13 Oct 2020

Eric's October Thoughts

Introducing our new article series: Each month, our own Eric Wall will share his thoughts on the market and what he’s looking at going forward. Eric is a part of the Arcane Research team and works as Chief Investment Officer.
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A second shot at governance tokens
One of the crucial things to be wary of are the circular dependencies underpinning the current DeFi token economy. These are indeed easy to observe. Ask yourself “what gives a governance token value?” and the answer is usually pretty simple: activity and usage within the protocol, and the ability for token holders to extract cashflows from that. Lately, we’ve seen hockey-stick-like charts for many protocols across the space, suggesting that we’ve only witnessed the cusp of an emerging industry.Now ask yourself “what caused the increased activity and usage for DeFi protocols across the space?” and the answer is more contrived; indeed, there’s been genuine uptake in DeFi, but in many cases, the predominant driver of growth has been the governance tokens issued to the users of the protocol—an effect of the “liquidity mining” mechanisms which recently became popularized to distribute governance tokens to users directly based on their activity. Not only is this dependency circular, but it is also the cause of a somewhat intended feedback loop. Token speculation drives usage, drives price, drives usage, drives price. At the crown of the spiral, what you’re left with (in the best case) is a protocol cleverly bootstrapped into a success—and in the worst case, a protocol where both the activity and the valuation is based on recursive hyperbole.  Now, the above observation is not one that has eluded DeFi analysts to any degree. What was theory six months ago is now observed history. What’s left for the industry to ponder on is whether these exact same circular dependencies which caused positive feedback loops on the run-up could cause negative feedback loops once they unravel. As governance token prices retrace, the incentive for users to engage with the protocol is subdued. As such, as usage de-escalates, governance tokens may follow further. Add to this that markets are inherently additive even without this mechanic circularity—greed triggers greed and panic triggers panic. Piling on, several popular DeFi tokens are tainted with rather daunting inflation schedules, meaning there’s overwhelming amounts of supply waiting to be unleashed on top of this unstable dynamic. In the same way we’ve seen overly optimistic valuations in the DeFi market, we may very well see overly pessimistic valuations as well. Patient investors who’ve been waiting at the sidelines could very well be served with a second chance to pick up distressed DeFi assets.
Layer 2 solutions bound to attract usage
There is one cryptocurrency trend that runs unabated of any market turbulence which I’ll be monitoring with a particular interest. Stablecoin usage has grown relentlessly each year since 2017 regardless of whether the cryptocurrency markets have been bullish or bearish. The majority (>2/3) of these stablecoins currently reside on the Ethereum mainnet, but it has become increasingly obvious that a substantial portion of these soon could migrate to Ethereum Layer 2s where fees are lower and the throughput is higher. Case in point: 52% of the donations during the recent Gitcoin Grant Round 7 were done through zkSync, predominantly in DAI-denominated transfers. Moreover, there’s a greater spectrum of transaction confirmation models to choose from in these upper layers, and transaction fees can often be paid directly in stablecoins instead of cryptocurrency. Some Layer 2s such as AZTEC (currently live on the Ropsten testnet) even usher Zcash-like privacy features. As much as the cryptocurrency industry is about cryptocurrencies and not dollars, the dollar is still the most important unit of account in the world. While inserting cryptocurrencies as a medium-of-exchange into ordinary people’s lives has proven difficult, cheaply-transferred privacy-preserving digital dollars that don’t require bank accounts or credit cards could become so appealing from a product-market fit perspective that it won’t be a matter bringing the product to the masses—the masses may literally rip the thing out of our hands once the groundwork has been laid. In my view, “privacy dollars” are one of the societal mega-trends that cryptocurrency networks are bound to give birth to, and they will reshape the entire payment infrastructure for cryptocurrency networks in their wake. Whichever Layer 2 solution that ends up becoming the rails for stablecoins will eventually begin to do the same for cryptocurrencies, settings standards and network effects today that will be too difficult to disembark from later. As with much of the current Ethereum landscape, some of these Layer 2 solutions have governance tokens. Whether you think this is good or bad is irrelevant—it means there is a potential financial reward at stake for those who are able to figure out which Layer 2 solutions will get traction.
Bitcoin – just hold
What is there to say about bitcoin? The asset is looking more bullish than ever. The corporate treasury narrative that has been brewing—MicroStrategy Incorporated recently acquiring some $425m worth of bitcoin and Square acquiring another $50m—is one of the most surefire signals of all time that bitcoin is maturing as an asset class ready for primetime. I won’t be on the lookout for anything in particular with regard to bitcoin, except perhaps to double-check that my cold-storage setup is secure and that my custodied bitcoin are insured.
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