Motus Capital Management
Motus Missives Vol. 8 | The Alpha is On Chain
In this edition of Motus Missives, we will illustrate why we believe that interacting directly with protocols is the best way to deliver alpha, provide case studies, and highlight unique “crypto macro” metrics we track to determine sentiment and regime.
What happens on centralized exchanges, centralized lending platforms, and OTC trading/lending desks is not blockchain, decentralized finance, or crypto. It is the financialization of crypto markets. While on the positive side this financialization helps with liquidity, adoption (easy onramps), ease of use (better UI/UX), and can more easily be regulated (Coinbase did not fail), most of the activity that occurs on these platforms does not occur on a blockchain (‘on chain’).
While those who invest in crypto primarily via exchanges are ‘early’ relative to the broader population, they are likely late to that specific asset relative to those who engage directly in decentralized finance, as assets only get ‘listed’ on exchanges after a certain level of adoption, liquidity, and most often price appreciation. Our objective is to find innovative protocols with value accrual before the token is listed on exchange. To be direct, we view exchange listings and associated boosts in liquidity as an opportunity to take profit.
Most invest in this market because they believe that blockchains and digital assets will deliver disruptive innovation to large addressable markets. All of that innovation occurs on chain. Additionally, we believe it is important to support the projects we invest in by either using the platform, providing liquidity, or both. This allows us to have our finger on the pulse of where this market and technology are heading, and best position ourselves to stay ahead of those trends and deliver alpha.
Interacting directly with protocols requires self-custody (wallets) and certain know-how. Companies such as Fireblocks and Copper allow users to do this in a secure way by providing:
Private key management
Multiple signatures required on trades and transfers
Whitelists to only interact with approved/vetted protocols
Motus Capital Management utilizes all of these controls (and more) in order to mitigate risks to the extent possible. In many ways, this is more secure than centralized exchanges because there is no need to trust anyone. As we have seen, users trusted that their balances on FTX and Celsius were correct, and that the companies were not doing anything risky with their deposits. Regulation can help with this, but regulation did not prevent the Great Financial Crisis, Bernie Madoff, Enron, and others. With a wallet from a provider like Fireblocks, you do not need to trust that your assets are there, you can see them in real-time. We hope these types of platforms are able to be designated “Qualified Custodian” or some equivalent status.
Real Time Financials
In equity markets, Analysts and Portfolio Managers attempt to make conclusions on company profitability and assign a value to that profitability. These conclusions are then confirmed or invalidated based on quarterly earnings reports and forward guidance. These reports are subject to creative accounting (ex-this, ex-that), and are typically months after the activity occurred. There is also very little information available for market participants to track activity until the next report.
Decentralized protocols on the other hand offer real-time information on users, volumes, revenues, etc.. This transparency provides an edge for investors that know where to look, and also drives elevated volatility. The growth of ETF investing for equities has lead to lower volatility on average, but higher volatility on events (i.e. earnings results or other company announcements). In crypto, there are no ETFs, and every second is an earnings update.
This availability of real-time financial data should make crypto a highly efficient market. However, there is a ‘funnel’ that exists that makes this the most inefficient market any of us have experienced:
Most people do not know how to navigate crypto. Over the years, many have asked us what they should buy. However, the opportunities we are excited about are not on any or most exchanges. For someone to access them, they need to create multiple wallets, transfer assets, understand how to do so securely, what to do if they need to act quickly, or how to account for this activity from a tax perspective. That right there eliminates the vast majority of people. (Accessibility and user experience are key themes for infrastructure development we are watching.)
Then you get to people who are comfortable with crypto – most of which are still retail investors.
Very few have a traditional investment background to underwrite opportunities or have a discipline around what to look for and what to avoid.
Then you have the institutional players in crypto.
We find that the most attractive opportunities in this space are those that are relatively newer, have a lower market cap, but therefore are less liquid.
An investor or fund with $150mm of capital or more simply cannot build a meaningful position in an asset that trades less than $5mm per day without significantly impacting the price or accepting that illiquidity risk. These players trade mostly on centralized exchanges.
There are very few people left, which creates inefficiency. This inefficiency is one of the reasons we are so excited about this space, in addition to the size of the opportunity on a standalone basis.
In addition to the above, there are no Generally Accepted Accounting Principles (‘GAAP’) for which protocols deliver earnings. There are infinite ways in which a protocol can incentivize activity and/or deliver value to token holders. This requires determining which metrics drive value and sourcing that information in real-time for each individual asset in order to make decisions.
Again the only way to source this information is from on chain activity. In the below we highlight some examples of where using on chain data has generated alpha.
GNS is a platform that facilitates the trading of synthetic assets across crypto and traditional markets, typically on margin, that first launched on the Polygon blockchain. We have a held a core position in GNS given these platforms can generate high volumes and fees in both up and down markets, and are increasingly taking share from centralized counterparts. Additionally, GNS offers a broader set of assets than competitor platforms, with a very user-friendly interface.
Starting in December ‘22, it appeared that market participants were either taking profits or rotating out of “last year’s winners”, most of which included synthetic trading / margin platforms. As a result, GNS lagged the broader market rally. However on January 1, GNS expanded their offering to the L2 blockchain Arbitrum, which we had been monitoring as a key catalyst for the asset. Once launched, we actively monitored on chain metrics such as users, open interest, volumes, assets traded, and revenues to determine if the launch was a success. We were also interested to see if current users would migrate to Arbitrum, or if the platform would pick up new users.
From December 1, 2022 – January 9, 2023 GNS returned -27% while the broader market was flat to slightly higher. In our view this did not match the actual activity of the platform, as during the same time daily volumes nearly tripled, daily fees more than doubled, and open interest was consistently 50% higher than prior all-time highs.
Mismatches in activity vs. price action are the types of opportunities we look for to inform investment decisions. From Jan 10 till now, the price of GNS has more than doubled. We will continue to monitor these on chain metrics in order to assess if price is a fair representation of activity. Additionally, GNS does not trade on any centralized exchanges, so only those interacting directly with blockchains could have taken advantage of this opportunity.
Our view is that prediction markets and parimutuel markets are a few of the areas where blockchain and digital assets have the best chance of obtaining broad adoption near-term.
Prediction markets include anything from what the weather will be, to who will win the 2024 election, to who will win the super bowl. Typically, odds are assigned to either outcome with a fixed payout, and the odds are updated by a centralized party as wagers are placed. The centralized party manages their risk and receives fees + net user PnL in return.
Parimutuel markets are similar, but the payout to the ‘winner’ is based on the relative amount wagered by the ‘losing’ side. For example, if $100 is wagered on outcome A, and $50 is wagered on outcome B, if outcome B occurs then those users receive a 2:1 payout. If this payout becomes irrational, it incentivizes users to take the other side. predictit.org is an example of a parimutuel market platform.
In 2021 the creator of Ethereum, Vitalik Buterin, noted that prediction markets remain some of the lowest hanging fruit for crypto disruption. In fact, the first Ethereum ICO was Augur – a platform launched in late 2015 to facilitate prediction markets in a decentralized way.
Augur may have been too far ahead of its time. Key infrastructure such as reliable data sources for events that occurred off chain (the weather), ability to generate randomized outcomes (think online Black Jack), or how to manage payouts and odds are fairly recent innovations. In our view, Thales is a platform that is positioned well for the opportunity, and on chain metrics show the same.
Thales introduces a novel way to deliver easy-to-understand prediction and parimutuel markets. We believe this will have meaningful network effects, and presents investors the opportunity to earn the returns of the house.
In order for decentralized versions of these markets to take hold, they need to provide 1) fair odds, 2) lower fees, 3) ease of use. Thales appears to be delivering on all three, while also allowing for markets that do not exist on traditional platforms.
Fair Odds – Thales sources opening odds from the largest traditional venues via Chainlink oracles. Oracles are what allow the use of any “off chain” data, such as the weather or stock price, to be used within smart contracts, with mechanisms in place to identify and remove bad data. Once the opening odds are set, Thales has developed an innovative mechanism (automated market maker) in order to balance the book in response to user activity. For prediction markets, the objective is the same as centralized peers - balance exposure to each outcome, smoothing returns and limiting downside. For parimutuel markets, there is no exposure to the platform, just a fee collected on all volume.
Lower Fees – Traditional providers of these markets charge a fee on all wagers, referred to as a “vig”. The fee is typically 10%, meaning you need to bet $110 to win $100, and requires users to win more than 50% of their wagers to be profitable. Thales effectively lowers the vig to 8%. Of which, 3% goes to an insurance fund of sorts to cover platform losses, with the remaining 5% going to those who provide liquidity (dollars). These liquidity providers effectively are “the house” – earning user PnL and fees.
Ease of Use – For those native to crypto, Thales’ is intuitive and easy to use. For us, the next step is an interface that abstracts away the “crypto”, allowing for anyone use the platform with dollars that are converted to stablecoins on their behalf. However, we would not be surprised to see users interact with crypto for the first time to access these markets.
Thales is rapidly introducing new prediction and parimutuel markets, and will eventually allow users to create their own markets (and receive a portion of fees generated). This also includes range markets (above X and below Y), and parlays.
In order to monitor the success of Thales and competitors, we watch in real-time the total volumes, daily users, and PnL of those users. From January ‘22 through August ‘22 total volumes grew slowly to a total of $3mm. Total volumes have grown 4 times since, starting with the World Cup, and continuing with the NFL playoffs and launch of additional markets. With March Madness around the corner, and announced plans to feature brackets and other contests on their platform, we expect these volumes to continue to grow.
To date the largest constraint on volumes has not been demand, but liquidity. In the next few months, Thales will allow anyone to provide liquidity to the platform, boosting capacity, and in turn fees.
There are far more details on how this all works, and the benefits provided vs. existing systems. Expect a separate piece from us on parimutuel markets and crypto platforms positioned to take advantage.
Crypto Macro Indicators
In traditional markets, there has been decades of collective efforts to find data points with a history of predictable outcomes, and anyone with a Bloomberg has these data points. The long history and availability of data contributes to the efficiency of markets such as US large cap equities.
This does not exist in crypto. In part because of the relatively short history (most assets have existed for less than 5 years), and because the pace of innovation has created the need to continually reassess which data points are relevant. However, as highlighted throughout this piece, any data point you can think of is publicly available to analyze.
Below we highlight two of the data points we look at in order to determine where we are in the cycle. The first is a measure of liquidity, and the second a measure of leverage.
Liquidity – measured by fiat-backed stablecoin flows. For every one of these stablecoin tokens issued there is $1 of cash & equivalents in a bank backing them. Institutional players interact with issuers directly to mint/redeem these tokens. Therefore, monitoring their total supply could be an indicator of institutional crypto inflows/outflows. Since September ’22, fiat stablecoin supply has been consistently shrinking. In early January ’23, supply started to level out, and has been slightly positive over the past few weeks.
Fiat-Backed Stablecoin Supply (source: Motus proprietary database, DeFiLlama)
Leverage – like any market, the use of leverage in crypto is a sign of overall sentiment, rising in bull markets and falling in bear markets. The rise and fall of leverage also contributes to price action, making it an important metric to monitor for inflection points. There are a variety of ways we monitor leverage, but one we find useful is borrow utilization in decentralized finance (‘DeFi’).
DeFi borrowing became prominent starting in early 2021, with the amount borrowed and percentage of available liquidity borrowed peaking with asset prices in late 2021. Since the bear market started in early 2022, both the dollar amount borrowed and percentage of available liquidity borrowed fell with asset prices. A few weeks after the FTX bankruptcy announcement these values started to stabilize, and in January we have seen borrowing increase slightly.
DeFi Borrow Utilization (source: Motus proprietary database)
We will continue to monitor stablecoin supply, DeFi borrowing, and other proprietary “crypto macro” metrics that we have found to be helpful in gauging market sentiment or regime. As with any metric, we understand there could be ‘noise’ in any individual signal, so we use these (along with broad economic metrics) to construct a checklist in order to separate the signal from the noise.
We believe that in order to successfully invest in this market you must engage directly with the protocols you are investing in. At Motus, we differentiate ourselves by the level in which we operate in decentralized finance. This enables us to deeply understand the protocols we invest in, identify their inflection points, and have our finger on the pulse of where innovation is occurring. This not only allows us to be early (before assets are listed on exchange), but guide decisions on when to buy or sell.
Additionally, understanding the on chain metrics that indicate changes in sentiment or market regime provides guidance on targeted aggregate exposure. This contributes to absolute returns, as well as managing risk.
Thank you for your continued trust in us to navigate these types of events, and we remain steadfast in our commitment to find attractive opportunities across the crypto ecosystem with risk at the forefront of our decision making.
Please do not hesitate to reach out with questions, comments, or feedback!
Motus Capital Management
Past performance is not indicative of future results. This communication does not constitute an offer to sell or solicitation of an offer to buy the Interests in any jurisdiction where, or to any person to whom, it is unlawful to make such offer or solicitation in such jurisdiction. This communication is being provided solely as a high-level overview and is not intended to be relied on for the terms of any offering. Motus Capital Management has or may hold a financial interest in the assets mentioned. Full disclosures can be found here.