Q9 Markets: Layer Cake 2

1st April, 2022

Q9 Capital: www.q9capital.com

• Crypto (mostly) continues to rally, Fear and Greed index returns to “Greed”
• Largest weekly product inflows since Dec
• Ascent of Layer-2s

You might see red today as the market gives back recent gains, but if you zoom out only a little, you’ll see a strong rally and most coins hitting their highest point since this year’s initial sell-off. Over the last 30 days, crypto’s market cap has increased by 10.5% to ~ 2.1tn. Bitcoin briefly tapped a yearly high of $48,022.29, and Ethereum reached $3,470.19 mid-week. Major Layer-1’s, DeFi projects, and metaverse tokens put in double-digit weekly gains at the top.

The Crypto Fear and Greed Index jumped back to the “greed” position for the first time in four months. The last time the index reached the current position was when bitcoin reached a high of $69K per unit last year, on November 10th. The index analyses the “emotions and sentiments from different sources and crunches them into one simple number.” This run is recent and rapid, which is exactly what the index is looking for. The index doubled in less than one week and tripled over a month, highlighting how market sentiment can turn on a dime in crypto.

Source: Alternative.me

Source: Crypto Fear & Greed Index

The futures market also exhibited bullish tones, with the one-month contract listed on the CME trading at an annualised premium of 6%, the highest since mid-December. The dollar value locked in CME-based open futures contracts rose above $3bn for the first time this year. The exchange is considered a proxy for institutional activity — as are crypto investment products which saw inflows totalling $193mn last week, the largest since mid-December. The mainstream investor is trying to buy the market.

Weekly Crypto Asset Flows (US$)

Source: Bloomberg, CoinShares, data available as of close 25 March 2022

However, this price action deserves a closer (farther?) look. If we zoom out a little further, we see that most coins were just trying to recapture early year losses and recent weeks saw Alts (finally) leading the charge. 2022 has not been a crypto native’s market for the most part, with relative safety in BTC and buying somebody’s latest coin offering not the easy path to gains. The most interesting data point might be the fact that in today’s down move, BTC is not a safe haven but solidly in the mix on the way down.

This might not bode well for Bitcoin Miami — one of the most significant crypto events of the year — where maximalists, minimalists and the greater crypto good will assemble for a week of networking and conferences. A lot of firms (and even governments) are expected to release major statements during the event. Perhaps the market is finally catching onto the ‘conference’ curse where one would follow a buy the ‘conference sell the announcements’ idea, being that most hype for a coin or the market is probably priced in before the conference gets started, or at least before it’s over. A recent example is the Avalanche Summit that took place last week in Barcelona. AVAX, Avalanche token, managed to rally this week but lagged massively behind its rival SOL seeing no conference tailwinds. Looking ahead, are investors now just selling BTC early to get ahead of the conference?

Extra Terrastrial

Terra’s total value locked (TVL) is rising and the network has quickly grown to become one of the top DeFi contenders. While Terra’s growth has come from its unique staking offerings, it has also received a significant boost from its decision to add more than $1bn of Bitcoin to its UST treasury. LUNA, Terra’s token hit a new record high of $111.01, rising more than 400% over one year period, making it one of the best performing tokens during that time frame. LUNA has a market cap of $36.5bn and is ranked the 8th largest digital asset. But it is not without criticism as paying an above-market return depends on growth and its reserve has definitely not been a one way street up.

Layering Up

Last week we wrote an analysis on the evolution of the Layer-1 market, the term used to describe the underlying mainnet blockchain architecture (ETH, SOL, DOT et al). We’re following this with some insight into the Layer-2 market.

To compete with legacy systems of payment processing, blockchain networks must become highly scalable — capable of accommodating an exponentially growing number of users, transactions, and data. Only by adequately incorporating scalability into their structure do blockchain networks stand to supersede other legacy systems. Layer-2s are one such scaling solution.

Layer-2s are essentially overlaying protocols that lie on top of the underlying blockchain and are often run by third parties. Consider Bitcoin and the Lightning Network. Bitcoin is the Layer-1 network, while the Lightning Network is a Layer-2. Layer-2s seek to improve upon a deficiency inherent within the Layer-1 network.

Bitcoin is fundamentally decentralised and secure — but this comes at the expense of scalability and speed, with BTC only able to process 5 transactions per second. The Lightning network sits on top of the Bitcoin blockchain, aggregating and netting transactions for its users and then deploying these transactions to the Bitcoin mainnet all in one go at a later stage — shifting the burden of transaction processing to its own adjacent system architecture and reporting back to the main blockchain to finalise its results. Therefore, millions of transactions per second can be executed across its network at exceptionally low fees.

Rollup Rollup

As the number of people using Ethereum has grown, the blockchain has reached certain capacity limitations, driving up the cost of using the network (a victim of its own success), pricing many users out of using the most coveted DeFi and NFT ecosystem. Vitalik Buterin has said that Layer-2s are the future of Ethereum Scaling.

They come in many forms, each with different solutions to the scalability conundrum: Optimistic Rollups, Zero-Knowledge Rollups, State Channels, Side Chains, Plasma, Validium, and others. All of these are succinctly explained in this YouTube video.

There is now $7bn locked in Layer-2s on Ethereum, a 40% increase over the past 30 days.

Source: L2Beat

So why are so many scaling solutions needed? Multiple solutions can help reduce the overall congestion on any one part of the network and also prevent single points of failure. The whole is greater than the sum of its parts. Different solutions can exist and work in harmony, allowing an exponential effect on future transaction speeds and throughput.

List of Notable Ethereum Layer 2 Solutions

Source: 101Blockchains

ETH L2 Scaling Solutions Landscape

Source: Clear Chain Capital

ETH L2 Finance Info

Source: L2Beat.com

ETH L2 Fee Comparison

Source: L2Fees.info

The “Ethereum Killer” Killers?

With the launch of Layer-2 scaling solutions such as Optimism and Arbitrum it is now a false equivalency to be comparing your chosen Layer-1 blockchain to Ethereum. Solana, BNB, Cardano, and others have all set out their stall to compete with Ethereum and solve many of its issues at the fundamental blockchain level. Solana has a significant speed advantage, and Polkadot uses parachains to spread transactions across the network (Messari just released a detailed report looking at the Polkadot ecosystem and its parachains).

Polkadot Structure: Represented Simply

Polkadot ecosystem example with various parachains

Source: Messari

Source: Messari

However, eventually the average Ethereum user will not interact directly with the mainnet and the Layer-2s will be processing the bulk of activity on the chain.

When you look at Solana or BNB and see amazing TPS and cheap fees, you can compare that to what ETH Layer-2 scaling solutions can handle. Once the miniscule and instant transactions of Layer-2 Ethereum are transacted they will settle on one of the most decentralised blockchains available today (not the case with many of the other L1s). Add on to this that there can be hundreds or thousands of rollup projects operating at the same time plus Ethereum’s much vaunted 2.0 upgrade, and we have solved the Scalability Trilemma.

Not Too Fast…

While Layer-2s are a much-needed and logical solution to scaling Ethereum, they come with their own question marks and potential issues. They are a relatively new concept and are still far from perfect.

Layer-2s are currently not fully interoperable, meaning the decentralised applications (DApps) built on top of one L2 find it very difficult to talk to DApps built on other L2s (this is called composability). Let’s say Aave is only available on Polygon, and Uniswap is only available on Optimism: one wouldn’t be able to compose a transaction that calls on both the Aave’s and Uniswap’s smart contracts. This is limiting to the potential magic of DeFi. We’ll likely have to see a lot of bridges between the L2s before they’re viable.

Another issue from the fragmentation of DApps on different L2 chains is that their associated liquidity is split up.

L2s are also criticised for not being secure enough. Arbitrum and others such as Solana have suffered outages in the past. Using an airline analogy, safety and security obviously come before speed and comfort.

L2Beat.com has detailed descriptions of the security risks for each rollup. This is early tech, so proceed with caution.

ETH L2 Risk Info

Source: L2Beat.com

Arbitrum Risk Summary

The Future Starts Now

Long term, L2s have higher scalability potential, functionality, programmability, UX than any L1 ever could. Real game-changers will create unique and innovative applications that are not even possible on L1s. The hope is that these new innovations with higher capacity and better functionality will drive new types of apps with orders of magnitude wider userbases.

Ethereum still has the highest security, liquidity, network effects, and also the most ambitious technical roadmap for scaling rollups. Many teams are ideologically aligned with Ethereum’s values, which are simply unavailable elsewhere. It’s still where most of the liquidity and opportunity is.

The L1 race is perhaps a winner takes most game or maybe an oligopoly. It’s just how technology has always worked, and there are stronger social consensus pressures in crypto. But it’s a team event and L2s are essential in supporting and enhancing the mainnets. There’s still a long way to go — UX is awful and fragmented with little standardisation across the board and security issues still exist — but the race is on and the future starts now. ETH is ahead, but it’s still not the proven winner, and its success is strongly intertwined with that of the L2s surrounding it. Others are playing catch-up fast and something completely revolutionary could still come along and obsolete Ethereum — and because it’s ossified and decentralised it may not be able to respond fast enough. Yes, but what does that mean for me?

Source: 21 Shares, State of Crypto 2022

A Piece of Layer Cake

If your head is exploding with all these names and coins and you think ‘I can’t possibly keep up with each new layer, coin and success story’, you are right, you can’t. Yes, there are those who’s full time job or hobby is to follow chat groups and read the latest research, but for most of us this is overwhelming. Don’t lose hope. This is not different than any other growing marketplace. Traditional markets have decades of product development in yield and portfolio offerings that help mainstream investors ‘buy the market’ Crypto markets are starting to see this development too. Our Auto Invest product, which offers portfolio exposure, is getting attention and we are seeing our largest product volumes in our newer products. Investors want to enter the market, but choosing is hard. It’s clear that with multiple L1s, L2s, and cross chains, there will be numerous winners and we have no clue what the real world of Web3 will look like in the years ahead. Nobody was complaining about the social impact of Twitter in 1999. A little of everything is easier than being right every time. The first step in making money in a market is being in the market.

In the News…

• Hackers steal about $600mn in one of the biggest crypto heists
• UK faces crypto exodus as firms sound off before FCA deadline
• Meet the ‘crypto caucus’: the US lawmakers defending digital coins
• Hong Kong bourse set to pilot digital-asset platform
• CME Group to offer micro Bitcoin and Ether options
• Russian PM, Economy Ministry support legalisation of crypto
• Bank of England, MIT to collaborate on CBDC
• Nearly 50% of Germans ready to invest in crypto
• Visa launches program for NFT-focused entrepreneurs
• Coinbase to require recipient information for crypto transfers from users in Canada, Singapore and Japan
• Alibaba leads $60mn funding into AR glasses maker Nreal in metaverse play
• NFTs could go Mainstream with Instagram’s planned support
• Why FTX Ventures’ Amy Wu sees Yuga Labs as a future Disney
• Lionel Messi signs multi-year deal to promote 'fan token' firm Socios

Crypto Markets

• BTC & ETH rallied posting gains of 3.6% & 5.6% respectively on the week (8am). The total market cap of crypto market crossed the $2tln mark and Bitcoin dominance stayed north of 41%
• Among other majors both SOL & EOS rose +20% & +11.2%, among large DeFi set COMP & AAVE jumped +25% & +22.3% respectively
• Annualized realised volatility in crypto markets continue to stay low, 66% for BTC and 78% for ETH this week

Legacy Markets

• Among legacy asset markets Oil futures plunged -9.9% and the SPX posted mild gains of +0.2%
• Global stocks are on path to their worst quarter in the last two years with the major drivers being the war in Ukraine and the risks due to central banks tightening monetary policy
• Elsewhere 10 year US treasury yields slipped 2 bps & the US Dollar index dropped -0.4% and the Gold & Silver index fell -1.4% week on week

Our Flows

• Our client pad was skewed towards clients taking profits on the recent rally (2x sellers vs buyers)
• Two way activity in SOL & BTC while net sellers in ETH
• Buying activity in ADA and AVAX on modest volumes

Q9 Capital: www.q9capital.com