Predictably, Q2 has been mostly quiet. Token prices are relatively flat, volatility is down, and outside interest in crypto is low. But don’t mistake a lack of action for a lack of opportunity. Though we remain defensively positioned after de-risking in early Q2, the future of crypto is much brighter than most realize. If you can look past the near-term macro trouble (general global liquidity contraction) and ham-fisted regulatory attacks, there are plenty of reasons for optimism (which we’ll cover in the second half of this report).
Positioning to protect against down-side risk
Coming into the quarter, we were worried about a few things on the macro front:
TGA running out and needing to be refilled (draining domestic liquidity)
Concern about resolution of debt ceiling negotiations
Inevitability of further rate increases and possibility of another downside shock (e.g. regional banks, commercial real estate)
China and Japan’s loose monetary policy beginning to wane
Increasing US regulatory overhang
As such, our priority was to preserve capital. We decreased exposure from ~75% to ~50% in April, taking profit on narrative outperformers (e.g. GMX, STG) and booking small losses on narratives that were running out of steam (e.g. ATOM, SYN). We have maintained some exposure to our highest-conviction alt coins, but remain generally bearish on alts relative to BTC and ETH in the near term. Alt coins inevitably get hit hardest in downtrends, and we anticipate opportunities to pick up quality tokens at distressed prices in H2. Case in point: the sharp drawdown on June 9 sent most alts down 20% in a single 15 minute trading window. BTC and ETH were only off by 4%.
Alt opportunities in a bear market
Though alts represent less than 30% of current holdings (a ratio that will reverse in an uptrend), there remain a handful of setups (e.g. catalysts, staking, farming) that we believe warrant continued exposure
LDO: Lido sits at the intersection of two increasingly strong trends: the growth of liquid staking, and the regulatory assault on centralized staking. Now that the Shanghai upgrade has de-risked the mechanics of staking, ETH staking has increased (up from 11% to 16% of total ETH). “LSTs” (liquid staking tokens) such as stETH have been the biggest beneficiary, accounting for one third of total staked ETH (more than any other mechanism). Lido is more dominant than ever (86% of liquid staking market; 32% of all ETH staked) and price action has been strong in response to news of threats to staking programs at Kraken, Coinbase, and other centralized exchanges. As the liquidity of stETH proliferates, their moat will continue to grow (as evidenced by backlash from community members that value decentralization). We see value in LDO in terms of both fee revenue and governance rights.
OSMO: Osmosis is the dominant trading venue on Cosmos and the team continues to ship innovative product upgrades (e.g embedded lending and borrowing via Mars). Notably, OSMO is the most common liquidity pair, and while we’d expect native USDC to gain some share when it launches, OSMO stands to obviously benefit from increased trading volumes in the Cosmos ecosystem. The token is highly dilutive (offset by staking), but the community recently voted to significantly decrease emissions as part of a broader tokenomics overhaul. There are still lots of exciting projects on Cosmos, and we believe OSMO has emerged as the best way to achieve broad-based exposure to them (over ATOM).
SOL: Solana has effectively weathered the FTX storm and continues to attract promising projects such as Helium, Render, and Hivemapper. The community remains strong and the focus on throughput is unmatched (even by Ethereum scaling standards). Its monolithic architecture is the source of much debate and skepticism in some circles, but we are happy to bet on an increasingly differentiated technical approach and value prop that caters to high-bandwidth use cases such as gaming, social, and physical infrastructure.
The scaling wars
L2 tokens are one of the few buzzy narratives right now. Effectively, L2s are subnetworks that sit on top of Ethereum, benefit from its security guarantees, and batch process transactions to the main chain at deeply reduced fees.
Currently, the two leading projects are Arbitrum and Optimism. Both employ what is known as an “optimistic” rollup solution, which technically requires 7 days for final settlement. Depending on your perspective, this could be a major shortcoming, a drawback which can be overcome, or a non-issue. Optimistic rollups are the first to market, but there are many forthcoming solutions which employ more sophisticated settlement mechanisms (e.g. zero knowledge proofs).
At a high level, it’s important that Ethereum has finally delivered a credible competitor to the scaling solutions of last cycle – namely alt L1s such as Solana, and EVM options such as AVAX and NEAR. But when it comes to investing, we remain skeptical.
Why we’re not buying L2 tokens…yet
Too soon to pick a winner: Arbitrum and Optimism are both impressive projects with strong teams and real traction. But the L2 competition is still early. Even if you assume that Ethereum will scale via L2s (we do), it remains to be seen whether Optimistic rollups will win. They have a headstart, but this will be a multi-year race with many competing approaches. It’s clear that there will be lots of development and interest in L2 tech, but it’s not yet clear what users will value most (i.e. brand vs. cost, privacy vs. convenience).
Too many tokens left to unlock: As of June 8, Arbitrum and Optimism have fully diluted valuations of ~$11B and ~$6B respectively (for reference, Coinbase MCAP is ~$14B). However, only ~10% of OP and ARB tokens are in circulating supply. 90% of equity remains locked in the hands of employees, investors and treasury funds (that will ostensibly distribute tokens to incentivize ecosystem development). In other words, too many marginal sellers relative to marginal buyers (mostly speculators, in this case).
Too uncertain value accrual: In a scenario where Arbitrum or Optimism do win, it’s not yet clear how their tokens would accrue value. Some will say L2s already have a great business model. They charge end users transaction fees, a portion of which they use to pay for gas on Ethereum and a portion of which they retain (Arbitrum DAO has collected ~$7m in fees so far). We question how sustainable that take rate will be once the space becomes more competitive. These fees also rely on centralized sequencers (the entity that processes the transactions to the L1), which have big question marks around censorship resistance and regulatory viability. It’s also not clear how much leverage L2s will have over their users considering they occupy the middle of the tech stack — with the base layer on one side and apps on the other, closest to users.
We expect winners in this space, but we’re not ready to pick one yet.
The SEC comes for Coinbase and Binance
The man we love to hate, Gary Gensler, is at it again. We have been expecting a negative development after Wells Notices were issued recently to Coinbase and Binance, and we finally got the full complaints. There is always cause for concern with a high-profile suit, but all things considered this was not a bad outcome. It comes in stark contrast to the Digital Asset Market Structure Proposal, which is making its way through Congress and offers a sensible path forward towards regulation in the US (including dual oversight by SEC and CFTC depending on asset and maturity). It also seemed to solidify Gensler’s reputation as an unserious political actor. Ritchie Torres described his actions as “in complete contempt of Congress”.
The claims against Binance are considerably more serious in that they allege mishandling of customer funds, and we would be wary to custody significant funds on Binance.com. That said, Binance has coolly weathered several bank runs to date and continues to dominate exchange trading (60%+ of global volume historically). They are likely to withstand this as well, but will need to show evidence that they take user security seriously to maintain their position as market leader.
The claims against Coinbase essentially boil down to listing “securities” illegally, despite the fact that Coinbase has repeatedly asked the SEC for clarity on this very issue – a request the SEC has inexplicably ignored. The general consensus seems to be that Coinbase has acted in good faith and Gensler has not. Coinbase has also been very public about its preparedness to fight this battle on behalf of the industry and CEO Brian Armstrong explained his confidence in their approach.
We like their chances to prevail if it actually gets to court, but it seems more likely that intervening congressional input might render the dispute less relevant. In any event, we believe the market is vastly underestimating and undervaluing Coinbase.
Other notable crypto events in Q2
Ethereum completes move to proof-of-stake with Shanghai Upgrade
By far the biggest (non-regulatory) event in Q2, Shanghai represents a monumental technical achievement: A distributed community of engineers transitioned the Ethereum protocol from proof-of-work to proof-of-stake with no downtime and no drama. In addition to diffusing concerns around energy consumption, the upgrade allowed users to withdraw staked ETH for the first time. The debate for months leading up to Shanghai was whether or not the newly-unlocked tokens would lead to lower prices; Or conversely, whether the de-risked staking module would actually attract more tokens.
Our take: We always viewed this as a bullish event for ETH. We certainly allowed for the possibility of a short-term dump, but it seemed inevitable that ETH stake rates would rise given how far below other L1s they were prior to the upgrade (12% vs. 70+%). After a batch of early withdrawals led by Kraken, (who were obligated to wind down their staking program in the US by the SEC), deposits have outpaced withdrawals and Ethereum stake rate now sits just below 20%. We expect this to continue to climb as holders seek the ‘risk-free’ rate offered to Ethereum stakers (which has fluctuated between 4-7%). We have confidently staked the majority of our ETH using Lido and Coinbase and are more impressed than ever by the core contributors to Ethereum.
Lido and Uniswap consider distributing a portion of revenue to token holders
Observers have long debated what crypto protocols should do with the revenue they generate. Two community proposals look to force the issue with two of the biggest protocols by redirecting as much as 20% of fee revenue back to the DAO and token holders in much the same way that a company would issue a dividend. Feedback on the proposals has been mixed, and will likely end in pilot programs on both to assess viability.
Our take: This is the right conversation at the wrong time. Protocols will only be as valuable as the revenue they generate, but at such an early stage, the focus should remain on growth rather than profitability. It would be absurd to expect a dividend from a pre-IPO tech company. There are some unique dynamics at play with tokens in that revenue distribution could attract new investors and drive growth, and there’s nothing wrong with an experiment, but we would prefer to see projects re-invest in growth until they are more mature.
Regulators in Europe and Asia soften anti-crypto stance and begin to craft regulatory policies
If you live in the US it might feel like everyone is against crypto, but it’s quite the opposite in other major jurisdictions. ‘China banning crypto’ is a meme at this point, but Hong Kong is moving to legalize trading and fashion itself as a hub for crypto builders in Asia (along with Dubai). Europe has gone a step further with its landmark Markets in Crypto Assets package (known as “MiCA”), which represents the most significant crypto-specific regulatory apparatus in the world to date.
Our take: It’s easy to focus on negative headlines in a bear market, but global acceptance of crypto is on the rise. We’ve passed the point of no return for this technology, and countries will look wise to have courted an innovative new industry in time. Hong Kong does not act without China’s approval, so this reversal of policy is a big deal which could lead to further progress in China. MiCA is but a first attempt at a policy framework, but validation from Western regulators is still an important step towards adoption at scale.
Ordinals create new demand for Bitcoin blockspace
Ordinals are digital assets (e.g. images, audio files) inscribed on Bitcoin. This feature imbues a fungible token with a non-fungible property (i.e., an “NFT”) and has become a popular (albeit controversial) design space. Bitcoiners have fractured the community in a heated debate over what is and isn’t worth using blockspace for.
Our take: Any resurgence in network interest is a good thing. Bitcoin still faces existential questions about its long-term security model (i.e., will there be enough revenue to incentivize miners once block rewards run out?), and this is certainly one path to increase transactions and ree revenue. It also prices out low-cost p2p transactions – the fundamental use case, which would mean that L2s (e.g. Lightning) have to fill that gap for users.
Blackrock files for Bitcoin ETF
The world’s biggest asset manager is pushing further into crypto with an ETF-like product that would offer widespread institutional access to BTC. It will be several months before a decision on their application, but most expect that Blackrock’s size and political influence will lead to approval. This prompted a number of fast follows including Invesco and WisdomTree.
Our take: A proper Bitcoin ETF is the white whale of crossover financial products, and this is a very big deal. In addition to new buyers, an ETF offers an important counter-point to recent SEC actions and a sign of things to come from other major financial institutions. Note that BTC rose almost 20% during the week of June 19 on the news, leading a broader rally.
Looking ahead: Key concepts and narratives for Q3
Who wins the next cohort of DeFi users? We continue to view finance as one of the most important and valuable existing use cases, but it’s not yet clear which cohort of apps are going to attract users and accrue value. OG protocols (e.g. Compound, AAVE) have durability but little growth, while newer protocols like GMX have the growth but no moat. Synthetix (and to a lesser extent, Uniswap) have shown the ability to combine new products with established brands and the prospect of sustainable revenue. Projects that can realize the latter will look like outstanding businesses when on-chain activity returns.
Can Cosmos keep up? ETH L2 scaling has the momentum, but Cosmos still has talented builders. But their window for growth is closing. DYDX – whose app-chain is expected to launch in Q3 or Q4 – remains a critical test for the viability of the ecosystem (and an interesting token play depending on unlock schedule).
Where do the gamers go? No investment category is more divided than gaming. “Play-to-earn” was an embarrassing failure for the industry, but gaming remains an obvious potential use case. Plenty of money has been deployed on promising projects which are expected to release later this year – can any gain traction? Once someone figures out the right game mechanic and economic model, followers will be fast and growth will be too.
Do AI and crypto converge? There’s too much early hype, but Tyler Cowen presented a simple yet fascinating bull case for crypto: AI bots will need to pay for things, and since they don’t have bank accounts, they will use crypto. Distributed compute networks such as Render have caught early attention, and others are sure to follow.
In closing
We continue to wait patiently for opportunities to invest in valuable and growing projects. We expected a mix of optimism and apathy coming into the year, and that outlook has not changed. Macro still drives price, and there are many concerning indicators despite the recent optimism surrounding the Blackrock ETF. We would not be surprised by global financial calamity, and are generally content to take advantage of volatility and apathy to build long-term positions in quality projects that have momentum and catalysts (e.g. DYDX, SNX). If you are willing and able to be patient, 2023 is a great time for building and buying.
Recommended content:
Protocol Economics (framework for thinking about protocols as businesses) by Myles O’Neil
Podcast: Bell Curve:
“How to value crypto tokens: Fees, flows, or Fugazi” with Vance Spencer and Michael Anderson (Framework Ventures)
Podcast: Empire/1000x:
“Why our Investment Thesis hasn't Changed” w/ Avichal Garg (Electric Capital and Hosseeb Qureshi (Dragonfly Ventures)
“Meme Mania, Why You Should Pay Attention” with Avi Felman (GoldenTree) and Jonah Van Bourg (Cumberland)
“Mike Novogratz on Crypto’s Outlook” with Mike Novogratz (Galaxy)