a lot of sense.  He clearly has thought this through and made his bet after much consideration for underlying conditions.  I am of the mind that the underlying conditions he describes are accurate, and that the direction he projects is correct.

So I’m going along for the ride.  And I will tell you what I want to do.  I want to take a really big position in Overstock.  I think the upside is so big if these ideas pan out.

But its really hard to jump heavily into a stock up as much as Overstock is. My position size right now is a relatively modest, but not insignificant, 3.5%.

I am in part writing this post as a request for comment.  Please send me emails with opinions of whether you think this makes as much sense to you as it does to me.  Or not.  And whether you think Overstocks initiatives or any of the other company’s I’ve taken a spec position in, will pan out or not.

Its so new and uncertain, but also seems to make sense.  So I am open minded.