May 3, 2023

Insights and analysis for the professional investor

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Welcome to Crypto Long & Short!

This week, Glenn Williams Jr. riffs on a comment at Consensus 2023 from a major crypto market maker.

Then, Connor Farley and Max Freccia of Truvius explore whether market caps really cut it in portfolio construction.

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

– Nick Baker

From the Analyst

Innovation and Regulation Should Be Partners, Not Adversaries

"There's no reason why innovation and regulation have to be mutually exclusive."

Out of the myriad thought-provoking statements made at this year's Consensus 2023 conference, this is the one that stands out the most to me. Uttered by Chris Zuehlke, the global head for crypto market maker Cumberland DRW, the comment brings together two important aspects of the economy.

The first (innovation) represents that which has yet to be discovered, the potential for efficiencies, revenue, growth, etc. The second (regulation) can help innovation flourish in a legal and orderly way – or regulation can hinder innovation completely.

Their coexistence is necessary, but when their relationship is contentious, it's highly problematic for all. Recent developments have me worried. Let me explain.

Blockchain developers design, build and maintain applications within crypto ecosystems. They, as developers, make a conscious effort to allocate their time, intellect, talent and resources to build things that they feel have utility.

Developers flocking to or retreating from a particular ecosystem arguably serves as an indication of the protocol's efficacy. Developer activity can also serve as an early indication of which crypto-focused projects are poised for growth and are generating value for users.

Recently, I came across a report that showed two developments, one of which was encouraging, the other not so much.

First, blockchain development is expanding. The report showed there are now over 20,000 monthly active developers across the various crypto ecosystems.

The top five by rank are: Ethereum: 1,975; Polkadot: 675; Cosmos: 530; Solana: 344 and Bitcoin: 328

The overall number has grown 43% in the past two years and 110% over the last three – though it is down 17% since November, when the FTX exchange's collapse caused so much industry turmoil.

The long-term increase even as we navigate a crypto winter is testament to the fact that crypto represents an expansion in technology and innovation.

Cryptocurrencies are not simply coins and tokens that exist only for the purpose of speculation. They also represent technologies where potentially valuable applications are being developed.

More developers have been attempting to build things of value on various ecosystems, which should benefit the general public. This is positive.

The second development has me concerned, however. While the overall number of developers has gone up, their ranks are dwindling in the U.S. The proportion of developers based in the U.S. has dropped to 29% from 40% in 2017.

The U.S. is now tied with Europe, which is also at 29% after remaining relatively stable in recent years. But Asia and Africa are rising fast, so it's reasonable to think the U.S. will be knocked from the top position.

What explains the American decline? The recent tone between the crypto space and U.S. policymakers has become unnecessarily strident. And, as such, individuals within crypto have concerns about a lack of clarity and whether actions they take in the name of innovation will run afoul of yet-to-be revealed or implemented regulations.

This is not simply limited to developers. Crypto firms have begun to consider overseas operations, with Coinbase reportedly considering moving a segment of its operations outside of the U.S. The primary motivation of a move is apparently the diversification of regulatory risk.

With Europe recently approving its Markets in Crypto Assets (MiCA) regulation, it seems more likely U.S. individuals and firms will seek out countries with greater regulatory clarity.

What we need is, believe it or not, for everyone to move toward sensible regulation and not regurgitation of party-centric talking points, on both sides of the political spectrum.

An example of a path forward is illustrated in a recent draft of a U.S. stablecoin bill, which is reportedly receiving bipartisan support. Elements of the bill include ensuring the maintenance of adequate liquid reserves, a moratorium on algorithmic stablecoins and licensing rules for stablecoin issuers.

But the most important part is that the two major political parties are apparently working together. If they can't do that more often, crypto innovation will absolutely move elsewhere.

– 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

A Closer Look at Market Cap-Weighted Crypto Portfolios

Digital asset investment management stands to benefit greatly from the techniques and lessons learned in traditional finance. From portfolio construction methodologies to regulatory frameworks, leveraging best practices from decades of research in traditional asset management will help accelerate crypto's broader adoption.

In certain ways unlike traditional asset classes, however, blockchain assets may warrant a closer look beyond familiar concepts. That includes using market capitalization as a weighting methodology for passive portfolios.

Portfolios across both traditional and digital asset classes often use market cap to determine how much to invest in each underlying asset. Doing so provides investors straightforward passive exposure to the overall market. For digital assets, though, complementing market cap with some measurement of a blockchain's usage may enhance portfolio construction.

One way to do that is with total value locked (TVL), which represents the value of assets deposited on a blockchain. A higher TVL suggests greater economic activity and potentially better prospects of future activity or a larger active user base. (A lower TVL implies the opposite.)

By taking the ratio of market cap-to-TVL (MC-TVL), we may glean a more fundamental sense of an asset's utility beyond the superficial view from market cap, similar to how equity investors use ratios like price-to-book (P/B) to discern a stock's value. A higher MC-TVL suggests an asset's capitalization may be bloated, with a valuation that disproportionately exceeds its usage. Conversely, a lower MC-TVL may imply an undervalued blockchain, where markets haven't yet priced in its activity.

We ran a simulation on a top-10 index weighted by market cap versus one weighted by MC-TVL. The results are below:

The MC-TVL approach produced better full-period returns in this hypothetical scenario, driven by outsized positive performance in 2021. Over the period, daily returns between the two had a 0.85 correlation, suggesting that while the weighting methodologies are similar (by design), meaningful differentiation still exists between them. Over the long run, integrating blockchain usage into passive products may improve overall market exposure and help investors better align themselves with crypto fundamentals.

This experiment, while a highly simplified and mostly illustrative simulation, is intended to encourage more nuanced analyses of crypto-specific properties and how they can be integrated into portfolio construction. Despite limited backtest duration, over the long run lower MC-TVL may prove a useful indication of assets with greater network usage versus higher MC-TVL assets, whose size alone may not completely reflect their value within the digital asset universe.

As crypto's track record unfurls in real time and new, richer on-chain data emerges, investors should monitor how fundamentals-based adjustments to portfolio construction could assist digital asset investment management.

– Connor Farley and Max Freccia, Truvius

CoinDesk is coming back to Austin for Consensus 2024. Get your super early bird tickets for the lowest possible rates and join us May 29-June 1, 2024. Get your tickets now.

Takeaways

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

THE OPTIMISM: I was a newbie at CoinDesk's Consensus 2023 conference held last week, and I was blown away by how big and impressive the event was. The high level of optimism was a surprise given just how bad the regulatory outlook is. I know that's partly self-selection bias at work: People who pay a lot of money to attend such an event tend to be bullish. Still, the juxtaposition of big questions about crypto's future and optimistic outlooks was striking to me.
MILLIONAIRE FROGS: There's another way to say people are optimistic about crypto: The market cap of the PEPE meme coin has surged to half a billion dollars following a 2,100% surge since its April debut. BitMEX is offering derivatives contracts tied to PEPE with enormous leverage. Caveat emptor abounds here, of course. With no apparent there there, just degens and day traders moving the price up and down, this sure seems like the kind of speculative fervor that usually ends in tears – though dogecoin (DOGE), probably the most famous meme coin, is still around after so many years, so who knows.
CRYPTO LEGISLATION: One of the more ear-catching announcements at Consensus was U.S. Rep. Patrick McHenry saying a key congressional committee will have a proposal for crypto legislation in the near future. It's hard to be – sorry to overuse the word – optimistic about this, though. We've been down this road before, hoping the U.S. will bring some legislative clarity to the industry with not much to show for it. In the runup to the 2024 presidential election it's hard to imagine much bipartisan work getting done.
KILLER APP: Traditional financial (TradFi) firms have talked about and experimented with blockchains and crypto for many years, but the hoped-for intersection of those two distinct realms really hasn't happened. In the view of JPMorgan, though, the movement toward tokenizing real-world assets is a "killer app" for TradFi, and the bank is pressing forward into that realm, "largely undeterred by the crypto bear market and regulatory uncertainty," CoinDesk's Ian Allison reports.