Crypto cycles tend to start as new technological advancements are made that allow new protocols to flourish. This gains users and increases adoption, and asset prices rise with it. What follows is hype around what is possible next. In the past, this hype led to price cycles far ahead of the current tech, accompanied by a sense of euphoria, ultimately leading to a significant decline in asset prices as promise is not delivered and leverage is wiped out. To distill what changes from once cycle to the next is that the tech stack improves to facilitate more efficient movement and productivity of capital. This brings in more users, activity, and fees, which drives asset prices to new highs.
There have been two major technology (and price) cycles for crypto, which can be loosely framed as 2014 – 2018, and 2019 – 2022. From one to the next we ended with better applications, more users, and asset prices making higher highs and higher lows. We believe we are at the start of the next cycle, where the improvements in technology already being used and further upgrades coming soon are head and shoulders above where they were in prior cycles. However, prices are only starting to reflect this. It is our view that this presents the ideal time to invest, as it was in the prior two cycles.
First a recap of history to illustrate these cycles:
Cycle 1 – From Ethereum to ICOs
2014 – The price of Bitcoin fell ~50%, continuing its slide to a low of ~$225 by mid-2015
2015 – Ethereum launches in July as the first “smart contract platform”, allowed apps to be developed on the blockchain. Prices stabilize and begin to drift modestly higher. Bitcoin ends the year at ~$425.
2016 – The first set of decentralized applications are built on Ethereum. Bitcoin ends the year ~$1,000.
2017 – Token-issuance (“ICOs”) booms, ushering in a wave of protocols promising to solve all problems. This is the first time most people ever heard about crypto, and rush of retail capital ensues. Bitcoin makes a high of ~$17,000.
2018 – The ICO bubble bursts, and promises are not delivered (with a healthy amount of scams). Bitcoin ends the year at ~$3,800.
While 2018 was the worst year from a price return perspective, it was also the year that Maker DAO created the Collateral Debt Position concept on-chain (facilitating decentralized borrowing & lending), Uniswap launched the first Automated Market Maker (“AMM” - facilitating decentralized trading), and Circle launched USDC – the first US based, regulated stablecoin. These developments are what drove the start of the next cycle.
Cycle 2 – From DeFi to Mainstream (and back)
2019 – Decentralized Finance picks up in a meaningful way (DeFi Summer), made possible by the innovations brought forth by Maker and Uniswap. FTX launches. Bitcoin ends the year at ~$7,200
2020 – Significant leaps forward are made in terms of technological advancement, capabilities, and users:
AAVE and Compound launch, expanding decentralized lending by allowing for more collateral types to be deposited or borrowed.
Uniswap releases their “v2” AMM, increasing the efficiency of pooled assets.
Covid and resulting monetary stimulus attract institutional capital to the asset class.
Competitor blockchains (“Layer 1s”) launch to address the scalability of Ethereum (Solana, Avalanche, Polkadot, Polygon, Terra) and applications begin to built on them.
Bitcoin ends the year at ~$29,000.
2021 – New “Layers 1s” gain usage and adoption. Decentralized derivatives platforms emerge (DYDX, GMX). Uniswap releases their “v3” AMM introducing “concentrated liquidity” increasing efficiency of pooled assets by multiples (i.e., the same amount of value can now provide more liquidity per dollar). Deposits in crypto lending platforms surpasses deposits at Morgan Stanley. Stablecoin transaction volume surpasses that of Visa. Sam Bankman Fried becomes the darling of media, politicians, and investors. Bitcoin makes a high of ~$65,000, finishing year at ~$47,000.
2022 – Leverage gets wiped out, with the start of the Fed tightening cycle and collapse of Terra Luna, Genesis, 3AC, BlockFi, and FTX. Bitcoin ends the year at ~$16,600.
2022 also capped the longest “bear market” on record as measured by the longest time that year-over-year BTC performance was negative (below).
Again, while 2022 was the worst year from a price return perspective, it also sets the stage for where we are today. 2022 saw the start of Ethereum scaling solutions (“Layer 2s”) start gaining adoption (Arbitrum and Optimism), the “Merge” (an upgrade of the Ethereum blockchain that changed the consensus mechanism to Proof- of-Stake), NFT standards introduced for assets deposited in decentralized finance applications (allowing these positions to be transferred while tracking ownership), and Account Abstraction became a near-term possibility.
These advancements are what have us extremely excited for the rest of 2023 and the years to follow and are the subjects of this piece.
2023 – The Start of a New Cycle
Where we are now is the start of a new cycle – the technology is far ahead of where it was in 2021, including advancements that even the hype during that time did not consider. However, prices are only just starting to reflect this. It is our view that this presents the ideal time to invest, as it was in the prior two cycles.
Price cycles are more volatile than cycles of innovation, as they are connected to macro and prone to booms and busts, but over longer periods of time, the relationship between price and innovation are more able to be observed. Here we mostly focus on innovation, as regardless of price lagging, highly consequential innovation is underway…
Source: a16z State of Crypto
The areas of innovation that are here and will drive this cycle accomplish 4 objectives:
1. Improve scalability
2. Increase capital efficiency
3. Increase the composability of assets
4. Make blockchain user friendly
The result of each is the following:
In just the last 18 months, interacting with blockchain has become materially faster and cheaper. Speed and cost should continue to improve, and we favor applications that are now possible with improved scalability.
Capital within crypto is now the most efficient it has ever been and will increasingly become more efficient in the future. This means that as capital begins to re-enter this space, we should expect to surpass 2021 highs in activity on a much lower capital base, and deliver multiples of activity relative to 2021 when we return to similar capital levels. Providers of liquidity and assets that accrue value based on volume should benefit.
Composability increases the productivity of assets. This leads to monetary expansion within crypto regardless of new inflows, and highlights another benefit of tokenization that traditional markets do not provide. Monetary expansion should act as a near-term tailwind, while tokenization benefits should drive longer-term adoption trends. Borrow/lend platforms are the likely near-term beneficiaries.
The highest hurdle to crypto adoption has been the technical know-how required to access it. The abstraction of the underlying tech, driven by companies such as Coinbase and decentralized applications will remove this hurdle. This is a major catalyst for broad adoption, and consumer focused applications should stand to benefit.
In short, during the past year and a half we have had advancements that will bring in more users, make capital more efficient, make assets more productive, and in a faster, more scalable way. This will inevitability lead to activity and value created that surpasses prior highs.
When you add the technology piece to the positive regulatory developments, and that FTX, Celsius, and Genesis are being replaced by the likes of Blackrock, Citadel, Fidelity, and Visa…we think we are at the start of the new cycle, and that presents the ideal time to be invested in this space.
Below we provide the supporting developments and rationales for these viewpoints. While we tried to make it digestible, including crypto-specific terminology is unavoidable. It is our view that these topics will underpin this market for the next 6 – 12 months and beyond, however, it does not seem like many are talking about them…yet. Please feel free to reach out for further explanation.
1) Improve Scalability
This addresses the “blockchain is too expensive and slow” claims. Last year we saw what are called Layer 2s (“L2s”) grow in usage. All this means is that instead of every transaction needing to be recorded as it occurs, transactions can be bundled and recorded as a group (ie. batch processing). This has the effect of reducing costs by at times a factor of 50-100x, and increasing transaction processing speed just as much. Arbitrum and Optimism are the dominant L2s to date. However, there are several others that have launched, and we would expect even more to come. This will drive competition and lead to better functionality and cost for users.
Cost to Send Funds: Ethereum vs. L2s
(Source: Cryptofees)
Today there is more transaction volume on these L2s than on Ethereum directly or on any other blockchain.
Daily Transactions: Ethereum vs. L2s
(Source: DeFiLlama)
Ethereum (L1) = Purple, Arbitrum (L2) = Green, Optimism (L2) = Blue
Within the next ~6 – 9 months we expect two more improvements to Ethereum scaling solutions:
Layers 3s (“L3s”) – Built on top of L2s and purpose-built for specific needs, while scaling transaction volumes and costs further. L3s also provide for account abstraction, a very exciting topic we will discuss more below.
EIP 4844 – This is an upgrade to the Ethereum blockchain that allows for different transaction types. It is a very technical concept, but the punchline is that this should allow the capacity for L2s to grow 100x and significantly reduce costs.
As daily users of these blockchains and applications, the speed and cost savings are a game changer. It also facilitates the development of new applications that require low latency (ie. gaming), minimal cost (ie. micro payments), as well as others most are not talking about yet. To be clear, even before these developments blockchain was a cheaper and faster way to send funds than sending wires. Now, the gap is even wider, and blockchain compares favorably to even more legacy infrastructure.
You may have heard the recent announcement of “Fed Now” – the Federal Reserve’s solution for instant payments. Already some are saying that this makes blockchains obsolete. The reality is that Fed Now is 20+ year old technology (Japan announced something similar in 2002), that does not change your ability to send your money outside of banking hours. Said differently, Fed Now is just the US catching up to other countries in technology that is outdated, while blockchain continues to innovate at a rapid pace.
As a final bit, we believe that the launch of L3s will coincide with value accruing to L2 tokens (notably ARB and OP). This makes sense as L3s are reliant on the security of L2s and thus we will see decentralized sequencers on L2s with their tokens being staked to provide this security. L2 sequencers are already highly profitable, and EIP 4844 should increase their profit margin. Additionally, the incentives are there for the respective foundations to accrue value to their token.
Arbitrum Sequencer Profit (Source: ASXN Research)
Optimism Sequencer Profit (Source: ASXN Research)
Conclusion: In just the last 18 months, interacting with blockchain has become materially faster and cheaper. Speed and cost should continue to improve, and we favor applications that are now possible with improved scalability.
2) Increase Capital Efficiency
Decentralized Finance (‘DeFi’) brings together those with idle capital and those who need it without an intermediary in between. The benefits of this are the removal of costs extracted by the intermediaries and the various infrastructure providers they use. Ultimately this leads to better returns for those that provide capital, and cost savings for those that use it. It also makes it easier for these participants to “shop around” for the best rate as there are far less frictions than say changing your banking relationship.
However, for DeFi to compete effectively, the capital within it must be more efficient. Historically, capital within crypto has been mostly passive and fragmented. The result has been less depth and worse liquidity, which creates volatility. It also makes it harder to connect those that provide capital with those who need it for whatever purpose, which reduces economic activity.
There have been two recent drivers of capital efficiency addressing both passive capital and fragmentation – concentrated liquidity and CCIP (“Cross-Chain Interoperability Protocol,” which enables users to interact between different blockchains). Soon we expect further improvements on the fragmentation piece. More on that below.
Active Capital – Uniswap v3
As highlighted in the initial timeline above, concentrated liquidity is the most recent version of what started in 2018 (automated market makers), which was upgraded in 2020, and again in 2021 (Uniswap v3 AMM).
This created deeper and more liquid markets for various services. And as of today, the capital in crypto is the most productive it has ever been as a result.
In the below chart we compare the amount of daily activity (volume) per unit of capital provided (Total Value Locked – TVL) since mid-2021 when Uniswap v3 was released. As you can see, the result has been increasing capital efficiency as more and more applications incorporated this update.
DeFi On-Chain Volume / TVL Ratio (Source: DefiLlama)
Unified Liquidity – CCIP
In July we saw the launch of CCIP – Cross-Chain Interoperability Protocol, by Chainlink – a major blockchain data and infrastructure provider.
In simple terms, what CCIP does is connect pockets of liquidity throughout crypto, so that those dollars or assets can be used wherever the demand needs it, in real-time. This has the impact of dramatically increasing capital efficiency and reducing idle capital, which is better for all participants.
In fact, CCIP is what the SWIFT network, the network all banks use to send wires, has been testing to facilitate payments via blockchain to improve efficiency of bank payment networks.
The founder of Chainlink, Sergey Nazarov, refers to CCIP as the “Internet of Contracts”, which he believes will connect banks, asset managers, and hedge funds to Decentralized Finance at the security, speed, and cost that they require. We agree, and believe this to be perhaps the most significant improvement to blockchain technology to date.
Unified Liquidity Part 2 – Uniswap v4 and Algebra
Uniswap and Algebra are the leaders in developing AMM methodology and infrastructure. Essentially every decentralized exchange (“dex”) leverages one or the other as their codebase, albeit via different paths.
Uniswap develops new versions of their AMM for their own dex, which has been the leader in both liquidity and volumes since it launched in 2018. Uniswap integrates new versions to their dex under a Business Source License, which gives them a competitive moat until the License expires and other dexs can adopt it. Uniswap v3 was under a 2-year license, which expired in April of this year. Quickly thereafter, all decentralized exchanges that were using Uniswap v2 quickly upgraded to v3, contributing to the efficiency gains in the graphic above.
Algebra is a technology and infrastructure provider, developing competing AMM methodology to that of Uniswap. Rather than operate their own decentralized exchange, they license the methodology to other decentralized exchange and receive a % of their fees in return. Over the past 12 months, some of the largest decentralized exchanges on Arbitrum, Polygon, and Binance Smart Chain have chosen to partner with Algebra rather than copy Uniswap v3.
While in some ways competing, both solutions are seeking to tackle similar challenges, most notably fragmented liquidity amongst decentralized exchanges. The way they do this is via a concept called “hooks”. In essence this means that any pool of assets that uses Uniswap v4 or Algebra infrastructure respectively is unified and available for participants, regardless of which blockchain or application those assets are currently held on. This is the equivalent of how we have unified liquidity in equity markets, and is an incredible development that will drive further capital efficiency within crypto.
Additionally, both solutions will offer features such as dynamic fees (volume adjusted) and customizable pools (incentivize liquidity), both of which provide further efficiency gains. Uniswap v4 is expected to be released following the EIP 4484 upgrade, while most of these features are already live or soon to be live for Algebra partners. As we get closer to the launch of Uniswap v4, we would not be surprised to see decentralized exchanges currently utilizing v3 switch to Algebra in order to compete. In either event, the innovations brought by these two protocols are to the benefit of all crypto participants.
Conclusion: Capital within crypto is now the most efficient it has ever been, and will increasingly become more efficient in the future. This means that as capital begins to re-enter this space, we should expect to surpass 2021 highs in activity on a much lower capital base, and deliver multiples of activity relative to 2021 when we return to similar capital levels. Providers of liquidity and assets that accrue value based on volume should benefit.
3) Increase the Composability of Assets
Composability is a term we use that means having standards in place that make an asset usable or fungible in more ways. That makes the asset more productive. An example would be your AAPL shares today – there is not much you can actually “do” with them but buy/hold/sell and collect a dividend quarterly, or maybe lend them out after a bunch of paperwork and people. Tokens however, can be freely moved and “used” across any and all applications built on the blockchain the token was issued.
Again in 2022 there were standards created that allowed for large pools of assets to be transferred while still tracking beneficial ownership. The effect of this that we are just starting to see is monetary expansion within crypto, that can boost activity even without new inflows.
This is exciting because it has broad appeal for any person or traditional business. We all own assets, whether they be financial assets in our brokerage account, or some intangible asset. For most those assets sit idle. However, there is likely someone or some entity who may want to utilize that asset, which would earn you as the holder an additional source of return. Assuming adequate protections to recover the asset you provide, most individuals would participate. Every corporate CFO would most definitely participate.
There are two significant improvements in composability that we are excited about:
1) Liquid Staked Tokens (“LSTs”) as prime collateral
2) Liquidity Pool (“LP”) positions as NFTs
Liquid Staked Tokens
“Staking” is the process of allocating tokens (typically subject to a lock-up) for the purpose of securing and verifying transactions for a Proof-of-Stake blockchain (e.g.,. Ethereum), and receiving rewards (income) for doing so. This is in contrast to a Proof-of-Work blockchain (e.g., Bitcoin) where the security and verification are compute/hardware based. This is oversimplified, but Proof-of-Stake and Proof-of-Work are consensus mechanisms that allow decentralized networks to exist rather than relying on centralized intermediaries for these functions.
Ethereum is now the largest Proof-of-Stake network, with the ability to stake ETH starting in December 2020. In September 2022, the “Merge” upgrade completed Ethereum’s shift to Proof-of-Stake. However, not until April 2023 (Shanghai upgrade) could participants “unstake” ETH (i.e., receive their ETH tokens back and claim prior rewards). In short, after years of upgrades, ETH can be staked and redeemed, allowing holders to earn passive income on their holdings, and also giving rise to Liquid Staked ETH.
Liquid Staking is the process of staking a token and receiving a receipt token (Liquid Staked Token) in exchange. This receipt token represents a claim on the staked asset (and rewards generated), and can be sold, transferred, deposited, or borrowed. In some ways it allows stakers to “have their cake and eat it too”.
LSTs first gained usage in 2021 with assets such as ATOM (stATOM), and perhaps most ‘successfully’ with LUNA (bLUNA). In either case their use drove meaningful increases in activity, as LSTs represent high quality collateral for borrowers. It also encourages staking, providing increased security for the respective blockchain.
Liquid Staked ETH is now the largest LST by market cap, with ~18% of all ETH staked (~$42B) at the time of this writing. We would expect the % of ETH staked to increase, perhaps doubling, as more protocols build out features that increase the productivity of this asset.
Liquidity Pools as NFTs
In traditional markets, centralized parties facilitate the exchange of one asset for another. In crypto, exchanges like Coinbase also do this, but in the fallout of FTX (and concerns over Binance), decentralized exchanges are seeing their share of overall trading activity grow.
Decentralized exchanges require participants to deposit liquidity for others to use (“Liquidity Pools”), and receive the trading fees paid for doing so. For example, you could deposit $100 of ETH and $100 of USDC to Uniswap, allowing others to buy or sell ETH for USDC with that liquidity provided. Providing liquidity in this way can generate significant yield, especially as liquidity has become more “active” as described above. It is not uncommon to earn APYs of 50%+, with those spiking during periods of higher volatility and associated higher volumes.
There are risks to this, referred to as “Impermanent Loss” – the loss of value resulting from the change in token balances within the Liquidity Pool. However, those that understand these mechanics and are active can construct very profitable strategies. This is a lever we use to generate returns outside of directional exposure.
Historically, once assets are deposited into a Liquidity Pool they remain there until withdrawn, and that LP position was non-transferable. Starting in 2022 and continuing this year, standards were introduced to wrap LP positions as NFTs. By doing so, LP positions can now be transferred or deposited, while still tracking beneficial ownership.
To digress for a second, this shows the power of NFTs. While media portrays NFTs as simply art (important), collectibles (also important), or for profile pics (maybe less so), the reality is that most of what we interact with everyday and holds value is non-fungible (unique and not easily replaced). For example, homes, commercial buildings, intellectual property rights, patents….people! are all non-fungible. NFTs just allow those assets to be easily transferred, borrowed, fractionalized, etc.. This will increasingly become more important as blockchain adoption increases.
Back to LPs – NFT standards have been introduced to allow these assets to be transferrable, making them far more productive. Stablecoin LP positions are the lowest hanging fruit, with $2B+ of these positions today. These would be the equivalent of a high-quality floating rate bond – earning yield on stable value. If you include pools with volatile assets, the number exceeds $13B. There are a number of protocols we follow that will allow these positions to be deposited for additional yield, or used as high quality collateral to borrow. This will encourage more liquidity as the positions are more productive, and expand the capital within crypto.
Conclusion: Composability increases the productivity of assets. This leads to monetary expansion within crypto regardless of new inflows, and highlights another benefit of tokenization that traditional markets do not provide. Monetary expansion should act as a near-term tailwind, while tokenization benefits should drive longer-term adoption trends. Borrow/lend platforms are the likely near-term beneficiaries.
4) Make Blockchain User Friendly
The term used for this is account abstraction, which simply means abstracting away the blockchain for a username and password, similar to how gmail abstracted away the underlying protocol that allows us to send emails.
Again in 2022, Coinbase announced they were building a Layer 2 blockchain called Base. As of last week, Base was open for Developers to build applications on it, many of which will be existing applications ported over, similar to an app being on both iphone and android.
The important part of this is that if you are a Coinbase user, you will be able to interact with this blockchain by signing in with your username and password. There will be a phone number to call if there is a question, and it will have protections in place to prevent and recover lost funds. Effectively the fact that there is a blockchain or tokens involved won’t matter, it will look and feel like any other app you use, but the services these apps offer will cost less, be faster, and will provide more functionality relative to their “traditional” peers.
Coinbase has over 100mm users globally, most of which never interact with blockchain directly. There are also a host of other companies creating these interfaces to draw more users into what we are confident is a more efficient way of doing things. Even if a small % of those users interact, it would drive meaningful growth in overall activity. Base went live for open testing in the past few weeks, and already we have seen meaningful amounts of liquidity and activity arrive.
Another benefit of account abstraction is that it could allow decentralized applications to pay for users’ fees or possibly use non-ETH tokens to pay for fees. When the transaction fees are low enough (as a result of L3s and EIP 4484), we think more applications may pursue this path, effectively changing the user experience on blockchains and allowing users to focus only on high-level interactions.
Conclusion: The highest hurdle to crypto adoption has been the technical know-how required to access it. The abstraction of the underlying tech, driven by companies such as Coinbase and decentralized applications will remove this hurdle. This is a major catalyst for broad adoption, and consumer focused applications should stand to benefit.
Summing this up
During the past year and a half we have had advancements that will bring in more users, make capital more efficient, make assets more productive, and in a faster, more scalable way. This will inevitability lead to activity and value created that surpasses prior highs.
When you add the technology piece to the positive regulatory developments, and that FTX, Celsius, and Genesis are being replaced by the likes of Blackrock, Citadel, Fidelity, and Visa…we think we are at the start of the new cycle, and that presents the ideal time to be invested in this space.
Please do not hesitate to reach out with questions, comments, or feedback!
Sincerely,
Team Motus
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.