May 24, 2023

Insights and analysis for the professional investor

Was this newsletter forwarded to you? Sign up here.

Supported by

Welcome to Crypto Long & Short!

This week, Glenn Williams Jr. explores the vital crypto math equations behind automated market makers.

Then, Misha Malyshev of Teza Technologies argues ChatGPT-style AIs can provide an edit to investors.

As always, get the latest crypto news and data from CoinDeskMarkets.com.

– Nick Baker

From the Analyst

Crypto's Quirky Automated Market Makers

The conceptual simplicity of cryptocurrencies drives much of the excitement and adoption of the asset class. Cryptocurrencies are, by and large:

digital units of account …
that store value …
and that can be exchanged for other items of value.

Readers who can still recall their early principles of economics classes probably recognize that those three tenets are part of the definition of money itself.

Still, conceptual simplicity gives way rapidly to practical complexity when users look closer at crypto. That's especially apparent with its use as a medium of exchange, point #3 above. And also often when it comes to transferring crypto from one party to another.

In crypto, unlike conventional finance, there are two very different kinds of exchanges. And helping you grasp them – just like any thorny topic in crypto – is a challenge I relish taking on.

There are two primary ways to transfer on crypto exchanges:

Order books
Automated market makers (AMMs)

Order books are most common, and they're also the most recognizable for anyone coming from a traditional finance background. This is just like how the New York Stock Exchange, Nasdaq and other conventional marketplaces assemble buy and sell orders in a public place so new orders can get matched up with them.

In crypto, this is how Binance and other centralized exchanges work. Binance, with roughly half of crypto exchange volume, is the biggest one.

In the order book realm, traders called market makers help keep business churning by buying from any seller and selling to any buyer, collecting the spread between bid and ask prices as their reward – something that can be quite profitable if done over and over. (Last week I talked about crypto high-frequency traders, firms that provide this service.)

One of the benefits of order books is they allow everyone to see market depth, i.e. the extent to which orders are concentrated around specific price points. Traders can gain insight into market direction by studying market depth and making subsequent decisions – a reason why order books are popular.

The AMM way

But crypto has its own unique way of transferring money from buyers to sellers, known as automated market makers. (The name sounds like the traders – market makers – mentioned earlier who prowl order books, but these are very different things.)

Where order books are prevalent across centralized exchanges (CEXs), AMMs are prevalent in decentralized exchanges (DEXs). Uniswap is a notable DEX.

Where order books represent a peer-to-peer arrangement underpinned by the matching of buyers and sellers, AMMs represent a peer-to-contract relationship underpinned by pools of liquidity.

Liquidity pools are collections of tokens that have been supplied by liquidity providers (LPs). Liquidity providers are users who decide to deposit their own assets into a pool, incentivized to do so by the receipt of something of value.

Users deposit coins into a liquidity pool. Other users who wish to buy or sell interact with pools holding the asset they're interested in, trading against the pool itself instead of another user. Depositors are rewarded for providing liquidity.

Oftentimes, that comes via the receipt of trading fees or governance tokens. A common term you'll hear specific to AMMs is "yield farming," where users deposit tokens into liquidity pools while searching for the greatest benefit.

The method of incentivizing users to deposit coins can have a network effect, whereby the pools of coins grow, increasing liquidity itself.

Where AMM meets DEX

Prices of the tokens are determined algorithmically, and often tied to the available quantities of each asset. For example a particular pool may hold $1 million worth of ETH and $1 million of USDC – an ETH/USDC pool). Increased demand for ETH represented by increased buying leads to a higher price for ETH, determined by mathematical formula.

With DEXs, there's a unique elegance borne out of that equation. In the case of Uniswap, the result is approximately $500 million in daily trading volume. For context, this pales in comparison to Binance trading volume, estimated to be as high as $4 billion daily.

Still, DEXs provide a valuable offering, particularly as it relates to traditionally less liquid coins. And while CEXs and DEXs are underpinned by different things, the intersection of capital, efficiency and incentives underpins them all.

And our goal at CoinDesk is to provide as much clarity as we can in exploring how they evolve.

– Glenn C. Williams Jr., CMT

Cboe Digital is a U.S. regulated exchange and clearinghouse bringing trust and transparency to the crypto spot and derivatives markets. Cboe Digital honors a separation of duties and includes intermediaries as a key tenet in managing risk and avoiding conflicts of interest. Our unified spot and derivatives markets are underpinned by responsible innovation and enable collateral efficiency. www.cboedigital.com.

Institutional Outlook

Does AI Generate a Trading Edge in Crypto?

If you ask a large language model (LLM) like ChatGPT how to choose an LLM, it will give you an answer such as this from GPT-4:

"Choosing the best large language model is a lot like speed dating: you ask it a few questions, hope it impresses you with its wit and intelligence, and then decide if you want to spend the rest of your project together!"

In the world of finance, the principle of supply and demand serves as a foundational mechanism for determining the fair price of any asset class at any point in time. This economic concept holds that the equilibrium price of an asset is established when the quantity demanded by buyers matches the quantity supplied by sellers.

Fundamental factors have long played a crucial role in assessing traditional equity markets, where investors analyze a company's financial health, industry position and overall economic climate to determine its intrinsic value. Key metrics such as earnings, revenue and debt-to-equity ratios provide a clear picture of a company's performance, enabling investors to make buy/sell decisions. However, such metrics are not available yet in the rapidly evolving world of cryptocurrencies.

The absence of financial statements and difficulty of estimating the impact of emerging technologies makes it hard to value cryptocurrencies by traditional pricing methods. Moreover, the extreme price volatility further challenges the efficiency of fundamental analysis in the crypto space.

In the absence of traditional valuation methods, the price often seems to be determined by the sentiment around the overall crypto market and/or a particular token. The perception and emotional reactions of market participants often play a more prominent role in driving price fluctuations and shaping investment decisions.

For a rational trader, such irrationality presents an opportunity in the market – if only she could quickly and accurately capture the mood (aka sentiment) of the market. For many years, working with sentiment seemed like an insurmountable challenge. Day traders mostly relied on crypto news headlines, Discord insider chats and announcements. And systematic traders had to invest considerable effort into development of just average-quality sentiment analysis tools. The limitations of technology at the time made it difficult to efficiently process and understand the vast amounts of data generated by global media.

The revolution in transformers and LLMs, specifically, allowed traders to approach sentiment at scale, delivering an incredible improvement over traditional methods that relied on manual scoring and Word2Vec models.

The competitive landscape of software-based technology companies vying to create the best LLM is rapidly evolving now. The table below provides an impressive illustration of this ongoing race, showcasing some of the key players and their respective contributions to the field:

These LLMs continue to increase in size and improve performance, surprising even their creators. And while people debate about whether LLMs are the first signs of artificial general intelligence (AGI) or just mindless parrots, their use in different industries and finance in particular will only accelerate.

The potential revolution brought about by transformers and LLMs could significantly transform the crypto trading landscape. With the capability to assess market sentiment on a larger scale, traders might be able to capitalize more effectively on market irrationalities.

You can learn more about LLMs, their types and applications in our most recent white paper, available here.

– Misha Malyshev, CEO of Teza Technologies

Crypto storage doesn't have to be hard and should never come at the expense of security.

Introducing Bridge Trust. We're a regulated trust company offering one of the first enterprise-grade custody solutions to individuals and businesses alike.

Whether you're just getting started in crypto or a seasoned investor seeking a hard wallet alternative, Bridge Vault will let you rest easy knowing your funds are secure and fully segregated. Open an account today.

Takeaways

From CoinDesk Deputy Editor-in-Chief Nick Baker, here's some news worth reading:

BITCOIN'S NFT BOOM: The Ordinals protocol has significantly shaken up the pecking order in NFTs, turning good old Bitcoin – shockingly – into a major player. In just a few months, Bitcoin has gone from a tie for last place in NFTs to the number two blockchain for NFT sales. Ethereum remains in first, which makes sense given its use of smart contracts; this was an ecosystem built for this kind of thing. But inscribing NFTs into Bitcoin was not an obvious use case for the original blockchain. And yet, here we are.
A FRENCH WELCOME: It's gotten hard to be a crypto company in the U.S. in 2023, with regulators taking tangible steps to increase scrutiny of the industry, and the looming threat of more action as politicians amp up anti-crypto rhetoric. Just this week amid the debt-ceiling showdown, President Joe Biden said he wouldn't accept a deal that "protects wealthy tax cheats and crypto traders." So, it should come as no surprise that other nations might try to lure American companies to their friendlier shores. Take France, for example. "If American players want to benefit, in the very short term, from the French regime, and from the start of 2025 from European arrangements, clearly they are welcome," Benoît de Juvigny, Secretary General of the Autorité des marchés financiers (AMF), told reporters Tuesday.
CANADA, TOO: Coinbase, the large U.S.-based crypto exchange, recently hinted it might move overseas if the regulatory environment continues to be, from its perspective, less than ideal. In a subsequent interview with CoinDesk, a senior Coinbase executive said the company likes Canada's approach, something he called "regulation by engagement," as opposed to the "regulation by enforcement" scheme elsewhere. Makes you wonder if Coinbase might consider heading north.
A LONG READ: CoinDesk journalists did an in-depth analysis of a crypto mining facility called Greenidge Generation in upstate New York. They did excellent on-the-ground reporting – something no one else seems to have done – to debunk misinformation in the debate over whether mining should be permitted or not on environmental grounds. It's well worth your read.