Cryptocurrency may become a second-layer asset class built on fiat currency systems

Author: QCP Capital
Compiled by: Glendon Mao

In this article, we delve into the trends, innovations, and developments in the cryptocurrency space that will shape the future growth of the sector.

Are We in a Cryptocurrency Supercycle?

A side-by-side comparison of cryptocurrency with the NASDAQ market capitalization (at different times) suggests that we are in a supercycle.

Figure 1

Both markets follow similar developmental stages typically seen in supercycles.

Stage 1: Awareness and Initial Adoption (Slow Uptrend)

The disruptive potential of a new technology begins to ignite the market's imagination, leading to a subsequent boom where valuations rapidly inflate. For cryptocurrencies, this was the bull market of 2017, while for NASDAQ, it was the internet bull market of 2000.

Stage 2: Bubble Burst (Rapid Sell-off)

As asset prices fall back to pre-speculation levels, the bull market abruptly ends. For NASDAQ, this was the explosion of the internet bubble, while for cryptocurrencies, it was the crash of 2018.

Stage 3: Consolidation (Sideways Trading)

This is followed by a prolonged bear market or consolidation phase, causing many to overlook the asset class or sub-sectors, even though the market continues to develop.

Stage 4: Frenzy (Rapid Price Increase)

Substantial adoption of the technology quickly exposes valuation gaps. The market chases this gap, leading to a frenzy where prices soar more than five times above previous highs.

The main difference in the supercycle stages of these two markets is the duration: NASDAQ has spanned over 40 years, while cryptocurrency has been less than 6 years to date.

The acceleration phase may be a result of exponential growth in money supply and the unprecedented trading tools and leverage brought by digital assets. If this is the case, we should prepare for shorter and faster market boom/bust cycles in the future.

The Next Supercycle ------ Decentralized Finance (DeFi) and NFTs

The DeFi and NFT markets seem to have just begun their own initial awareness/adoption phase, with many still unaware of the opportunities within the ecosystem. As BTC matures into an investment asset (even with the advent of Tradfi ETFs), DeFi and NFTs are just getting started.

DeFi

Decentralized Finance (DeFi) currently has a total value locked (TVL) of $200 billion, spanning over 500 independent platforms. About half of the TVL flows into lending and decentralized trading protocols, totaling a TVL of $100 billion (Figure 2).

Decentralized exchanges are unique to cryptocurrencies, being non-custodial peer-to-peer exchanges that use automated market makers instead of order books.

Figure 2

Decentralized exchanges (DEX) and lending protocols are currently the main attractions of DeFi, but more innovative and increasingly practical protocols are making significant contributions to the ecosystem's development. These new innovative protocols include insurance, payment plans, derivatives trading, and other services, with many teams launching new protocols daily.

The increasing number of innovative projects directly leads to more TVL being attracted to the entire DeFi ecosystem. We expect DeFi to become a major growth pillar in the future cryptocurrency space, a sentiment echoed by Goldman Sachs.

NFTs

Between DeFi and NFTs, NFTs are relatively more unfamiliar as they blend art and technology. NFTs are unique single-issue tokens that prove a piece of digital media is one-of-a-kind and non-reproducible. Imagine that any digital file or media has a unique serial number (chain code) to guarantee its authenticity as part of a collectible or unique work.

For example, the Mona Lisa or any other priceless artwork. The Mona Lisa can be replicated by any capable artist, but it will never be the original. This is similar to digital artworks, which can be easily copied, but as NFTs, can be easily proven non-original by checking the blockchain. This gives them an advantage over artworks, as interested parties may have to go to great lengths to authenticate a piece with experts, which takes a lot of time. In cryptocurrency, you can simply check the blockchain in seconds.

However, unlike a simple canvas or marble block, NFTs can be programmed with functionality. They can serve as keys or access/permission codes for various functions. For example, the Bored Apes Yacht Club NFT also serves as a membership card for exclusive Bored Apes events.

Other examples of NFT utility include the "keys" issued to early liquidity providers of the young DeFi platform Gfarmv2. These keys are no longer being issued, but for existing holders, they can now increase their interest rates when staking on the platform. This has led to a secondary market developing around the ecosystem, where not only tokens can be traded, but also NFT keys from yield farmers (stakers) to other yield farmers.

Undoubtedly, as the NFT ecosystem continues to evolve, more innovative use cases will be developed, just as innovations have emerged with the growth of the DeFi space.

Is There a Bubble in NFTs, Will Prices Crash?

The wild price fluctuations of NFTs have been a source of excitement and speculation for many. The following section presents our views on NFT valuation.

The first logical question to ask is whether NFTs create scarcity.

Nansen's market-leading NFT tracker shows that there are currently 1,288 independent ETH collections on Opensea, with 700 created in the past month and 200 in the past week alone. This does not even include NFTs on other chains like Solana.

In each collection, the number of circulating NFTs can range from the usual thousands to as high as 2 million (Cryptokitties) or even 7 million (Gods Unchained Cards). The supply is entirely dependent on the decision of the project's original designers, and the manufactured scarcity is a well-known feature of many NFT projects.

In the past three months, the number of NFTs has grown exponentially, indicating that the speed at which "investable assets" can be created and traded in cryptocurrency is limitless.

In the past, any collectible, such as baseball trading cards, would have a complete production/distribution cycle to navigate before entering a very opaque secondary market. In contrast, for any NFT, there can be a primary auction in seconds, followed by secondary trading—all of which, including every transaction and live order, is completely transparent on the blockchain.

While most collectibles may be worthless, the total market capitalization of all Opensea ETH NFTs amounts to 5.8 million ETH ($19.8 billion). The top 30 collectibles alone account for 4.6 million ETH, valued at $15.7 billion.

The reason these CryptoArt NFTs can increase indefinitely is quite simple—by randomizing combinations of several basic attributes, any number of appearance traits can be generated using basic algorithms.

Cryptopunks, as NFT pioneers similar to BTC, may be worth the current average price of 123 ETH ($420,000). In fact, its value has held up better than any other collectible so far. The Bored Ape series is also noteworthy, with 107 pieces selling for $24.4 million at a Sotheby's auction, gaining recognition in the broader art world. Of course, there is also the successful blockchain game Axie Infinity. (Chart 3: Top Opensea ETH collectibles by market cap as of October 5 --- Nansen.ai)

Many analysts have tried to determine the ultimate value of creations through statistics, such as release dates or artists, but none of these have shown any correlation, reinforcing the view that it may all just be random. Undeniably, popularity and community are driving factors behind the price increases of collectibles, all of which boil down to the allure of culture and status. Many previously anonymous collectors have come forward to showcase their online collections.

Figure 3

The community plays a significant role in the price growth of collectibles. The Bored Ape NFT collection has created a prisoner’s dilemma among its holders, as many Bored Ape NFT holders collude to bid up the floor price, believing that other collectors will not actually sell. This is done to raise the floor price displayed on Opensea, which is highly beneficial for them.

Strong community ties and collaboration foster enthusiasm within the project's holder community. These holders begin to express themselves through their NFT avatars on platforms like Twitter, attracting the interest of those still outside the micro NFT community.

As enthusiasm grows, many find themselves wanting to purchase the project to be part of something greater. Coupled with existing users' strong reluctance to sell, this could drive the floor price higher. A good example is the Solana chain's Solana monkey business and its MonkeDao.

After all, this is an era of meme-flex-game, where for many, the virtual world often feels more real than the real world itself. The value of NFTs and almost all art lies solely in how much someone is willing to pay for it. By this logic, there is no logical upper limit to any art.

However, the current NFT art trend and the Play-to-Earn (P2E) trend bear a striking resemblance to the tulip mania phenomenon. Like all such bubbles, this story will ultimately evolve into an exponential distribution, with only a few top projects or series able to survive, just as 99% of ICOs disappeared during the 2018 ICO crash.

Yet not all prospects are bleak; the bursting of the NFT bubble will clear out junk projects and make everyday consumers wiser, similar to how the 2018 ICO craze enhanced the ecosystem.

The frenzy phase of CryptoArt and P2E will coincide with a paradigm shift, where people's daily lives become more intertwined with the metaverse. This will greatly benefit both markets.

For the entire NFT space, its frenzy phase will arrive when it finds itself embedded in everyone's daily life, with various real-world use cases ranging from proof of asset ownership to digital service certifications.

At the end of August, a new experiment surrounding the Doge meme NFT provided a glimpse into the immense long-term potential and broad impact that current NFT trends can offer the world, beyond just dazzling valuations.

PleasrDAO purchased the original Doge NFT meme image for 1,696 ETH ($5.5 million) and immediately divided it into nearly 17 billion NFT shares, supporting the same number of ERC-20 tokens called DOG—each person holding DOG tokens will own a small fraction of the original NFT. To some extent, this is a form of "asset-backed" security.

The market cap of DOG, or implied market cap of the original meme NFT, exceeded $225 million within days of its release. Setting aside the incredible valuation, this successful experiment has many use cases in the world of asset securitization. Such a thing could not have been imagined at any point in history—instant securitization and distribution.

Ultimately, the nuances of this field do not provide a simple answer to whether prices will crash. Our personal bet is on NFTs in P2E, and we are actively seeding upcoming games and guilds.

Cryptocurrency Valuation

The questions surrounding NFT valuation can broadly apply to general cryptocurrency assets. How exactly do we determine the fair value of coins and tokens?

In traditional markets related to the real economy, we can use various indicators related to the real economy itself to measure the extent of artificial inflation in asset prices.

For example, in stocks, by comparing the valuation of the S&P 500 index relative to U.S. GDP and M2, we can see how the overvaluation driven by quantitative easing (QE) 2, 3, and the latest Covid-driven QE 4 (to date) has inflated stock values relative to the real economy (Figure 4).

Based on this, it can be said that every round of QE after QE 1 has produced an incredible diminishing effect, but that is a completely different matter.

Figure 4

In contrast, there is nothing truly anchoring cryptocurrency assets beyond popularity and capital flows. This is both a blessing in a bull market (no upper limit to the upside) and a disaster in a bear market (the lower limit of asset prices quickly becomes non-existent).

The pricing and valuation of cryptocurrencies have little connection to the real economy. There is no reference point for fair value. Any number can be justified in some way. Are we all flying blind?

So How Should We Trade?

In the absence of valuation anchors, as long as one can remain flexible, cryptocurrencies may offer the most alpha opportunities of any asset class currently.

However, to navigate such a market in the long term, we tend to adopt some universal frameworks.

Ultimately, we expect that as broader utility is developed within the cryptocurrency space, there will be greater divergence in asset prices within cryptocurrencies.

To this day, BTC has been the leader of the overall macro trends in the cryptocurrency space. Even now, many tokens still exhibit a high correlation with BTC's price movements, making it the de facto market leader. Where BTC points, many others follow.

However, starting this year, we have begun to see a sharp decline in correlation as the market shifts towards thematic trading, which many long-term cryptocurrency natives like us have been hoping for (Figure 5).

Even when BTC declines or consolidates, many tokens have begun to perform well, indicating that the market is maturing and decoupling from blindly following BTC trends.

Figure 5

Our Long-Term Framework:

1. Global M2 (money supply) must increase for us to see widespread macro asset price appreciation (bull market cycle). The only two periods since 2017 when BTC has been in consolidation were periods of stagnation in global M2 (Figure 6—red box and M2 stagnation during Covid (red line)).

Despite the daily noise in the headlines, it ultimately comes down to M2 expansion/contraction driving the larger trends.

Figure 6

2. Since 2017, comparing BTC with the S&P 500 index shows that they are beating the same drum, just with different rhythms (Figure 7).

Figure 7

BTC, with its higher β value and sensitivity, peaked 9 months earlier than the S&P index in both previous instances (yellow line BTC peak vs. red line S&P 500 index peak), but both always bottomed simultaneously against the backdrop of global liquidity injections (green line).

This different performance of macro assets reflects the β value of M2 expansion/contraction, where high β value assets are more sensitive to global liquidity conditions.

The speed, magnitude, and lead/lag time of global liquidity injections/extractions all depend on this. The reasons for different beta coefficients (β coefficients) vary—related to asset liquidity, risk conditions, and the supercycle phase of the asset.

3. Ultimately, demand and supply drive asset prices, just like anything else in the economy.

While the expanding M2 can provide sustained demand, to generate positive real returns in the long term, it needs to be combined with a fixed (maximum) supply or, better yet, a deflationary supply compared to fiat currency. This gives us the holy grail of investing—scarcity.

a. Bitcoin's halving mechanism is widely understood as reducing its supply inflation until it ultimately becomes fixed. Considering lost tokens and dormant wallets, the fixed supply can thus be seen as effectively mild deflationary, as many tokens are inaccessible and can be considered lost in the general market.

b. With the implementation of EIP-1559 in August and the transition to ETH 2.0 sometime next year, the major hallmark change for ETH means that due to its newly implemented burning mechanism, ETH will soon have a thoroughly deflationary supply.

Assuming an average gas price of 50 Gwei and the anticipated implementation date of ETH 2.0 by the end of Q1, the supply of ETH will peak at around 119.4 million ETH on the ETH 2.0 release date, after which the total supply will begin to contract (Figure 8).

This sharply contrasts with the previously unlimited supply in the old proof-of-work structure, which was on par with fiat currency in terms of supply dynamics. Of course, the implementation date of ETH 2.0 will be an event that could potentially alter this timeline.

Figure 8

c. Additionally, despite recent high-profile promotions, the current form of Doge, with its unlimited supply, is unlikely to serve as a good long-term store of value (SOV).

Vitalik's joining as an advisor indeed brings hope, and perhaps changing Doge's tokenomics is on the agenda. Or perhaps Doge's intent is to create a pseudo-fiat digital currency that can continuously expand its supply, but it is not intended as SOV; rather, it is developed as a widely accepted medium of exchange.

In contrast, due to Bitcoin's design, it is less likely to become a widely used medium of exchange in its current form, although many South American socialists may wish it to be so. However, if Doge's transaction speed can be accelerated to match that of new tokens (like SOL or ALGO), then with sufficient support from a strong community, Doge may achieve this goal in the future.

Overall, we are structurally bullish on BTC, ETH, and most first layers like ALGO and SOL. Our short-term trading focuses on the inefficiencies of the options and forward curves of these coins. As crypto trading becomes increasingly institutionalized, derivatives are the area where we see scalable alpha, similar to the stock, bond, and forex markets decades ago.

Cryptocurrency as a Second-Layer Solution to Fiat's First-Layer Problems

In the decentralized ecosystem of cryptocurrencies, the definition of the first layer refers to the underlying blockchain layers, such as Bitcoin, Ethereum, Polkadot, Solana, Algorand, etc. The second layer refers to networks and protocols built on top of the underlying first-layer blockchains, significantly enhancing the scalability and efficiency of the entire layer.

The concept of layers can be simply broken down: the first layer serves as the foundation, while the second layer consists of free services built on top of the first layer. In other industries, one could say that the internet is the first layer (protocol layer), and Google is the second layer, which is a service built on the internet that helps users navigate it more easily.

In the macroeconomic world we live in, there are similarities to the cryptocurrency first-layer/second-layer structure. Our current fiat-based monetary system represents the fundamental first layer, while future cryptocurrencies will become the first second-layer asset class built and expanded on top of the fiat first layer.

This means that the foundation on which cryptocurrencies rely is the traditional monetary system, while cryptocurrencies as a second layer will help make it easier for everyday people to grasp. This is because cryptocurrencies eliminate many intermediaries in traditional finance. One of the reasons El Salvador designated Bitcoin as legal tender is that it helps eliminate intermediaries like Western Union, thus removing additional costs for Salvadorans.

We view the current fiat-based currency exchange rate system as the first layer, as every commodity, service, and asset in the global economy is merely a derivative of it. The quantity of first-layer expansion (M2) will affect the prices of everything—especially all asset prices.

For the following reasons, cryptocurrencies will serve as a second layer:

• The ability to create value on a large scale through verified token inflation multipliers.

• The use of cryptocurrencies will ultimately extend to all sectors of the real economy, allowing everyone to access the cryptocurrency ecosystem. Covid has become a catalyst, undoubtedly solidifying this irreversible shift.

The first layer is the fiat-based foundational layer, and then most innovations subsequently develop into the second layer—the decentralized/crypto ecosystem.

Cryptocurrencies have many value propositions, not just as mainstream alternative stores of value (SOV) or as a recognized medium of exchange; there are also applications related to the mass democratization of finance or art, culture, sports, and everyday functionalities.

Fortunately, we are still in the early stages of cryptocurrencies evolving into the economic second layer, and it can now be said that BTC is merely becoming the mainstream SOV.

If our vision of cryptocurrencies developing into the economic second layer comes true, then undoubtedly, the total market capitalization of cryptocurrencies will further grow exponentially.

How much of the total global M2 will actually flow through the second layer? We are still debating this question. But for assets with fixed or decreasing supply in the second layer, price appreciation will be inevitable.

We are often asked whether we think it is too late to invest in or enter cryptocurrencies, whether prices have risen too much, and whether the boat has already sailed. As the crypto ecosystem continues to evolve into applications and interaction layers built on top of fiat systems, our view is that this is just the beginning.