A review of what happened in the crypto markets over the past quarter – enriched with institutional research on key industry topics in collaboration with Swiss digital asset specialist 21Shares AG.
2020 was categorized as the emergence of Ethereum based DeFi infrastructures such as Uniswap, Yearn, Compound, and curve. These projects are now considered DeFi blue chips. They have democratized access to the market making business and disrupted the supply side of stock exchanges. On the flip side, summer 2021 was defined by a paradigm shift for first-time crypto investors. The prevalent retail investor would in the past buy mainly Bitcoin and Ether on centralized exchanges and store the assets on hardware wallets like Ledger or Trezor. This has changed dramatically.
NFTs: The next narrative for Ethereum
However, the explosive resurgence and recognition of crypto-native art collections and games (NFTs) have given a new face to this industry and attracted new cohorts of builders such as illustrators, musicians, game developers, photographers, and 3D artists. New exciting integrations and marketplaces came out these past three months, such as Fractional unlocking access to the most expensive NFTs by allowing owners to sell a fraction of their piece of art at a relatively more affordable price. In addition, Tik Tok released a creator-focused NFT collection available on Immutable X, a marketplace where creators will record some of their best videos available for sale to their fanbase – onboarding billions of users to the NFT world. Proceeds will essentially go directly to the creators and NFT artists involved, providing TikTok and NFT fans with a way to show support to the creators they love.
On the demand side, the buying pressure for Ether has been second to none, pushed forward by newcomers snipping NFT collections made of avatars portrayed in profile pictures like Bored Apes or participating in play-to-earn games like Axie Infinity. This resulted in NFT marketplaces experiencing enormous month-over-month growth in trading volume, increasing by more than 900% from July to August to reach an all-time high of over $3 billion alone in August from slightly over $300 million in July. The third quarter ended with the second-highest dollar amount in volume with $2.8 in total.
The real spotlight shone on the spectacular growth of an NFT-gaming project similar to Pokemon, called Axie Infinity – generating over $800 million in revenue over the last 90 days. This is 3x greater than Opensea’s revenue in the same time frame. The AXS token experienced a growth of 110% in the week of September 28, putting the company at a higher market cap valuation than established gaming companies such as Ubisoft and T2. The blockchain game also enjoyed the highest volume within the growing sector by reaching $2.25B in token sales since inception. What prompted the rally was the news surrounding the plans to airdrop AXS worth $60M to early adopters and the launch of a staking service that locked 29% of the circulating supply into the staking smart contract.
Besides art, media, and gaming, the imminent use case for the NFT sector will undoubtedly be music. NFT music will reduce the barriers between artists and their fans. For example, 3LAU, the American DJ and electronic dance music producer, launched Royal – a platform for fans to invest in their favourite musicians and share their potential success by owning a piece of an artist’s work through royalties. This will be a game-changer. Ownership is certified on-chain, removing gatekeepers and resulting in lower rent-seeking costs for artists. Until now, only record labels and agents had this privilege.
Ethereum competitors on the spotlight
This stratospheric demand put Ethereum as a victim of its unmatched success reflected in relatively high gas fees driven by increasingly more sophisticated market-order attacks and manipulation, called maximum extractable value (MEV). In a nutshell, the concept of MEV describes bots attempting to front-run users by mimicking lucrative transactions and bidding higher transaction fees to get their arbitrage opportunity prioritized on the Ethereum network by miners. Market friction has formed a strong narrative in favour of Ethereum competitors and driven developers to learn and build on other networks with value propositions zeroed in on higher throughput and lower transaction costs than Ethereum. These networks include Solana, Avalanche, Fantom, and more.
Solana has been the fastest growing chain to reach the $1 billion mark in total value locked (TVL) in just 95 days, in comparison it took 140 days for Fantom, and 199 days for Avalanche. However, comparing the identical TVL amounts of these networks against Ethereum indicates that these networks are possibly undervalued. For instance, Fantom, with over $1 billion in TVL is valued at $3 billion, while Ethereum had an equivalent market cap of about $25.5 billion in June 2020 with the same TVL.
It is important to note that these blockchains are relatively more centralized and less secure than Ethereum as they have fewer validators and staked capital allocated to secure the network. However, many see the road to decentralization and security as a marathon, not a sprint. So we can expect this infrastructure to not happen overnight. The 17-hour Solana outage, which occurred on September 14 was caused by trading bots and a demonstration of how early in their development stage these Ethereum competitors are. Battle-testing during the development phase is, therefore, more critical than the theoretically superior processing capabilities of a blockchain. 50,000 transactions per second are evidently not enough for the Solana network to onboard over a billion users.
Clones of DeFi applications
Most services built on Ethereum alternatives are predominantly clones or variations of Ethereum’s native applications. These include decentralized exchanges, yield aggregators, and lending platforms. Many also implement the same playbook to incentivize capital inflow through incentivised yields via liquidity mining programs and airdrops. For example, Fantom, Avalanche, and Celo allocated hundreds of millions of dollars to liquidity schemes to lure users from Ethereum last quarter. Fantom hopes to attract ecosystem builders beyond DeFi, while Celo provides wider DeFi accessibility tailored for mobile users.
Terra enjoyed its most significant network upgrade to date with the deployment of the Colombus-5; it will initiate Cosmos’ Inter-blockchain-communication (IBC) standard after a community vote. IBC allows for interoperability and transfer of assets between blockchains. Another monumental change pertains to the tokenomics of LUNA, as the token will now be directly burnt as a result of minting UST, instead of sending it to the community pool.
The migration of capital to networks outside Ethereum has led to the unprecedented adoption and growth in total value locked (TVL) or the assets under management (AuM) held by decentralized financial services applications built on Ethereum alternatives. One concern is that these liquidity schemes do not foster long term user traction and engagement. Forensic studies led by Nansen indicate that nearly 60% of the user base of these applications take their capital out for other investment opportunities within 48 hours as the rewards drop. This also creates selling pressure for the newly awarded tokens, which may lack vesting schedules.
Largest hacks in DeFi history
The DeFi sector is not immune to hacks – particularly when it comes to unaudited code. The third quarter represented the highest dollar amount of hacks in history, accounting for $886 million, predominantly from unaudited protocols. This is a reminder that DeFi is still early in the adoption lifecycle, similar to the early years of crypto exchanges back in 2011. More importantly, projects need to strengthen their security practices, such as launching bug bounties and battle test their products in real-world conditions for an extended period. This mind-blowing figure is 2.7x greater than the previous year’s high of $319 million in Q2. According to Rekt, $1.3 billion has been stolen in 2021 alone.
The largest hack to date, costing investors $600 million, was an attack on Poly Network, an interoperability network for trading assets. The silver lining is that blockchains’ flow of funds is transparent and therefore easy for law enforcement agencies and the community to track and identify the digital trail of attackers. The support of the crypto community has been essential, and as a matter of fact, in many cases, hackers often returned a portion of the stolen funds.
At 21Shares, our thesis is that the next generation of crypto services should be less about copycats or derivatives of Ethereum-based apps and more focused on financial inclusion, mission-driven products and services, fair launches, protection from scams, hacks, and MEV in the coming year. On the application layer, although the pace of innovation has been unprecedented, few have crossed this chasm. One good example is Flashbots. The latter launched a tool called Flashbots Protect to protect daily users from frontrunning, similar to dark pools in traditional finance. In the same vein, KlimaDAO might embody the paradigm shift where blockchain technology and DeFi can play a part in climate change solutions. The project has built a novel currency, Klima, with its own treasury designed to sustainably capture real-world carbon offsets. The currency is backed 1:1 with at least 1 tonne of carbon dioxide mitigated or removed.
China Ban: Largest product-market fit for DeFi
On September 24, the People’s Bank of China (PBoC) issued a circular stating that cryptocurrency-related transactions and venues are deemed illegal activities in mainland China. Overseas crypto services were also prohibited from serving China-based users. A handful of crypto exchanges and other services took drastic measures in response to this new regulation.
- Mining pool service, StarkPool will shut down its operations
- Crypto exchanges, Binance and Huobi will prohibit access to Chinese users
- E-commerce giant, Alibaba, will ban the sale of crypto mining machines on its site.
We are expecting more crypto services to prohibit access to Chinese users. Crypto exchanges will undoubtedly remove China from their geographic range of services. The list of blacklisted locations is usually composed of North Korea, Iran, and even the United States – in a discovery conducted by 21Shares’ research team last year. We also predicted a firewall on crypto services upon learning this announcement.
The crackdown on crypto venues represents the most important promotion for DeFi and scalability solutions which helps onboard users with a better user experience with low transaction costs. We are already seeing capital inflows to DeFi applications reaching all-time high daily trading volumes, such as dYdX – a derivatives platform built on StarkEX, a scaling application.
The underperforming crypto assets in the top 15 market cap were Polkadot and Cosmos; both are interoperability protocols whose investment case has not fully resonated with investors. Our research team believes the narrative will shift as Ethereum competitors continue to grow and the need for blockchain interoperability starts to rise – we expect to see this soon, especially when Polkadot becomes fully functional with Parachains.
Parachains are also dubbed Layer 1s (L1), in other words, blockchains like Bitcoin and Ethereum or Solana can be implemented in the Polkadot platform to become interoperable with one another thanks to Relay Chains. The Polkadot design requires these parachains to win an auction to operate in the Polkadot ecosystem via a community vote called crowd loans. The Polkadot token, DOT, will serve as the currency the community uses to vote for a given Parachain to win an auction.
Most of those auctions have previously been launched on Kusama, the testnet of the Polkadot blockchain to battle test real-world conditions prior to implementing them on Polkadot. Millions of dollars have been raised via crowd loans on Kusama, here is the list of auctions. At 21Shares, we anticipate the same pattern once the community votes yes to launch parachains on Polkadot next month.
In the meantime, as interoperability platforms have yet to launch, scalability solutions dubbed L2s such as StarkEX, Arbitrum and Optimism have been flourishing – increasing by 592% in Q3 overall with TVL estimated at $2.5 billion. The outlier of this category has been Arbitrum with an extraordinary growth rate of 1,547,253.8% from just $92K in TVL on June 30th to over $1B by the end of Q3. It’s likely that scalability solutions will keep up with this rate of adoption as more applications get integrated and these solutions improve over time with upgrades, optimisations in tandem with greater adoption.
In a nutshell, these Layer 2 blockchains (L2s) bundle transactions and settle them on the Ethereum network at a later point in time. This technique removes the computation and storage required out of Ethereum – increasing the capacity up to 20,000 transactions per second for a few cents in fees compared to over $30 on Ethereum. Right now, Ethereum’s throughput for complex transactions in DeFi is limited to 15 transactions per second. In simple terms, Ethereum is like the Fedwire settling commercial banks’ transactions while L2s are the commercial banks offering consumer-facing services.
All in all, this is great news for the whole crypto industry and the DeFi infrastructure. This would mean that over In the coming year, we’ll witness greater interoperability across blockchains, not only those that are necessarily compatible with Ethereum. This will improve user experience by orders of magnitude and unlock the next generation of internet services that are already budding in financial services (DeFi) and media, art and games (NFTs).