Monday 5pm GMT: Since March 9th, financial markets are going through one of the fastest downturns in recorded history, as western economies scramble to battle the spread of Covid-19. On Sunday (16/03) the Fed announced a round of emergency rate cuts, down to a target of 0% to 0.25%, along with $700 billion worth of asset purchases, that include Treasuries and mortgage-backed securities.
Global markets had none of it; the Dow is down ~9%, the FTSE 100 is down more than 10% on the opening, while Asian markets are hit less hard, though still down to the tune of ~4% - the MSCI Asia Pacific Index was down 3.8% at the opening. As global economies go in lockdown mode, the appetite for risk has vanished, pushing bonds and all the USD forex pairs higher as capital finds its way to safety.
This past week was also the worst week for crypto since at least 2013. Amidst the global flight to safety, Bitcoin has also lost its uncorrelated status, and is moving in tandem with traditional markets, almost tick for tick. The drawdown in crypto was accelerated as highly leveraged positions on Bitmex started getting margin called, putting a liquidation cascade in motion.
Since then, liquidity seems to have evaporated, as order books across most exchanges are much thiner than usual and open interest in futures is in multi-year lows.
In all, we are now deep in bear country. Rallies are being sold aggressively, and as if everything else happening wasn't enough, with the halving coming up Bitcoin will see an additional set of natural sellers emerge; unprofitable miners. As the block rewards get cut in half, the effective cost of producing bitcoin will double. Reports have it that S19 and S15 miners are already shutting down, and that the greater mining community is in panic mode. As the BTC/USD pair edges closer to the $4k level, increasingly more miners will be shutting down and selling BTC to cover costs. Those with cash will survive this. Those without will be exiting. And as they do, prices will likely slide.
The week of March 9th 2020 was a strong test for cryptoassets; one which they failed to pass with flying colours. The narrative that Bitcoin is a store of value has come under fire.
While it has undeniable potential as a SoV asset, this week put the debate about its current status beyond any reasonable doubt. Bitcoin is still a risk-asset, as are the rest 4,000+ cryptoassets in the investable universe.
It will take some time before the global sentiment for risk returns. But, eventually, it will. Possibly not before long. And while sentiment and prices change, fundamental properties do not.
As this downturn exposed the chronic pains that underlie cryptoassets (e.g. scalability, oracles, fragmented markets), I believe that over a longer time horizon this will be remembered as a pivotal point that served as a wake-up call for builders, investors and pundits alike - to ground expectations and re-focus attention on what really matters in order to bring this technology to a massive global audience.
From an investment standpoint, the weaknesses that were exposed over the past week represent investable opportunities. There are strong teams with ample runway that are working on solutions to the industry’s endemic problems, and cryptoassets that are economically tied to the success of those solutions.
Many of these cryptoassets also happen to be priced a lot more favourably than they were just a week ago.
Over the coming weeks, it is highly likely that the pricing of these opportunities will become even more attractive.
As the global economy moves towards a recession and with interest rates being already at - or close - to 0, deflation will kick in. But then, as the effect of the coronavirus wears off, confidence will return. People will start spending again, interest rates will rise, and with all the liquidity sloshing around, eventually inflation will come around.
Bitcoin was never a hedge on a global emergency. It does though have the fundamental properties of an asset that can be a hedge on the debasement of fiat currency. And as growth - and with it inflation - returns and with the money printer already firing on all cylinders, Bitcoin will get its ultimate test.
And we believe it will succeed.
Why fair distributions don't work for broad use cases - adapted from an internal memo drafted in May 2019.
Bitcoin’s volatility profile is - by now - the stuff of legends. Monumental, euphoric rallies give way to abrupt, violent crashes and proclamations of Bitcoin’s demise (380 and counting). Thus far, the cycle has repeated without failure, earning Bitcoin the “Honey Badger” appellation in the process.
As the current cycle is unfolding, behind the BTC/USD pair’s most recent wild gyrations, new types of market participants are trickling into the market. Traditional macro money managers (e.g. PTJ) and nation states (e.g. Iran) are becoming increasingly open about dipping their toes in the cryptoasset ecosystem.
With every new type of player that jumps on board, the likelihood of Bitcoin becoming a widely accepted store of value and the Bitcoin blockchain becoming a globally accepted settlement layer, increases. The “why” Bitcoin makes for a good settlement layer and store of value has been covered extensively. However, the “how we get there” remains somewhat elusive. In this post, I will attempt to unpack that.
Let's for a moment imagine what an optimal state of the Bitcoin network at maturity looks like; Bitcoin is a widely accepted global store of value and/or settlement layer; global institutions (e.g. central banks) are on board, co-existing in harmony with crypto-native actors (e.g. miners); market manipulation is too expensive to attempt, as are hashrate attacks on the network; BTC is distributed widely among holders, such that network participants extract maximum value by being able to settle with all other parties they may wish to, and that no party has disproportionate “bargaining power” over network outcomes, allowing participants in the network to be continuously incentivized to remain participants.
From the above, a “fair” allocation of BTC among holders seems to be a key underlying requirement for this future to come to bear. Note that “fair” is not the same as “equal”. Fairness implies that every participant’s utility function is maximized, subject to their unique constraints. Under that condition, “equal” is “unfair” and therefore, unsustainable.
If we assume the “fairness” condition as requisite, then while not necessarily an easy pill to swallow, the rollercoaster ride might be the only path available to get us there. To illustrate the point, an approach by deduction reveals why the competing approaches cannot work;
So if we agree that neither of the two are viable options, the only option left is a free market mechanism; a continuous game, that is played by individualistic agents with hidden preferences, in near infinite (and infinitesimal) rounds, that allows for each participant to opt-in at the valuation that perfectly satisfies their objective function (what they strive to maximize under given constraints), therefore covering the full utility spectrum of the population of agents.
Hidden preferences become revealed ex-post and as such competing agents cannot devise a strategy that creates a surplus for themselves that leaves others at a deficit ex-ante, yielding to an ultimately fair distribution. And in the process of revealing preferences in a continuous game with infinite rounds, bubbles are created.
Competing agents with similar objective functions are forced to respond to the first mover among their counterparts and jump on the bandwagon. Under scarcity, the price rallies, until the reservation price of agents that opted-in earlier is met. At that point the distribution phase begins, as earlier participants divest and get rewarded for stewarding the network thus far, by locking in a margin.
As the "rounds" of the tacit negotiation - come free-market-bonanza - game unravel, the very nature of the platform evolves, opening up to a wider possible utility spectrum. With time, the network becomes more secure as wider margins become available for miners (either through higher prices or through advances in operational efficiency) and more resources are committed towards Bitcoin’s Proof of Work. It follows that as the network’s security improves, it opens up to new types of agents that are striving to maximize value preservation potential, subject to the liability they have to their constituents (measured as risk). The more types of agents there are on the network, the better a settlement layer it becomes, and so on.
Therefore, there is sense to the idea that progressively larger agents would opt-in at a higher prices, as they are effectively buying into a fundamentally different - and arguably better - network for value store and transfer. And with every new type of agent unlocked, the bandwagon effect re-emerges.
Bitcoin might not have been a secure or wide enough network for Square (an agent to its shareholders) to consider as its future payment rails and settlement layer in 2015. It is in 2020. Similarly, while Bitcoin might not be a secure or wide enough network for a sovereign to opt-in in 2020, it might be in 2025.
So, not only should we not be surprised by the new type of participant that is emerging in the early innings of this cycle, but we should expect more of this as the network’s value increases and its security profile improves.
And in the process, we should learn to accept the nature of the game.
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Exchanges are central nodes in the blockchain ecosystem. These are the venues where buyers of cryptoassets meet sellers, where liquidity lives, and ultimately where the price of a cryptoasset gets decided. Abstracting away the complexity of an exchange’s operation, we can view these ecosystem building blocks as pools of capital that generate value by putting that capital to work. Without capital living in and flowing through the exchange, the construct creates (and therefore captures) no value. As such, the value created and the fraction of that captured by the exchange, should be proportionate to the amount of assets that live under an exchange’s custody.
In the paper we present here we build on this idea and propose a novel relative valuation approach for tokens issued by cryptoasset exchanges, based on their Price-to-Assets ratio (PA hereon). The PA ratio seeks to compare an exchange token’s market price, to its total Assets Under Custody (AUC hereon) - such that a PA ratio average of ~1, implies that over the long term, the token is trading at the value of AUC.
The exchange tokens examined in this paper are those issued by Binance (BNB), Huobi (HT), Bitfinex (LEO) and OKex (OKB).
All the on-chain data relating to the AUC calculation is provided by Glassnode.
We believe that the PA ratio approach is extensible to all assets and protocols that require AUC in order to create value, and subsequently distribute it to token holders - especially those in which the relationship between value creation and value distribution is intermediated by a protocol (e.g. DeFi lending facilities and AMM driven exchange models), rather than a firm with discretion over the distribution mechanism.
While the PA approach might miss nuances that some of the proposed extensions and alternative approaches to valuation attempt to capture, we firmly stand behind the approach because of its simplicity and generalisability.
Thanks to Charles Edwards, Dimitriy Berenzon, Joel John, Mika Honkasalo, Rafael Schultze-Kraft, Roy Learner, Ryan Youngjoon Yi and Tara Tan for their invaluable feedback and ideas.
Disclaimer: Decentral Park Advisors, LLC (‘Decentral Park’) has prepared this material for informational purposes only. This material does not constitute trading strategy or investment advice, or an offer to buy or sell, or a solicitation of any offer to buy or sell, any security or other financial instrument. Decentral Park Capital holds HT tokens. For ethical reasons, Decentral Park Capital abides by a ‘No Trade Policy’ for the assets listed in this report for 3 days (‘No Trade Period’) following its public release. No officer, director or employee shall purchase or sell any of the aforementioned assets during the No Trade Period.
Over the course of 2020, a surge in DeFi activity has meant Ethereum has seen its network usage surge, making the network more expensive to transact. In order to accommodate increased usage long-term, Ethereum can scale through layer 2 (L2) scaling solutions by taking transactional activity off-chain in order to relieve the base chain of network congestion.
In this report, we will explore the different types of L2 solutions that exist today and dive deeper into specific projects that are implementing their respective solution, through the lens of value accrual and investable opportunities.
Decentralised exchanges (DEXs) are one of the fastest growing primitives in the decentralised finance (DeFi) ecosystem. For DEXs, users do not relinquish custody of their assets but instead trust smart contracts when engaging in trade activities. Throughout 2020, Uniswap has taken the lion's share of overall trade volume. More recently, Sushiswap, a fork of Uniswap V2, has started to compete with Uniswap in terms of vole and liquidity.
In this report, we analyse Sushiswap’s strengthening fundamentals, valuation, as well as how the protocol may be able to differentiate itself from its main competitor over time.