Market View
Crypto markets are holding up well despite the liquidity interference from US holidays and corporate month-end (and quarter-end) rebalancing. US dollar demand often picks up around this time of the month / year. Tax season still looms as a potential catalyst for realized profit-taking in the near term, too. Moreover, we think speculators playing the short MicroStrategy (MSTR) vs long bitcoin trade may be contributing to some of the recent market volatility. On the other hand, a lot of the headwinds we identified earlier this month are now in the rear-view mirror, and looking ahead, the setup for 2Q24 appears more conducive for crypto performance, in our view. That said, we think those positive factors may only manifest themselves more clearly starting in the second half of April.
For example, the impending Bitcoin Halving (estimated sometime between April 16-20) remains the big event to watch from the supply side, which we’ve covered in-depth here. But on the demand side, the 90-day review period that many wirehouses employ when conducting due diligence on new financial offerings - like spot bitcoin ETFs - could conclude as early as April 10. That is, it’s customary for large broker-dealers to undertake rigorous 360-degree evaluations before permitting wealth advisors to allocate client assets. Their assessments thoroughly examine (1) whether such products satisfy investment minimums and liquidity thresholds as well as (2) whether the requisite daily trading, custodial and regulatory reporting activities impose any insurmountable operational challenges to their existing infrastructure.
That said, wirehouses like Morgan Stanley, Bank of America, UBS and Goldman Sachs are not the only gatekeepers of wealth here. Some major wealth management platforms operating in the US exist outside of these large financial conglomerates. While three months is the typical (and stated) observation period for money managers like LPL Financial, some have shorter and longer windows as well. We think this could yet unlock significant capital for US-based spot bitcoin ETFs over the medium term.
Meanwhile, it seems like institutional interest in this space remains elevated based on the level of leveraged short positions in CME bitcoin futures, which has climbed to a record high of 19,917 contracts as of March 19, based on the latest CFTC data. That compares to total open interest on CME bitcoin futures of 33,196 contracts or $10.5B (as of that date). We use leveraged funds’ net short position in CME bitcoin futures as a proxy for bitcoin basis trading activity, akin to what the Bank for International Settlements (BIS) cites as its proxy for basis trading activity in US Treasury futures. Many institutions who do not have direct access to crypto spot often use this spread to gain long bitcoin exposure. Interestingly, the basis (30 days) between bitcoin spot and CME futures has averaged around 16% annualized in March, only up slightly from the 14% average in February, but inside the margins of profitability for many market players despite the capital requirements for this trade.
Onchain: Dawn of the Derivatives
Separately, the increased availability of high throughput and low-cost blockspace (following a heavy focus on infrastructure building throughout the bear market) has enabled new forms of onchain products. This has materialized in the onchain derivatives space where the total value locked (TVL) has reached new all time highs at $3.4B, even as the broader DeFi TVL remains approximately 50% off of its previous cycle highs. This is particularly noteworthy considering the collateral deposited into these protocols are typically constrained to major L1 tokens and stablecoins.
The use of central limit order book (CLOBs) in many of these derivative protocols is a direct consequence of cheaper blockspace, as it allows for the rapid creation and cancellation of orders at minimal costs. This is critical for enabling liquid exchanges via more traditional market making strategies. In fact, one of the original design considerations for the early automated market makers (AMMs) was that provisioning liquidity via order books was not only too costly, but also generally infeasible given the long, discrete block intervals and transaction ordering uncertainty.
CLOBs typically have the advantage of being more capital efficient than AMMs when measuring trading volumes relative to TVL. For example, GMX and dYdX, the two leading derivatives protocols by TVL, have similar levels of aggregated TVL across their versions according to DeFiLlama ($610M and $520M respectively). However, dYdX does more than 20 times the volume of GMX (~$5B versus ~$200M weekly) on a similar capital base. In part, the discrepancy of capital efficiency is because GMX leverages underlying AMMs for liquidity, while dYdX runs on a CLOB. This allows for reduced price impact and slippage as well as potentially lower fees.
That said, trading volumes have a propensity to be distorted in the short-term due to trading incentives like point and airdrop farming, temporary fee reductions, and broader market volatility. Furthermore, with many of the CLOB architectures, it can be difficult to separate market maker activity from organic trading. Thus, we think TVL growth is a clearer symbol of sticky early stage interest in protocols, though volumes and revenues will ultimately determine a protocol’s longer term success.
From the perspective of TVL, derivative protocols in this cycle are far more diversified than the previous cycle. At the former TVL peaks in 2021 and early 2022, the top 4 protocols controlled more than 85% of all TVL in derivative protocols. Today, the largest protocol, GMX, controls 17.7% of market TVL across its V1 and V2, while dydx controls 15.6% in aggregate (see Chart 3). While certain protocols have an early lead and increased trust due to their longevity, we believe that clear winners in this space are yet to be determined.
Various scaling strategies will impact the ease of onboarding, liquidity bridging, and long term technological scalability. Different approaches like dydx’s application specific Cosmos chain, GMX’s integration into the Arbitrum rollup, Aevo’s application specific rollup, and Drift’s deployment onto Solana all come with various tradeoffs. At the same time, competition from centralized derivative exchanges will continue to put performance pressures onto these decentralized protocols.
