A Token Market or a Market of Tokens?

Value investors in equities have long bemoaned that easy money and the longest credit expansion in US history has turned the stock market into one highly-correlated glob of stocks focused almost solely on Fed policy. Highly accommodating Fed: Risk on. Fed trending Hawkish: Risk off. And for a long time it’s been a risk on trade. But each stock is different, and its idiosyncratic nature should cause it to fluctuate in its own space based on perceived visions of its future value.

Historically, Bitcoin has led markets, higher and lower. It feels that recently, however, there have been several sector themes that have dominated for extended periods. For example, DeFi was the market darling in late 2020/early 2021, after which there followed a long decline. In the search for alpha in digital asset markets, therefore, we have found we need to quickly identify momentum shifts between “crypto sectors” when we allocate to the most promising tokens.

Will Bitcoin Drive Markets?

For many years the crypto markets have been led by the big token on the block, Bitcoin. When Bitcoin crashes, so, historically, have all tokens. Yet Bitcoin usually corrects less on the downside after rising less in the previous cycle.

A typical example is in mid 2018. BTC lagged the other high market cap coins in the month before the correction but then fell less over the next 7.5 weeks.

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Generally we need a BTC bull to ignite other bull markets. BTC and ETH, for example, were highly correlated in the medium term throughout 2020. In such cases, diversification is a meaningless exercise. If everything goes down by the same amount, or more, than Bitcoin, there’s very little risk mitigation value in holding multiple assets.

Very high correlations are not always the case, however. Chainlink’s LINK token, for example, outperformed the crypto markets during the bear of 2018-19.

May 2021 was also a (slight) exception to the norm in that BTC had grossly underperformed DeFi and other layer 1s in the months leading up to the correction. Yet the correction affected BTC the least, as per usual.

Since May, however, we have seen several sets of price leaders begin to rise and fall of their own accord. Could it be that the digital asset markets are maturing? Is sector rotation about to become a thing?

We figure that Bitcoin macro speculation won’t drive the increasingly diversified digital asset markets that now cover so many sectors: gaming, collectibles, decentralized web storage, permissionless social media, and new financial primitives such as real world asset tokenization and decentralized options trading.

New Themes in Digital Assets

There can be no doubt that certain themes (memes?) have moved in and out of favor lately. Axie Infinity's successes stoked a rally in gaming and metaverse tokens. Then incentive announcements pulled challenger layer 1 blockchains, and select tokens within these ecosystems, higher.

Most recently we have seen big moves in “DeFi 2.0”, both up and down: OlympusDao and its copycats, new and improved stable protocols such as Abracadabra, and riskier money markets such as Rari. The promise of improved ponzinomics resulting from better management of incentive pools has sparked a renewed interest in DeFi.

The resurgence of DeFi comes not a moment too soon. A spark was definitely needed. Indeed, DeFi is a perfect example of a long-term trend that does not appear related to the dominant cryptocurrencies – layer 1s such as ETH, BTC, ADA and SOL.

There are a number of ways to discern trends and change in interdependencies. Another time we’ll show how measuring return correlations is the worst. For now we’ll just look at ratios of token prices.

DeFi 1.0

Our first trend to watch has to be DeFi (1.0). In terms of ETH (or BTC), the top DeFI tokens by market cap have vastly underperformed. In the last 90 days, it’s a sea of Red versus ETH:

But DeFi performance has been even worse over the long term. Using the DeFi Pulse Index, which covers 9 out of the 15 protocols with the highest market cap and 14 overall, ETH was the much better investment:

Ethereum DeFi TVL denominated in ETH has actually been stagnant for some time:

Ethereum TVL in ETH terms. Source: DeFi Llama

Is it any wonder that DeFi needs a re-branding? In ETH terms, the top Ethereum-based DeFi protocols are down 73% from September 2020 and 69% from the all-time high (ATH) in April. Even in US dollar terms, recent performance is not much better, with a drop of 50% from ATHs. In fact, in ETH terms, the best time to get into DeFi 1.0, on average, was never. Airdropped and farmed tokens generally should have been sold when earned.

DeFi 1.0’s troubles are the result of a fundamental problem with tokenomics: Most of the dominant protocols have issued tokens that don’t have an obvious value accrual mechanism. Uniswap has a fee that could go to tokenholders but is not turned on, and governance could allocate a portion of its treasury to whomever they like. However, the protocol currently has no way of supporting the token. Some tokens, like SUSHI and CRV, do provide cash flows to staked holders, but issuance continues to reward users of their protocols. As a result the P/E ratios of high-incentivized protocols such as Curve or Alpha are ridiculous.

Some of those earning tokens may hold, but many sell them as they are received. This can put obvious pressure on prices. CRV is a great example of this. Alpha Homora is not much better.

It all comes down to over-issuance to buy users of the protocol and providers for the token. ALPHA for example has almost tripled its float in eight months, holding on to total value locked through incentives.

DPI does not tell the whole DeFI story, of course. For example, DeFi on many chains is ignored. Many smaller yet successful protocols are also not included and may have done better. New protocols, who might be more innovative, are also ignored.

Nevertheless, at Hartmann Capital we eschew the incentive tokens on Ethereum with little to no value accrual and inflationary ponzinomics, and have been over-allocated to DeFi on other chains (see below) and what is now known as DeFi 2.0 (more of which later) since the May correction.

Layer 1s

It’s easy to see from the Messari chart that Solana DeFi has done well recently. This, then, is a second trend to highlight: Non-Ethereum layer 1s and ecosystem protocol tokens have had their own run of late.

Gas prices on Ethereum have spiked to unusable levels recently, due to general network congestion and the occasional rush to mint NFTs. This has coincided with a mad rush for users and devs on challenger layer 1s. TVL has exploded with use cases and incentives:

We’ve often spoken about the long-term prospects of Terra and Solana, but other layer 1s have also woken up this year. Many had languished for many years.

The most intense rally in layer 1s occurred as ETH was flat.

Investing in layer 1s as a sector makes a little bit less sense than selling DeFi 1.0. Some players in the sector are sure winners in a multichain world. Some look like they will survive, and even thrive, while the jury is out on others. Hartmann Capital was long Solana and Terra ecosystems for their fundamentals, but jumped on other challengers as the sector rotation to the likes of FTM and Harmony (ONE) played out in September.

We are watching for signs that the momentum is fading, or if rotation might occur from the past winners (in TVL and/or price terms, e.g. AVAX) to new candidates (e.g. Celo). LUNA and SOL, and many of their ecosystem tokens, however, are not for sale!

One promising candidate is Cosmos. Cosmos bridging looks to connect the ecosystems of an array of specialist chains, including Secret Network, Terra and Injective. As we’ve mentioned previously, all that is left is for Cosmos’s ATOM tokenomics to improve.

Axie Infinity and the metaverse

Sometimes, sector analysis can obfuscate real value creation. Indeed, there are few protocols that shrugged off the May correction with as much grace as Axie Infinity, even as the broader sector did not perform as well. The May price action in Axie’s AXS token was a mere bump on the road to 10x since then.

Axie’s success as a play to earn (P2E) game has spawned an entire ecosystem around it, including Yield Guild Games and Merit, while launching an arms race for the next on-chain game successes. However, even Axie couldn’t save the so-called metaverse sector of games, collectibles, virtual worlds and miscellaneous other services, however. This time.

The underperformance of the metaverse overall is a great example of how choosing the sector is not always enough: The idiosyncratic success originates from one protocol (or two). Illuvium has done well. Decentraland has not.

As regards fundraising, it’s a split market, with games dominating Q3 and marketplaces lagging. One quarter of all money raised went to gaming.

There are two problems with thinking in terms of sector rotation for the metaverse. The first that is absolutely unclear what the metaverse is, never mind what it will become. For certain virtual worlds are part of the metaverse. Games and collectables perhaps also qualify.

Hartmann Capital believes in the long term potential of the Metaverse, but it is worth remembering that these are early days.

Very simple card games like Gods Unchained and Axie are fairly straightforward on chain, but Axie still took four years to get to where it is today. More complex games will take years. The founder of Star Atlas expects the final game to take 5 to 7 years. According to Keiran of Illuvium, a AAA game can take as long as eight years. On the other hand, investor and player expectations remain high for the space. As we wrote just last week:

….a16z’s Arianna Simpson predicted this gaming revolution would arrive in months, not years. And TAM is “everyone”, so billions of potential users. At one Mainnet panel, Axie’s founder Sky Mavis’s Jeff Zirlin and Yield Guild Games’ Beryl Li believed that P2E would 10x the number of users in crypto, in short order.

Disappointment will almost certainly affect sentiment along the long runway to MVPs for high-quality P2E games. Virtual worlds are also underwhelming to date, but that doesn’t mean there isn’t potential.

Without momentum, investors must be picky. While Axie’s success seems obvious in hindsight. A Bankless panel of leading founders in the crypto gaming space believe we will see a lot of attempts crash and burn, and that it will be years before we will truly know who the winners are.

Kieran from P2E crypto game Illuvium and others believe that the metaverse will be more popular than DeFi in the medium term, reaching billions of gamers, but that we’re in for a long wait. Source: Bankless — **Kieran from P2E crypto game Illuvium and others believe that the metaverse will be more popular than DeFi in the medium term, reaching billions of gamers, but that we’re in for a long wait.** Source: Bankless

Rather than play the momentum in a heterogeneous space, Hartmann has chosen to make a select few long term investments in the most promising P2E ecosystems and in a few other subsectors. Vulcan Forged is the latest investment we have made in the space (more on that next week). When the momentum swings back to P2E, we will be well positioned.

DeFi 2.0

Most of crypto twitter is asking what DeFi 2.0 is. The short answer is that it’s simply not the “old” DeFi that has underperformed by two-thirds or more since the ATHs of April. The longer answer is that DeFi 2.0 is just the newest DeFi protocols, some of which have improved capital efficiency, better tokenomics, protocol cooperation (e.g. OlympusPro and Terra/Abracadabra) and exist across chains.

A full treatment of the topic will have to wait for another time. Needless to say, we welcome the improvements in tokenomics – paying less for users and liquidity through token inflation – that have arrived under the leadership of OlympusDAO. Protocol-owned liquidity can reduce the token inflation required to incentivize liquidity providers. Other new trends such as inter-chain and inter-protocol composability/cooperation are also to be welcomed.

On the other hand, some of DeFi 2.0 is simply riskier DeFi. Maker and Compound survived in bear markets with massive corrections because they were ultra-conservative. With less volatility and less patient capital, it isn’t surprising to see more risk being demanded. Some protocols are happy to oblige. The most popular Rari Fuse pools, for example, have failing safety grades (F and D) under their own signalling system, for example.

Abracadabra.money is the new MakerDAO, extending credit to allow leveraged yield farming, and crossing chain faster than the others.

The protocol’s USD-pegged stablecoin is quickly catching its competitors, approaching Terra USD (UST) in market cap. It remains to be seen if the protocol is as solid as the battle-tested MakerDAO, however.

OlympusDAO’s OHM can only work in the medium term if almost everyone bonds and/or stakes (hence the 3,3 from prisoner’s dilemma) and nobody sells. The slightest hint of the end of the Ponzi could be deadly in the meantime. Overnight price action in OHM just today provided an indication of how quickly sentiment can affect prices. On the other hand, we are not about to bet against the OlympusDAO community’s resolve, and prices have only returned to where they were two weeks ago (not counting staking rewards).

While DeFi 2.0 can be identified as a real sea change in many aspects of decentralized finance tokenomics and product design, it is not a get out of jail free card for protocols who lack strong leadership, vibrant communities, positive tokenomics and a product in demand.

Yet the theme of less ponzinomics and cross-chain interoperability has caused this new generation of DeFI to diverge from the previous one, at least in the near term.

Protocol-owned liquidity and seamless multi-chain experiences cannot be the only value drivers. Tokenomics need to be driven by real value-added. We see real value in Rari (RGT), 88mph (MPH) and Abracadabra (SPELL). All are cross-chain. None have protocol-owned liquidity. Yet.

DWeb

It wouldn’t be a Hartmann Capital blog without a mention of the DWeb (Web 3.0). The DWeb, like the metaverse, should be able to escape the influence of Bitcoin and Ethereum as the sector matures.The global adoption of censorship-resistant storage, decentralized streaming and permissionless social media should be little-affected by the whims of crypto speculators.

Final Thoughts

As maxis know, just being long BTC and/or ETH has been a winning trade in USD for many years, and much of crypto outside of the two heavyweights can be a distraction. How many NFT PFPs do we need? How many layer 1s? We counted twelve protocols that offer fixed rates on vaults on Ethereum, alone. Do we need Pendle, APWine, BarnBridge, 88mph, Swivel and Element all doing the same thing? Probably not.

But while there is a lot of noise in crypto, there also is a lot of potential. Will BTC 10x this year? Maybe with hyperinflation. Yet USD hyperinflation is extremely unlikely. Will ETH 10x? Ah it might. But it is the new new thing that has the opportunity to 10,000x, a la Axie Infinity.

We are setting up to profit from the next Axies in the metaverse and are fully onside with innovation in DeFi and the momentum it has brought over the last few weeks.

Hartmann Capital is focused on what sectors have the opportunity to shrug off weaknesses in the seasoned token markets, and even potential stagnation in BTC. Previously we have highlighted our conviction in gaming/metaverse (is Vulcan Forged the new Axie?), the best of the best multi-chain ecosystems (especially on Terra, Secret and Solana) and tokens, and innovative DWeb competitors (e.g Arweave). We’ve recently added to our DeFi 2.0 positions in MPH, SPELL and RGT.

It’s been a long time since the crypto thesis was just about hard money and even longer since it was about payments. Ethereum’s virtual machine made smart contracts possible. At first, the usage was confined to financing crypto token speculation (DeFi). DeFi 1.0 therefore was inextricably linked to the tokens themselves: bear and bull.

DWeb growth will be a function of its superiority over Web 2.0. Does this have anything to do with hard money and the BTC thesis? Should game popularity be dependent on tokenholders willingness to leverage ETH in bull markets (as in DeFi 1.0)? No.

But it’s worth keeping in mind that sentiment can change rapidly even after a long trend has played out, and investing against the popular view can be extremely popular. But sector rotation is likely to become more important in crypto markets as they mature. We are therefore always on the lookout for the next hot sector with the same intensity as the next winning protocol.

In the next bear market for BTC, we expect there will still be winners.

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