Q9 Markets: Ready Layer One

24th March 2022

Q9 Capital: www.q9capital.com

• Crypto regains $2tn total market cap
• Institutional demand for crypto is surging
• Layer-1 protocols post double digit weekly gains

Crypto markets jumped above the $2tn market cap this week led by strong performances in Layer-1 protocols. Cardano (ADA) was the standout L-1 weekly performer posting a 35% gain, followed by Solana (+16.3%), Polkadot (+13.3%), Ethereum (+10.4%), and Avalanche (+10.1%). Bitcoin held above $43k with a gain of 7.3%.

The annualised rolling premium in three-month Bitcoin futures listed on the CME, a proxy for institutional participation, rose to 4.8% on Thursday, hitting the highest since Jan 4th. This is likely caused by bullish institutional investors and the ongoing rolls from the BTC ETFs which might cause buying pressure for farther dated futures.

Institutions are coming in thick and fast. Recent reports show 70–80% plan to make an allocation in the near term. The much-needed infrastructure and on-ramps to enable investment that were missed in the last cycle are now here, and the world’s largest custody banks have recently added crypto custody. Just this week Goldman Sachs executed a milestone over-the-counter crypto trade, Cowen announced it will offer spot trading to its clients, and BlackRock’s CEO Larry Fink confirmed they are exploring how to serve clients with digital currencies.

Another report highlights the growing appetite in Europe’s richest nation. 44% of Germans are “motivated to invest in cryptocurrencies to be a part of ‘the future of finance’” while over a third or “37% of German crypto investors have been trading cryptocurrencies for over a year. BaFin’s recent actions such as approving custody licenses and Bitcoin-based security tokens are also promising signs.

Crypto was seemingly unfazed by US Fed Chair Jerome Powell’s hawkish comment that the interest rates could go up by 50 bps in May and will be incrementally increasing throughout the year. Below are “dot plots” showing each Fed board member’s expectation for where the policy rate is going. The left side from December, and the right from Wednesday. The 2022 columns show Fed members revising up their projections from a median policy rate of 0.9% to 1.9%.

Source: Financial Times

The Layer Cake

There are now a number of high-profile Layer-1 blockchains battling it out for market share, each promising different solutions, features and ecosystems.

Layer-1’s are the base layer blockchain protocols upon which DeFi projects (the universe of crypto-based lending, saving, and trading apps), NFTs and decentralized autonomous organizations (DAOs) are built upon using smart contracts.

The majority of these projects are still built upon Ethereum, but competitor projects such as Polkadot, Solana, BNB, Terra, Avalanche and Cardano are catching up fast.

A few years back general consensus held that a single, monolithic L-1 would dominate the industry. Now it looks like the future will consist of many competing network layers, each solving different issues associated with speed, scalability, security and decentralization, and connected to each other via blockchain bridges such as wormhole that facilitate transfers of information from one chain to another.

As an analogy, imagine multiple island nations with their own distinct cultures, governance and systems but connected to each other by a series of roads and bridges that permit the transportation of assets, goods and information.

Source: Coin98 Analytics

The Scalability Trilemma

So why is there a need for all these different L-1 projects? While blockchain technology is proving itself to be a new pillar of the global economy, its underlying structure of decentralised networks faces a unique challenge known as the Trilemma: the balancing act between decentralisation, security, and scalability/speed.

The trilemma states that any blockchain technology can only feature two properties at most, never all three at once. Thus, current blockchain technology will always have to compromise on one of the fundamental properties. An excellent example of this is Ethereum. While its blockchain has managed to optimize decentralisation and security, it has had to compromise on scalability and continues to be plagued by speed issues and extremely high gas fees.

Solana, meanwhile has a focus on scalability/speed, but at the expense of security and decentralisation. Its network allows for an enormous theoretical throughput of 65,000 transactions per second (Ethereum has a throughput of 15 transactions per second), but has suffered many outages and is fairly centralized: you need to have extremely powerful hardware to run a node, crowding most participants out of running one.

(A node is a network’s stakeholders and/or their devices, which are designated to keep a copy of the distributed ledger and serve as communication points that execute various essential network functions. A blockchain node’s main purpose is to verify the validity of each succeeding batch of network transactions, called blocks.)

The Hypotenuse Hypothesis ∆

The Trilemma essentially means that each L-1 can only pick one side of the triangle. You cannot be all three.

Decentralisation refers to the distribution of computing power and consensus throughout a network, while security reflects a blockchain protocol’s defenses against malicious actors and network attacks. Both are considered non-negotiable to the function of a blockchain network.

Scalability refers to a blockchain network’s ability to support high transactional throughput and future growth. Scalability is crucial because it represents the only way for blockchain networks to reasonably compete with legacy, centralised platforms such as Visa with rapid settlement times. In order to compete with these existing systems, blockchain technology must match or exceed these high levels of scalability.

Another way to solve these issues are to build Layer-2’s on top of the existing network protocols which aggregate and net transactions to increase throughput and lower gas fees — we will write an analysis of the Layer-2 market next week.

The Ethereum Killers

Ethereum still remains the industries go-to smart contract protocol. It has the network and bundles of accompanying infrastructure. Gas fees have also plummeted on the network — where some transactions were costing $250 a few months ago, now suddenly they are costing $25. This can be attributed to the drop in NFT traffic and Layer-2’s such as Polygon easing the stress on Ethereum and lowering transaction costs.

But ETHs much delayed 2.0 upgrade is a risk. Pulling off an upgrade of this magnitude with so many stakeholders is an enormous undertaking. This is giving ample wriggle room for others L-1’s to play catch up and market their supposed benefits.

The Layer-1 ecosystem is still nascent and highly experimental, and each network will need many future upgrades to compete with legacy centralised platforms. New L-1 protocols are launching almost on a weekly basis and picking the next Solana (684% over one year) or Terra (471% over one year) is a formidable task.

The current field all have promise, but they all won’t make it. Just over 20 years ago you could buy all kinds of internet names like Amazon and Pets.com. Not every name makes it. The internet certainly did however.

Taking a broad investment approach to the blockchain Layer-1 market is a sensible way to maximize returns while reducing idiosyncratic risk. Q9’s newly launched Auto-Invest is a convenient tool to allocate capital across the market. A combination of “Blue Chips” and “Ethereum Killers” will give you an exposure to both ETH and leading L-1 names such as Solana, Polkadot, Avalanche and Cardano. We don’t know who Web3’s Amazon will be, but it only takes 1 or 2 winners to ride the greatest tech wave of the next decades.

In the News…

• El Salvador postpones Bitcoin Bond
• Honduras signals intent to follow El Salvador in making Bitcoin legal tender
• Thailand bans crypto payments for goods and services
• BIS partners with four central banks to develop multi-CBDC platform prototypes
• Fidelity Executive: Crypto markets forming setup identical to commodities boom of 1990s
• ApeCoin is rewarding Bored Ape insiders with billions of dollars
• Australia’s largest bank looking to offer additional crypto services
• Japan’s social media giant Line to launch NFT marketplace

Legacy Markets

• Global markets saw a risk on week, Oil futures rallied +8.8% and SPX rose +1.3% week on week.
• 10 year US treasury yields rose 22bps. US Dollar index rose +0.4%.
• Gold & Silver index rallied +3.1%.

Crypto Markets

• BTC & ETH rallied posting gains of 7.3% & 10.4% respectively. The total market cap of crypto market was just shy of $2tln mark and Bitcoin dominance hovered around 42% during last week.
• Among other majors BCH & EOS rose +23.5% & +21.6% respectively from last week levels, among metaverse coins AXS saw a standout +39.7% rally.
• Annualized realised volatility in crypto markets saw a mild contraction vs previous week levels, 66% for BTC and 80% for ETH mostly due to the one way direction of the market.

Our Flows

• Client pad was aggressively bid up (32x buyers vs seller) but on muted volumes during last week
• Buyers in ETH and LINK with a two way flow on BTC
• Mild selling activity in SUSHI

Q9 Capital: www.q9capital.com