The Next Phase of Crypto

Level 3 - Virgin DeFi Analyst

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After extensive research and interesting discussions within the team we’re excited to share our vision for the next phase of crypto and the future of DeFi Education.

Since the early days of the crypto industry the market has placed a very high value on blockchains. In the beginning, blockspace was scarce. Bitcoin could process around 7 transactions per second and there were no other chains. Developers and investors rushed to build and back “the next Bitcoin” resulting in dozens of new chains.

The most successful new paradigm after blockchains was the smart contract. Ethereum pioneered the technology necessary to build DeFi, but within a year of the first decentralized exchange and borrow/lend apps being deployed it could cost $50 to swap a token or arrange a small loan.

Although Ethereum processed batches of transactions every 15 seconds (compared to every 10 minutes for Bitcoin), there was still not enough transaction capacity to satisfy the increased demand from DeFi and NFTs.

The basic laws of supply and demand operated as expected:

1. people who wanted to make profitable DeFi transactions bid up the price of blockspace (higher gas fees) ; and

2. the price signal caused capital and talent to focus on increasing the supply of blockspace to meet demand (create new chains)

Scaling the supply of transaction capacity in crypto was both horizontal and vertical:

• vertical scaling improved transactions per second from the tens to the tens of thousands by running powerful servers (Solana)

• horizontal scaling created new Ethereum-based chains designed as independent blockchains (Layer 1: Avalanche, Fantom, Polygon) and a rollup layer on top of Ethereum (Layer 2: Arbitrum, Base, Optimism, zkSync)

Transaction fees are down from tens of dollars to fractions of pennies. Software tooling has improved to the point where an application developer can easily deploy on their own L1 blockchain (Appchain) and major corporations are building rollups on Ethereum Layer 2.

Our conclusion: blockspace is now commoditized. It is no longer scarce.

This shift calls for a review of your long term investment thesis. Crypto is a booming industry and we continue to expect significant growth. We need to ask: Where will the value accrue?

Although there are significant differences between blockchains (notably decentralization and security), the “back end” of an application isn’t what most users notice first.

DeFi users are likely to choose a service provider based on availability of the products and services they want to use, transaction costs, the user interface and user experience, and trust/security/marketing. There are several secure and mature blockchains and we think users, including institutional investors, will be relatively chain-agnostic.

With many blockchains to choose from, market forces will compress fee margins to some reasonable percentage on top of the cost of running the validator/sequencer/node hardware. Running a centralized L2 sequencer can be very profitable (if your userbase has a reason other than decentralization to trust your chain). Fully decentralized chains have higher transaction costs, but there is now sufficient supply and more efficient use of blockspace - these costs will remain reasonable during mass adoption.

Thesis: The Value Will Flow To Applications

The total crypto market cap is $2.15 trillion.

The combined market cap of the two leading blockchains (Bitcoin and Ethereum) is $1.51 trillion, or 70%.

• Top 12 Crypto Projects By Market Cap (excl. stables)

  • Bitcoin: $1,202 billion

  • Ethereum: $304 billion

  • Binance BNB: $79.2 billion

  • Solana: $69.8 billion

  • Ripple XRP: $32.2 billion

  • Dogecoin: $14.5 billion

  • Tron TRX: $13.9 billion

  • Toncoin (Telegram): $13.7 billion

  • Cardano: $12.7 billion

  • Avalanche AVAX: $9.9 billion

  • total $1,751.9 billion, or 81.5% of total market cap

Stablecoins account for $0.17 trillion, or ~8%. This means that smaller layer 1 blockchains, layer 2 blockchains with a token, and all the applications which make crypto useful account for around 10% of crypto’s market cap.

Without these applications there would be nothing to do on chain except send/receive tokens (couldn’t even swap).

As we onboard the next billion users to crypto, our thesis is that the majority of the value will be captured by the application layer. The total value of DeFi applications should therefore grow faster than the total value of Layer 1 chains, and the outsized returns will be made backing the very best apps.

Consider fees and revenue over the last 30 days broken out by DeFi verticals:

• Staking: Lido’s customers have earned $77mm on their staked ETH, with $7.7mm in revenue accruing to the protocol. Solana’s Jito has facilitated $42.6mm in staking rewards, earning $1.7mm.

• Borrow/Lend: Decentralized moneymarket Aave earned revenues of $4.67mm; stablecoin issuer MakerDAO earned $6.97mm.

• Exchanges: BSC’s PancakeSwap captured $4.67mm in revenue from trading fees; Base’s Aerodrome earned $16.7mm. Uniswap Labs captured $7.13mm from fees charged on its web interface. GMX (derivatives) booked $1.44mm in trading fees.

• Tooling: Telegram bots provide an improved trading experience compared to interacting with a website. The value add is so great that they can charge significant fees, 1% or more of the transaction value. The highest revenue bots are Photon ($14.6mm), Trojan ($8.65mm), Maestro ($3.8mm), and Banana Gun ($3.52mm).

• Automation: The most successful sub-segment so far is launchpads, automating the process of generating a smart contract for a token, raising initial liquidity from the public, and deploying a pool on a decentralized exchange. Market leader Pump Fun achieved $23.53mm revenue.

There are a few dozen protocols in the above verticals which consistently generate more than a million dollars a month in revenues. Users are willing to pay for applications which add value. But. Most users couldn’t tell you the technical details of the backend of the app, including how its blockchain works.

What Does This Mean For “Majors”

DeFi Education was founded on the idea that crypto’s properties of censorship resistance, global access, permissionless financial transactions, and an open playing field for anyone and everyone to build would create unique and exciting use cases that would alter the way we live as we know it.

As we spent more and more time in the industry we got much closer to the actual projects, the market, and starting developing our own “edge”. As a result the DeFi Education newsletter became more and more trading and markets focused over time.

We are pushing the reset button here.

We’re focused on learning how to build, use, and profit from (e.g. farm, buy tokens) DeFi protocols and other crypto apps. While investors have historically sought to allocate to Bitcoin, Ethereum, or Solana to express a view on the growth of the crypto industry, it’s debatable whether that strategy will perform as well going forward.

The main thing to consider is that majors are essentially market beta and, unless you are a completely passive participant in crypto you probably want to understand the altcoin market. Market beta is available to everyone, including those with no knowledge of crypto.

Anyone can buy and hold Bitcoin or Ethereum. Even boomer pension funds can buy via ETFs now. If you want to continue to level up and outperform in crypto you want to be getting ahead of this by staying on top of the major trends in crypto at the application and protocol level.

Crypto Twitter is as far from reality as you can imagine.

The future of crypto is not flipping coins with no value back and forth among the same pool of people (fun as it may be).

We also have no interest in a life of waiting around for 4 years at a time for “exit liquidity” while no progress is made.

While we have traded memecoins, we think they have become too much of a dominating force in the public forum. The future can only be built, by people who are reading this and believe in a crypto-centric future. And why is that future worthwhile, you ask?

Crypto-centric Future

Brian Armstrong’s recent tweet sheds light on the unexpected twists and turns tech adoption can take.

Payments (and money remittance) are an obvious crypto use case - one that many of us make use of to transact online! It’s possible that Coinbase brings USDC payments to the real world.

Coinbase partly owns the issuer of USDC, the proliferation of which will drive huge revenues for Coinbase via the yields they earn from the underlying capital. That means they are heavily incentivized to drive growth in this business which in turn will bring millions more people onchain. With this initiative, among others, we believe Coinbase is going to build one of the most successful onchain businesses in history with Base.

Coinbase’s success with Base should serve as a proof of concept that creates institutional grade demand for ecosystem building. Why wouldn’t a large company with an existing brand want their users to transact via a network that they earn revenue from? For smart contract chains to have sustainable long-term demand, there needs to be growing value creation that is economically worth the time of founders, executives, and other business people.

Sony is one of the first brands to give it a try, with their Ethereum L2 “Soneium” launching their testnet this week. We plan to test it out. What we'd like to see is Sony onboard people to crypto by making use of their unique value proposition as a company, rather than simply competing with other L2s for existing crypto native attention. There is a graveyard filled with big brand corporate projects that did little for the industry. Will an L2 will break the curse?

What About Decentralization?

One of the greatest challenges in crypto since the day we first got involved in crypto as an industry is trying to convince people decentralization is important. If a network isn’t decentralized, it becomes trivial to attack the network. This in turn puts all other capabilities of a blockchain and everything built on top of it at risk of censorship, and in extreme cases, theft or failure.

At the same time, coordinating humans in a decentralized manner has proven to be difficult and inefficient. “DAOs” have largely faded away, with governance processes preventing fast moving business operations and a lack of participation from the people who are supposed to govern. This makes a strong case for having centralized organizations build decentralized technology — if they can follow through (it can be difficult to convince people to decentralize once the money flows in).

Crypto’s trustless, permissionless, and censorship resistant nature is upheld by decentralization. The root problem has been solved from a technology perspective (Ethereum), but centralized organizations have proven to be effective when it comes to building startups and applications. As a result corporations should be welcomed to build in crypto just as much as an individual or small team of crypto anons. However, they should leave their beliefs around what people can do, say, or post onchain in the traditional realm and embrace the open source, open world culture of crypto.

Crypto Is For The People

Regardless of what value corporations add, crypto is truly for the people.

You can go learn to code and deploy something you believe should exist onchain starting today. You can get a handful of users simply by DMing people or posting on Twitter. If it’s really good and you can crack distribution, you might get a whole lot of users. Even if that doesn’t happen you’ll make valuable connections and build your skillset.

There is nothing stopping you from doing this right now from anywhere in the world at any time. You don’t have to jump through any of the typical hoops. That’s how powerful economic freedom awarded to us by crypto networks is.

What Should You Focus On? - The Opportunities & Challenges

The opportunity set is essentially the bell curve meme. On one extreme end the best opportunity is consumer applications. The other extreme end is institutional applications and UHNW. Institutional business has far more gatekeeping but is the larger market by a longshot for financial use cases.

They key is bringing consumers onchain in a way that does not simply make them “exit liquidity” for crypto traders. In other words, driving them solely to buy coins instead of to use apps and products is not going to create the most long-term value for crypto. That only creates immediate value through generating revenue for crypto protocols (which is important), but it doesn’t solve the industry’s “closed loop” problem long-term.

The biggest challenge today isn’t actually building the apps (though more devs are always welcome), it’s onboarding people to use them. With L2s becoming extremely fast and cheap to use, the ability to build real businesses and real apps has improved exponentially. All while Ethereum as the L1 maintains decentralization. Solana has also done an excellent job of serving active crypto native users.

High Level Approaches

Your approach is going to be highly dependent on what you’re good at, the time you have to dedicate to learning crypto, the time to hunt for opportunities, and your own personal portfolio size and goals. We argue that the more time and interest you have in crypto, the more you should be able to take +EV risks. If you’re a largely passive participant, there are still plenty of DeFi Ed readers who subscribe to our paid stack to know when we think the cycle bottoms and tops are!

To outperform in crypto across cycles, focus on getting paid with a more active strategy depending on your skillset. For us:

• Market timing and providing liquidity to large liquidation events

• High beta plays in select altcoins where we have research alpha or edge (e.g. select alts, memecoins)

• DeFi yield farming and/or airdrop farming depending on opportunities

• Delta neutral arbitrage (perps funding, cross chain)

• Occasional seed/venture investments

• Staying current with tech, security and market developments to find future opportunities early

We’ll continue to cover our strategies in detail at DeFi Education, with a greater focus on project deep dives.

What Value Are You Adding To Get Paid?

This question should be top of mind for those wanting to succeed in crypto.

As an investor or trader, you get paid to buy undervalued assets and sell overvalued assets. Profiting from research alpha helps prices move towards fundamental values, providing a service to other market participants. In the shorter term, moving liquidity to another chain where it is demanded (arbitrage) or filling liquidation orders for a fee deserves payment for successful efforts.

Founding a company or protocol is a legitimate path.

As is starting a career in crypto in a technical role, as a salesperson/marketer, etc. We’re bullish on crypto as a career, and in the value of having crypto knowledge to enhance your positioning in adjacent careers.

If you have the time, skill, and capital to commit, you can definitely outperform passive holding by allocating your capital wisely based on knowledge and research. This is our current focus.

We didn’t set out to create an investment tips letter, but to teach how to use and understand the tech at a deep level and create a framework for people to develop their own investment process. Over time we’ve become known for some good (and contrarian!) market calls. While the market context is important, we can tell you first hand that your investing / trading performance improves the deeper you get into the industry because you learn what makes protocols tick and how stakeholders in crypto think.

A key piece is that blockchains (L1 & L2) have historically captured much of the value in crypto, and as blockspace becomes commoditized a higher percentage of value can flow to the application layer (in a more friendly regulatory environment). And the most profitable crypto applications are in DeFi!

Those are the opportunities we want to capture going forward.

Join DeFi Education for this next phase of crypto.

Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.

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