LD Capital Research

Author：Jaden, LD Capital

The emergence of FERC has led to the appearance of a series of tokens based on the concept of fair launch.

The $FERC token was minted for free on June 1 and quickly attracted community attention, reaching a market value of $15 million at its peak. If the minting gas fee is considered as the cost, about 5U per slip (1000 coins), FERC has increased by about 300 times. Its emergence has spurred the appearance of a series of tokens centered around the concept of fair launch.

What is Fair Launch?

Fair launch refers to every person having a fair opportunity to participate at the time of token issuance. The fairness of Bitcoin’s distribution mechanism is currently the most widely agreed upon. All miners can participate in mining autonomously, and the initial participants bear the cost of computing power and electricity on their own, knowing that there is no expectation of investment return.

The most common token distribution mechanisms on the market include:

1) IDO/IEO/ICO, etc.;

2) Instead of pre-selling tokens, projects are cold-started through community distribution.

There are unfair phenomena in the process of token issuance on-chain, such as malicious contracts, blocking attacks, and exchange manipulations, all of which can disrupt the fairness of token issuance. Token sales on centralized exchanges often require the possession of the exchange’s platform coins, becoming a goldmine for whales. A cold start completed through community distribution, where the number of distributed tokens depends on the contribution of community members, is relatively fair, but generally still requires verification through centralized means.

However, the Ordinals protocol provides a relatively fairer launch method, where anyone can easily deploy and participate in token minting on a first-come, first-served basis. As contracts are not deployable on the Bitcoin network, participants have the opportunity to participate equitably. The speed at which their transactions get picked up by miners is determined by the transaction fees they are willing to pay.

The erc20.cash platform, launched by @jackygu2020, aims to transfer the BRC20 fair launch concept to Ethereum, intending to combine the advantages of Bitcoin’s fair distribution and decentralization with the flexibility of Ethereum’s smart contracts and programmability. $FERC is a token it launched.

The main characteristics of currently fair distributed tokens are:

1) Anyone can deploy and mint tokens, with strong community nature;

2) No pre-mining of tokens, the total amount of tokens is mined from zero until it reaches the token cap;

3) The ability to add holding conditions;

4) Adding a freezing period, during which minting coins requires payment of additional fees, increasing the cost of robot participation;

5) The ability to set prices. However, tokens currently recognized by the market are generally minted for free.

Below are the main token data for fair launch platforms on different chains. This type of token is mainly sentiment-driven, and current trading activity is concentrated on FERC and BERC.

Erc20.cash

Chain：Ethereum

Berc.cash

Chain：Ethererum

Features: After using 49.25% of tokens to create a liquidity pool, they are transferred to a black hole address, 49.25% are fair launched, 0.5% are sent to the Vitalik’s address, 0.5% are sent to the token developer’s address, and 0.5% are sent to the BERC team. On top of FERC, an attribute to automatically add to the liquidity pool has been added.

Merc20.cash

Chain：arbitrum

Oerc20.cash

Chain：Optimism

Serc20.cash

Chain：ZkSync

*Data as of June 7, 2023.

website: ldcap.com

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Author：Yilan，LD Capital

Introduction

With the expiry of Uniswap V3’s license, numerous fork projects from Concentrated Liquidity Automated Market Makers (CLMMs) have started to emerge. These ‘Uni v3-Fi’ projects include Dexes (either pure forks of V3 or strategies that customize pricing ranges based on V3), yield enhancement protocols (such as Gammaswap), and various options and other protocols aimed at addressing the issue of impermanent loss in V3. This article primarily discusses Dexes like Trader Joe v2, Izumi Finance, and Maverick Protocol, which optimize strategies based on pricing ranges in V3.

The Issue with Uniswap V3

In Uniswap V3, liquidity is concentrated within specific price ranges. This means that if the price of an asset deviates from this range, an “impermanent loss” (IL) can occur. An impermanent loss is a loss suffered by liquidity providers (LPs) in the AMM relative to simply holding the assets. When the price deviates from the range chosen by the LPs, the impermanent loss may significantly increase, even exceeding the loss of the original assets.

The IL risk is greater in Uni v3 due to concentrated liquidity. Part of this explanation involves the ‘gamma’ concept in options from Greek letters. Gamma refers to the rate of change of the price of an asset relative to the change in Delta value. When Gamma is high, it indicates that Delta is highly sensitive to price changes in the asset, requiring timely position adjustments to avoid potential losses. This is known as Gamma risk. Without considering time, it can be said that as the volatility of the underlying asset increases, the price of the option also increases as higher volatility increases the probability of realizing a profit. Therefore, the market demands a higher price for such options.

When the asset volatility is high, the gamma risk and the impermanent loss borne by LPs are also high, necessitating higher compensations for impermanent loss. Hence, AMM can be viewed as embedding a perpetual options market, with LPs exposed to gamma risk, enduring the risk of impermanent loss in exchange for transaction fees or mining rewards.

To address this challenge, LPs need to closely monitor the prices of the assets they provide and take timely actions such as withdrawing liquidity and reallocating funds to new price ranges to mitigate the impact of impermanent loss. However, this process is time-consuming, incurs additional gas fees, and carries the risk of incorrectly setting price ranges.

Furthermore, Uniswap V3 faces other issues. For instance, the concentration of liquidity within specific price ranges can lead to liquidity fragmentation, increasing transaction costs. In addition, due to frequent asset price changes, LPs need to constantly adjust and manage, which can be challenging for those engaged in large-scale and frequent trading.

Therefore, while Uniswap V3 can offer higher fees and annualized returns, LPs need to balance these potential challenges and risks. Solutions to the problems inherent in Uniswap V3 can be classified into the following categories: optimization against impermanent loss, tool optimization for the best LP market-making schemes (providing diverse liquidity-adding choice tools for different risk preferences), and strategy optimizations built in for enhancing LP NFT yield.

This article will focus on analysing three DEX projects that optimize LP market-making schemes: Trader Joe, Izumi, and Maverick.

Trader Joe v2

The most significant enhancement in Trader Joe V2’s Liquidity Book (LB) over Uniswap V3 is the introduction of the “Bin” concept, enabling a strategic approach to liquidity distribution. A “Bin” is a price range that serves as a unit of liquidity distribution. In the Liquidity Book, liquidity is divided into discrete “Bin” units. The liquidity within each bin is exchanged at a fixed rate. This allows liquidity providers to concentrate their funds within specific price ranges, thereby avoiding slippage. It means transactions within that price range can be executed with zero slippage, enhancing trading efficiency and cost-effectiveness. The strategic liquidity distribution refers to the semi-fungibility of LB Tokens and the vertical direction of liquidity distribution, allowing LPs to deploy their liquidity based on certain strategies, rather than merely spreading it evenly across bins.

Trader Joe v2.1’s Auto Pool began its deployment in June. The General is the first Auto-Pool to be deployed on AVAX-USDC (Avalanche) and ETH-USDC (Arbitrum). The General automatically rebalances liquidity positions to maximize fee income, responding to market trends and asset imbalances, making it adaptable to most markets and environments. In the future, The General will also be used for other liquidity pools.

Auto-Pool accumulates a share of transaction fees collected by the liquidity pool. Tokens can be deposited into yield farms (to be released in the future), and Auto-Pool can offer incentives through partner tokens (to be released in the future). Every rebalancing incurs an automation fee, equivalent to an annual interest rate of 4.5%. The automation fee is used to cover operational costs, such as gas fees during rebalancing. In the future, automation fees may be distributed to sJOE stakers.

Deployment in different liquidity distribution strategies can yield more rewards for LPs if the strategy estimation is accurate, i.e., the liquidity falls within the chosen range more often. Furthermore, dynamic swap fees enable LPs to charge different fees based on market volatility, thus better managing risk and returns.

Izumi Finance

Izumi’s AMM employs the DL-AMM algorithm, a novel discrete concentrated liquidity algorithm that shares similar market-making characteristics with Uniswap V3. However, it can precisely distribute liquidity at any fixed price, as opposed to a price range. This makes iZiSwap more manageable in terms of liquidity management and supports a wider range of trading methods, including limit orders.

Besides Swap, LiquidBox is also one of Izumi Finance’s core products. LiquidBox is a liquidity mining solution based on Uniswap V3 NFT LP tokens, attracting liquidity through various incentive models. It allows project owners to set up trading pairs and liquidity pools more efficiently and offer different rewards across different price ranges.

These liquidity reward models include:

1） Concentrated liquidity mining model: Generally, the capital efficiency of a specific range is over 50 times higher than the xy=k model. Concentrated liquidity usually increases impermanent loss for non-stablecoin pairs. Given the limited fluctuation range of stablecoins, this model is more friendly towards stablecoin pairs.

2） One-sided non-impermanent loss mining model: Specifically, when an LP deposits 3000 USDC and 3 ETH, Izumi manages by placing 3000 USDC within the (0, 3) price range on Uniswap V3. When the XYZ price drops, a purchase order is formed using USDC. The 3 ETH are placed in Izumi’s staking module to lock liquidity (the staking portion is not on Uniswap V3) and won’t be sold passively when the price of ETH rises, thereby avoiding impermanent loss or passive selling pressure on the project side.

3）Dynamic Range model: This model aims to incentivize liquidity providers to offer effective liquidity around the current price.

When a user stakes Uniswap V3 LP tokens in Izumi’s protocol for farming, LiquidBox automatically determines whether the value range of the LP tokens is within the liquidity incentive range set by the project owner. The value range setting aims to ensure liquidity providers offer liquidity within the required price range.

This is a strategy to create more income for Uniswap v3 LPs and similarly provides a means to help project tokens generate liquidity. Those who stake LP NFTs can manage their liquidity positions based on their prediction of the market trend, using features like fixed range, dynamic range, and one-sided, which can avoid IL under appropriate circumstances.

Maverick Protocol

Maverick’s Automated Liquidity Placement (ALP) mechanism in its AMM is similar to Uniswap V3. However, the important difference is that the ALP mechanism can automatically rebalance concentrated liquidity, resulting in lower slippage than non-concentrated AMM models, and lower impermanent loss compared to concentrated AMM models (scenarios where the single-sided liquidity mechanism reduces impermanent loss).

Its key mechanism is the use of “bins” to manage liquidity. A “bin” refers to the smallest available price interval. In Maverick, LPs can choose to add their liquidity to specific bins. LPs can select from four different modes: Right, Left, Both, and Static mode, which determine how their liquidity moves with price changes.

When LPs add liquidity to a bin, they must add base and quote assets in the same ratio as that already in the bin. LPs will receive corresponding LP tokens, representing their share of liquidity in that bin.

In Maverick, when the price changes, non-static bins can move right or left according to price fluctuations. When a bin moves and overlaps with another bin of the same type, these two bins merge. The merged bin will acquire the liquidity shares of the two bins before the merger.

When liquidity providers wish to withdraw liquidity from a specific bin, they can do so by redeeming their corresponding LP tokens to claim their share from that bin. If the bin in question has undergone merging, LPs will need to employ a recursive approach. They will have to pass their withdrawal request down to the active bin in the merger chain, and then assets are proportionately withdrawn from the liquidity share of the merged bin.

Conclusion

Trader Joe V2 and V2.1 introduced three significant features:

1) Zero-slippage transactions within bin.

2) The Liquidity Book introduces dynamic swap fee pricing. The fees are applied to the swap amount within each bin and distributed proportionally to the liquidity providers in that bin. This empowers LPs to mitigate the risks associated with impermanent loss, particularly in volatile market conditions. From the perspective of a built-in perpetual options market in AMM, such a setup is reasonable. It employs an instantaneous price fluctuation function to price high volatility, similar to the compensation given to options sellers (LPs) in the options market.

3) An automatic liquidity re-balancing feature maximizes fee income through the Auto Pool. Later updates will introduce Farming strategies and functionality to incentivize liquidity from project creators, similar to Izumi’s Liquidbox.

Izumi Finance brought three main improvements:

1) Precise Value Range: LiquidBox enables project owners to specifically define the value range for incentivizing LP tokens. This allows liquidity providers to gain a more accurate understanding of the value range of the liquidity they’re providing, thereby enhancing risk management and potential rewards.

2) Enhanced liquidity management: By setting a value range, LiquidBox enables liquidity to concentrate at specific prices instead of merely within a price range. This enhanced liquidity management makes the Izumi protocol more manageable and supports more trading methods, such as limit orders.

3) Various liquidity reward models which serve as excellent liquidity management tools for projects.

Maverick offers different modes to adjust how liquidity moves with price changes. When the price changes, bins can move and merge to maintain the efficacy of liquidity. This mechanism allows LPs to better manage impermanent loss and gain better returns during price movements.

Comparing the performance metrics, over the past week, Maverick had a volume of 164 million, Trader Joe had 308 million, and Izumi had 54.16 million. In terms of TVL, Maverick had 27.83 million, Trader Joe had 140 million, and Izumi had 57 million. Despite a lower TVL, Maverick captures a higher volume, indicating high capital efficiency. The fact that most of Maverick’s trading volume is routed by 1inch also suggests a stronger price discovery capability.

Compared with Uniswap V3, Trader Joe V2, Izumi, and Maverick are all upgrades to the Concentrated Liquidity Market Maker (CLMM) model, with the primary improvements occurring on the liquidity provider (LP) side. Summing up, a common feature of these protocols is the introduction of customizable price ranges, allowing liquidity providers to select specific price ranges to provide liquidity. Through customized price ranges, liquidity providers can more precisely control the liquidity they offer, create strategic combinations, meet specific positional requirements at certain price points, and identify the best market-making plans and strategies. The differences lie in the degree of customization each protocol offers in terms of liquidity management tools and the stage of development their respective ecosystems are currently in.

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Author: Duo Duo, LD Capital Research

Currently, the competition is fierce in the DEX derivatives sector. Despite the overall market trading volume declining, new protocols are constantly being introduced. In a shrinking market, traders have become more sensitive to various incentive measures and yield rates, prompting DEX derivatives to compete more aggressively for users.

Since late March in 2023, the overall trading volume of DEX derivatives has been on a downward trend. Out of the six main DEX derivative protocols, five have shown a declining trend in trading volume, with only Kwenta demonstrating counter-trend growth.

Kwenta, a perpetual front-end built on Synthetix, has contributed to over 95% of the trading volume growth and revenue growth of Synthetix. Synthetix, in turn, is a liquidity provision protocol with a TVL exceeding $400 million, supplying liquidity pools to frontend projects like Kwenta.

Figure: Weekly Trading Volume of Major DEX Derivatives

Source：tokenterminal

*The data related to this article primarily comes from Tokenterminal. Due to varying measurement standards, there may be discrepancies between different data platforms.

Order book-based DYDX still occupies nearly half of the market’s trading volume. However, in the liquidity pool derivatives DEXs, GMX has been challenged by Kwenta and Level. Particularly in this week, Kwenta and Level’s trading volume exceeded that of GMX.

Table: Weekly trading volume of main derivatives DEX since April 2023 (in millions)

Source：tokenterminal

Figure: Market Share Distribution of Liquidity Pool-Based Derivatives DEX

Source：Dune Analytics

GMX’s peak trading volume occurred in mid-April, after which it displayed a continuous downward trend. The current trading volume level is comparable to that at the end of 2022.

Figure: Weekly Changes in GMX Trading Volume

Source：tokenterminal

Kwenta, a DEX launched at the end of 2022, saw a substantial increase in trading volume beginning from mid-February 2023 when it initiated a trading incentive program. As of late April, they incorporated the use of OP tokens as part of their incentives, which further propelled a marked surge in trading volume throughout May.

Figure: Kwenta Trading Volume Weekly Changes

Source：tokenterminal

Level also experienced its peak trading volume in mid-April, reaching $2 billion in that week, followed by a decline. However, a rebound occurred in the week of May 22nd.

Figure: Weekly Changes in Level Trading Volume

Source：tokenterminal

Reasons for Growth in Trading Volume: More Incentives, Lower Costs

The counter-trend growth in Kwenta’s trading volume can potentially be attributed to two factors:

Firstly, Kwenta has been more aggressive in terms of trading incentives. In addition to token incentives from the protocol itself, starting from April 26, 130,000 OP tokens were rewarded each week. From May 10 to August 30, the weekly reward increased to 330,000 OP tokens, with a market value of about $500,000.

Secondly, Kwenta’s transaction fees are relatively lower than GMX. The current transaction fee ranges from 0.02% to 0.06%, varying based on whether one is a taker or maker. GMX, on the other hand, charges a transaction fee of 0.1%, along with loan fees based on positions held. For actual users, the cost of transacting on Kwenta is lower.

Figure: Kwenta Trading Incentive Rules

Source：mirror.xyz/kwenta.eth

Level has also implemented trading incentives. For every $1 of transaction fees paid by a user, they receive one Level Loyalty token (lyLVL). Each day, a total of 10,000 LVL tokens are distributed, their allocation being determined by the proportion of an individual user’s lyLVL in comparison to the total lyLVL across the platform. Users have a 24-hour window to claim these rewards.

Beyond the basic rewards mentioned above, there’s also a Ladder reward mechanism in place. When the platform’s daily revenue exceeds a specific threshold, an extra allotment of LVL tokens is added as an incentive. These additional rewards accumulate over time and are distributed on a weekly basis.

Note：Level n = (Revenue-$100,000)/$50,000

Source：LD Capital

The Ladder reward is for the top 20 traders on the weekly leaderboard. A trader’s rank is determined by the number of points they have accumulated throughout the week. Reward Points are earned based on the trader’s contribution to the protocol’s transaction fees and can be increased by multiplying by (1 + boost). The boost factor is determined by the total number of LVL tokens a trader has staked on the platform. For every 1000 LVL tokens staked, the boost factor increases by 1%.

Over the past six months, there have been 46 days when the revenue exceeded $100,000, accounting for 25% of all days. Of these, there were 19 days when the revenue exceeded $150,000, eight days when it exceeded $200,000, and two days when it exceeded $250,000.

Figure: Daily Revenue of Level

Source：tokenterminal

Additionally, the order book model of DYDX has maintained a high level of trading incentives since its launch. Although the incentive tokens have been reduced twice, there are still approximately 1.58 million DYDX tokens as incentives per epoch. If valued at market prices, this amounts to around $3 million, with daily incentives reaching $100,000. In the current derivatives DEX model, this is a relatively high incentive.

It’s crucial to take into account the effects of trading incentives on the selling pressure exerted on protocol tokens, along with their long-term sustainability.

In Kwenta’s incentive schemes, the ecosystem token, OP, constitutes the major portion of rewards, while the protocol token incentives are gradually decreasing. This leads to slightly reduced sell-off pressure on the protocol tokens. Furthermore, Kwenta’s trading incentives are acquired in a weekly cycle and come with a vesting period. If tokens are unlocked prematurely, a portion of them needs to be burnt. Currently, OP’s incentives are set to last until August 30. If there are no subsequent measures in place once this period lapses, it could result in a substantial decrease in trading volume.

All of Level’s incentives are based on the protocol token, which can be claimed daily without any lock-in period, resulting in increased selling pressure on the protocol token. Additionally, Level’s Ladder incentive mechanism, which aims to boost trading volume, offers substantial rewards to the top 20 users, far more than what average users receive. This could potentially lead to a significant concentration in trading volume.

DYDX also faces substantial selling pressure due to its large token incentives and the release of a large number of tokens. The market is continuously monitoring and waiting for the launch of the DYDX chain and modifications to the token mechanism.

Analysis of Real Trading Volume

Given the presence of trading incentives, it is necessary to analyze trading volumes to understand the rough situation of real trading. We have briefly compiled statistics on the number of users, trading volume, concentration, and position size for several AMM-based derivatives DEXs.

Table: Analysis of Trading Volume in AMM-Based Derivatives DEXs

Source：LD Capital

GMX has 4–5 times the number of users compared to other projects and has significantly more open interest, three times that of Kwenta and five times that of the Gains Network.

In addition, the average trading volume per user for Kwenta and Level is significantly higher than for other projects without incentive measures.

For Kwenta, the average 30-day trading volume is approximately 1.6 million, four times that of GMX. The top five traders account for 33.35% of the trading volume, indicating a relatively low concentration. It has 2986 users, making it the leader in the second tier. The open interest fluctuates between 40 million and 60 million.

Level has an average 30-day trading volume of 5.76 million, a staggering 15 times that of GMX. Its trading volume is highly concentrated, with nearly 75% coming from the top five traders. The open interest is only 2.6 million, and there are less than 600 users, indicating a high proportion of wash trading on the platform.

Overall, GMX still leads the field with a significant advantage in terms of user count and open interest. Kwenta has more real users, and its trading volume is less centralized. After attracting a portion of the users with its incentive measures, it might retain users by offering better liquidity depth and lower fees. Level, on the other hand, has a relatively high proportion of wash trading and high inflation.

Recent Development Plans

GMX

Based on information obtained from the community, the GMX project team attributes the decline in trading volume and yield to an overall market downturn.

GMX’s recent focus is on the launch of its V2 version. The V2 test version was launched on May 17th, 2023, and users can participate in the testing. The main modifications include:

GLP is transitioning from a combined pool to separate pools for each currency pair. This segregation allows for the inclusion of higher-risk assets.

Two types of assets will exist: one type includes trading pairs backed by native assets like BTC and ETH, and the other comprises synthetic asset trading pairs entirely backed by USDC. Traders will have the freedom to choose the liquidity of various pools.

Indeed, with multiple pools, the task for LPs will become more complex as they need to analyze usage and yield changes of each pool to decide their participation.

The funding rate and price impact factor have been implemented to balance the changes between long and short parties.

Kwenta

On May 25th, Kain Warwick, the founder of Synthetix, proposed several ideas for the future development of Synthetix, which including:

Implementing SNX for trading incentives, with a plan to allocate 5 to 10 million SNX to the incentive program.

Considering the introduction of passive staking for SNX to enhance participation and expand the size of the liquidity pool. Previously, Synthetix utilized an active staking model, where stakers had to outperform the overall staking pool to earn higher yields or utilize hedging tools to mitigate risks. The addition of a passive staking pool simplifies the process and facilitates user participation while maintaining a baseline yield.

Subsidizing the costs of front-end operations. Currently, the income of front-end operators largely goes to SNX stakers, which may not provide sufficient incentives for them in the long-term, for instance, protocol revenues from Kwenta are entirely allocated to SNX stakers.

It is suggested to allocate a certain proportion (e.g., 10 million SNX) from the treasury to subsidize front-end costs, and representing the front-end through staking. This measure will generate a baseline fee revenue of 3–5%

Given the above, these plans consider the relationships between users, funds, and product development, and if implemented, could have significant incentivizing effects for projects constructed on the Synthetix.

Level

In May, Level conducted a community vote and introduced a new cross-chain feature by migrating to Arbitrum. Currently, liquidity pools for the LVL token have been deployed on Arbitrum, enabling trading activities. The front-end trading operations are expected to go live in mid-June. Given the substantial user base and liquidity on Arbitrum, the migration is expected to draw in a fresh influx of users and foster increased capital participation.

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【Summary】

LSD: The growth rate of Ethereum staking on the Beacon Chain increased last week, with a 2.05% growth compared to the previous week. The staking rate has reached 17.92%. LSDFi projects showed mixed performance, with LBR, ZERO, and TENET performing well, while AGI and USH underperformed expectations.

Ethereum L2: The total value locked (TVL) in Ethereum Layer 2 solutions increased by 5% in the past week, reaching a total of $9.05 billion. Among them, zksync had a strong TVL growth in the past two weeks and had the highest bridged ETH amount, with nearly 10,000 ETH. Its on-chain activity also surpassed Arbitrum multiple times.

Derivatives DEX: The overall trading volume of derivatives decentralized exchanges (DEX) slightly rebounded compared to the previous week, with a total trading volume of approximately $6.5 billion across six major protocols, representing a 6.5% increase. Kwenta experienced significant growth in trading volume during the past week, surpassing GMX, mainly due to its strong trading incentives (33,000 OP tokens per week) and lower transaction fees.

BRC20: The trading volume of BRC-20 related projects showed a downward trend last week, but saw some recovery over the weekend, mainly concentrated on OXBT and ORDI. OXBT has been listed on OKex Ordinals marketplace and Alex BRC20 DEX. The on-chain transaction count and the number of holding addresses have surpassed ORDI.

GameFi: The overall enthusiasm for the sector is not high, but various projects are continuously progressing and announcing updates, which brings market opportunities. It is worth paying attention to Metaverse-related projects before the Apple Developers Conference on June 5th.

【LSD and LSDFi】

Last week, the staked ETH on the Beacon Chain increased by 2.05% compared to the previous period, entering a faster growth phase. Currently, the staking rate for ETH has reached 17.92%. The staked ETH last week reached 18.8947 million coins, with a 2.05% growth compared to the previous period. The queue for entry into the Beacon Chain increased to 76,900 coins. As of May 28th, the number of validators on the Beacon Chain reached 590,500, with the daily growth limit raised from 1,800 validators to 2,025 validators, entering a faster growth phase.

Image: Accelerated growth of validators on the Beacon Chain

Source: LD Capital

Image: ETH staking yield remains flat compared to last week

Source: LD Capital

Among the three major LSD protocols, Lido has accelerated its growth, while Rocket Pool’s growth has slowed down. Last week, Lido’s staked ETH increased by 5.82%, Rocket Pool’s increased by 4.64%, and Frax’s increased by 8.87%. Currently, Lido has a staked ETH amount of 6.8098 million coins, representing a growth of 14.64% since the Shanghai upgrade. Rocket Pool currently has a staked amount of 711,900 coins, a growth of 53.57% since the Shanghai upgrade, and Frax has a staked amount of 229,600 coins, a growth of 73.53% since the Shanghai upgrade. Comparing the growth data since the Shanghai upgrade with the growth data from last week, it can be observed that Lido’s growth rate is still accelerating despite the high staking base, while Rocket Pool’s growth has significantly slowed down. Currently, Rocket Pool’s dynamic deposit pool remains at zero, with a Minipool queue of 1,091, indicating a potential release of staking demand from the Atlas upgrade. Currently, Frax’s CR (Collateralization Ratio) remains at 94.75%.

The Frax team initiated a proposal to grant Fraxlend AMO (Asset Management Organization) limits to sfrxETH/FRAX on the BSC, Optimism, and Arbitrum chains. The discussion on staking dividends for Lido was denied by the team’s strategic advisor, Hasu. Many stablecoin protocols that mint CDPs distribute the benefits of minting to users, while Frax uses the mechanism of AMO to return the profits from minting back to the protocol. The Frax core team initiated proposals FIP231–233, aiming to grant Fraxlend AMO limits to sfrxETH/ETH on the BSC, Optimism, and Arbitrum chains, with a cap of 5 million FRAX. This move not only expands the protocol’s revenue but also helps lower the borrowing rate for sfrxETH, promoting the growth of Frax ETH staking business. The discussion on staking dividends for Lido was denied by the team’s strategic advisor, Hasu, mainly due to the insufficient treasury reserves to safely sustain team expenses if dividends were enabled. At the current stage, Lido should focus on product development rather than staking dividends.

LSDFi projects showed mixed performance, with LBR, ZERO, and TENET performing well last week, while AGI and USH underperformed expectations. It is important to monitor the continuous development of new projects, timely product delivery, and the magnitude of selling pressure from initial mining on the secondary market. We look forward to the performance of protocols such as Gravita Protocol, Prisma Finance, Tapio Finance, Swell Network, Ion Protocol, Equilibria, and others (based on publicly available information, not investment advice).

【Ethereum L2】

The overall TVL (Total Value Locked) in Layer 2 solutions increased by 5% in the past week, reaching a total locked amount of $9.05 billion.

Among them, zksync has shown strong growth in TVL over the past two weeks.

Source: l2beat

Starknet’s TVL continues to maintain a stable upward trend.

Source: l2beat

In the past week, the total value bridged on Arbitrum and Optimism was close, with zksync bridging the highest amount, nearly 10,000 ETH. However, starknet experienced a slight decline compared to the previous week.

Source: Dune

In recent times, the overall on-chain activity has been as follows: Arbitrum > zksync era > Optimism > Starknet. It is worth noting that zksync era has surpassed Arbitrum multiple times in terms of on-chain activity.

【Derivative DEX】

Last week, the overall trading volume of derivative DEXes showed a slight rebound compared to the previous week. The cumulative trading volume of the six major derivative DEX protocols for the previous week (May 15th to 21st) was $6.1 billion, while the cumulative trading volume for last week was approximately $6.5 billion, representing a 6.5% increase.

Among the six major derivative DEX protocols, five exhibited a continuing downward trend, while only Kwenta showed a counter-trend growth. Kwenta, which is built on Synthetix, contributed to over 95% of the trading volume and revenue growth for Synthetix.

Image: Weekly trading volume of major derivative DEX protocols

Source: tokenterminal

In the order book model, DYDX continues to dominate nearly half of the market’s trading volume. Among the fund pool model derivative DEXes, Kwenta’s market share in terms of trading volume surpassed GMX for several consecutive days last week. GMX had reached a recent peak in weekly trading volume in mid-April, while Kwenta’s weekly trading volume showed an overall increase in May compared to April.

Image: Market share distribution of fund pool model derivative DEXes

Source: Dune Analytics

Image: Weekly trading volume changes for GMX

Source：tokenterminal

Image:Weekly trading volume changes for Kwenta

Source：tokenterminal

Kwenta’s counter-trend growth in trading volume can be attributed to two main factors. Firstly, Kwenta has implemented significant trading incentives. Starting from April 26th, it began rewarding 130,000 OP tokens weekly, and from May 10th to August 30th, it increased the weekly reward to 330,000 OP tokens, valued at approximately $500,000.

Secondly, Kwenta offers lower transaction fees compared to GMX. The current trading fees range from 0.02% to 0.06%, varying for takers and makers. On the other hand, GMX charges a trading fee of 0.1% and additional lending fees based on positions held. In an environment where market trading volume is declining, there are fewer new users, and existing users are primarily seeking better trading solutions. As a result, they have turned to Kwenta for their trading needs.

Image: Kwenta trading incentive rules

Source：mirror.xyz/kwenta.eth

However, in terms of Open Interest, GMX still maintains a significant position with a value of around $150 million. On the other hand, Kwenta’s previous Open Interest was approximately $40 million, but recent data regarding its Open Interest has not been disclosed on its official website, making it difficult to observe changes in this regard.

In terms of daily active users, GMX remains the protocol with the highest number of users, with approximately 1,200 individuals. Kwenta, on the other hand, has a daily active user count of around 400.

While trading volume can be easily influenced through trading incentives, Open Interest and daily active user count provide a more accurate reflection of real trading data. Therefore, despite Kwenta surpassing GMX in trading volume this week, GMX still maintains a significant advantage in terms of actual trading volume.

【BRC-20】

Last week, the overall trading volume of BRC-20-related projects showed a downward trend, with a slight recovery over the weekend, primarily concentrated in OXBT and ORDI.

Image:Volume changes

Source：dune.com，LD Capital

The trading volume of Ordinals BRC20 tokens showed a continuous downward trend last week, but experienced a slight recovery on Saturday and Sunday. The primary trading volume and market attention were concentrated in OXBT and ORDI.

OXBT, led by @BitGod21, originated from a proposal by @Frankdegods to migrate DeGods to BTC and create a related BRC20 token. @Frankdegods is the founder of Solana NFT projects Degods and y00ts. Degods has successfully bridged to the Ethereum network, while y00ts has successfully bridged to Polygon. Both NFT projects have solid community foundations, resulting in naturally high attention for OXBT.

Currently, OXBT is listed on OKex Ordinals marketplace and Alex BRC20 DEX. The on-chain transaction volume and number of holding addresses have surpassed ORDI.

【GameFi】

GameFi, after reaching its peak in 2022 and entering a calm period in December of that year, experienced a resurgence in February 2023 as the market conditions improved. The sector saw a significant increase in new game releases, but the actual number of active participants did not show significant improvement.

Source: Footprint

The most popular GameFi project in the previous week was MoDragon, a new incubation and nurturing game launched by Mobox. The game’s Genesis NFTs were airdropped via a lottery system to addresses that had participated in previous airdrops on the ARB chain and Mobox deep users. On May 25th, the NFT airdrop was distributed, and the game was officially launched.

Currently, the total number of transactions has reached 6,175, with a trading volume of approximately 2,125 ETH, valued at around 4 million USD.

Source: MoDragon Official Website

In addition, the COCOS token will be renamed COMBO, and the official token swap timeline has been confirmed. Binance will close the COCOS spot trading pairs on May 29th and reopen trading on June 2nd.

Currently, the top-ranked games in terms of trading volume in the market are still the older generation GameFi projects like Axie Infinity, Mobox, and Kingdoms. The GameFi sector has yet to see breakout projects. It is recommended to pay attention to metaverse-related projects leading up to the Apple Developer Conference on June 5th.

Source: Footprint

website: ldcap.com

medium：ld-capital.medium.com

【Summary】:

Market Summary: The debt ceiling crisis continued to plague the market at the beginning of the week; however, significant progress was made in the latter half of the week. Nvidia’s better-than-expected earnings report sparked a chase for core technologies such as AI and chips, leading to a surge in the US stock market. Meanwhile, defensive assets declined as funds focused on the technology sector.

Economic Indicators: PMI data showed a divergence in the economy in May, with the service sector remaining strong and manufacturing rebounding. Durable goods sales and PCE reflected persistent inflation, indicating a resilient economy, which caused expectations of a rate hike in June to rise while expectations of rate cuts for the year disappeared.

Cryptocurrency Market: Driven by the extreme optimism in the technology sector, the cryptocurrency market also rebounded. However, expectations of an increase in the terminal point of interest rates, along with the anticipation of the TGA withdrawing market liquidity, created resistance to its rebounding sustainability.

Debt Ceiling Negotiations: US President Biden and House Speaker McCarthy reached a budget agreement in principle, raising the debt ceiling for 19 months. Market attention shifted to Wednesday and Friday when the House and Senate would vote on the matter. Given the expected depletion of funds by Friday, the voting process is not expected to encounter any surprises.

Opinions: June to August is a critical time window as four major contradictions will become very apparent. These four major contradictions include the issuance of new national bonds, extreme polarization in the stock market, the Federal Reserve raising the terminal point of interest rates, and the strong attractiveness of fixed income to funds. The development of AI is expected to reduce investors’ reliance on interest rate changes, and while valuations are already high, they are not unreasonable, leaving room for the bubble phase to continue. The optimistic sentiment is likely to spread to the crypt

Weekly Market Overview:

Last week, global stock markets showed divergent trends as negotiations to raise the US debt ceiling progressed and optimism surrounding artificial intelligence (AI) grew. The US and Japanese stock markets ended the week strongly, while European markets rebounded on Friday but ultimately closed lower. The Chinese stock market remained weak throughout the week, ending with losses.

In the US stock market, AI was undoubtedly the hottest theme of the week, with the technology sector surging over 5% and the communication sector rising over 1%. On the other hand, defensive sectors such as consumer staples and materials lagged behind, both declining over 3%. This indicates that funds continued to move away from defensive assets and towards industries with higher growth potential.

Last week, strong economic data and the tough rhetoric from central bank officials sounded the alarm on interest rate expectations, as people realized that inflation would remain sticky for a longer period. This led to a continued rise in US Treasury yields:

The 30-year Treasury yield reached the key level of 4%, reaching the highest level since the end of last year.

The 10-year Treasury yield rose from 3.66% to 3.81%, and the 2-year Treasury yield increased from 4.24% to 4.57%, both reaching the highest levels since March this year.

Short-term Treasury yields, including the 1-month and 3-month rates, experienced slight declines, indicating reduced market concerns about debt ceiling risks.

In addition, US crude oil rose by 1.2% to $72.67, as major oil-producing countries released conflicting information about future supply adjustments.

Spot gold prices saw a slight increase of 0.33% to $1,946.69 per ounce. This can be attributed to the cooling of the debt ceiling negotiation crisis and market bets on another interest rate hike by the Federal Reserve, which reduced the demand for safe-haven assets like gold. The rise in real interest rates also negatively impacted interest-free assets like gold, which theoretically could exert potential pressure on the price of BTC.

CFTC Futures Position Changes:

Overall, net long positions in US stocks (Asset managers + Leveraged funds) saw a slight increase last week. However, there was a significant divergence among the three major indices. Net long positions in the Nasdaq increased to their highest level since early 2022, while net long positions in the S&P 500 slightly decreased. Net short positions in the Russell 2000 significantly reduced and are now almost back to a neutral level. These position changes align with the trends observed in the spot market.

In the bond market, net short positions increased to nearly record highs, with net short positions rising for the 2-year, 5-year, and 10-year maturities, while net short positions decreased for the 30-year maturity. In the foreign exchange market, net short positions on the US dollar slightly decreased, primarily due to a slight reduction in net long positions on the euro.

Global equity fund flows:

According to EPFR data, as of the week ending on the 24th, global equity funds continued to experience net outflows, amounting to -$4 billion for the week. This represents an improvement compared to the previous week’s -$8 billion. Developed market equity funds led the outflows, with US equity funds seeing outflows for the sixth consecutive week, albeit at a significantly slower pace than the previous week. Emerging market equity funds also experienced net outflows.

Debt Ceiling Negotiations:

US President Biden and House Speaker McCarthy have reached a tentative budget agreement to raise the debt ceiling for 19 months until May 18, 2025. As this agreement represents a compromise, any compromise solution is almost certain to lose opposition from both the far left and far right, so the market’s focus has shifted to whether the agreement will pass in both chambers of Congress this week.

Currently, the leaders of both parties are expressing confidence that the debt ceiling agreement will pass. The bill needs to secure 218 votes in the House of Representatives and 51 votes in the Senate. President Biden strongly urges Congress to pass the US debt agreement immediately and expects no situations that could undermine the agreement. McCarthy claims that 95% of lawmakers in the party are “excited” about the agreement, but he acknowledges that the bill “doesn’t have everything everyone wants, but in a divided government, this is what we end up with.”

Treasury Secretary Yellen has updated the date when the government will exhaust its funds to June 5 (four days later than the original estimate), urging Congress to reach a negotiation outcome as soon as possible to avoid a debt default.

It is expected that the Senate will vote on the bill on Wednesday, and the House of Representatives will vote on Friday at the earliest, as Friday is already the Treasury Department’s expected last date for cash depletion. Therefore, the progress this week needs to be error-free. Although the possibility of unexpected events disrupting the passage of the bill is currently low, any unexpected occurrence during the voting process that delays the bill’s passage beyond the X-Date and into next week will increase market uncertainty.

Key Economic Data from Last Week:

The most influential economic data released last week were the Personal Consumption Expenditures (PCE) Price Index and Durable Goods Sales, which had a significant impact. They indicated that inflation remains stubborn, and the economy remains resilient, further increasing expectations of a rate hike in June.

The April PCE index rose by 0.4% on a monthly basis, surpassing expectations of 0.3% and the previous month’s 0.1% increase. On a year-over-year basis, it increased by 4.4%, also surpassing expectations of 4.3% and the previous month’s 4.3%. The core PCE index, which excludes food and energy, also rose by 0.4% on a monthly basis, exceeding expectations of 0.3% and the previous month’s 0.3% increase. On a year-over-year basis, it increased by 4.7%, surpassing expectations of 4.6% and the previous month’s 4.6%.

Clearly, these data indicate that inflation remains persistent. Despite the Federal Reserve’s 125 basis points rate hike since December last year, the core PCE index has remained around 4.7% without a decline. This data further supports expectations of future rate hikes by the Federal Reserve.

As soon as the actual data was released, CME interest rate futures immediately priced in a 70% probability of a rate hike at the next FOMC meeting, compared to only 17% the previous week. This means that the market previously believed there would be a pause in rate hikes, but last Friday, the expectations shifted towards continued rate hikes.

There are several important data releases in the future, including the May Non-Farm Payrolls and Consumer Price Index (CPI). If either of these reports shows strong performance, the hope for a pause in rate hikes at the June and July meetings will diminish. Considering that consumers will also engage in summer travel, this will further stimulate consumption and contribute to inflationary pressures.

In addition to inflation, Friday’s data also showed growth in personal income and consumption. Personal income rose by 0.4% on a monthly basis, exceeding the previous month’s 0.3% increase. Consumption, on the other hand, surged by 0.8% on a monthly basis, compared to only 0.1% the previous month. On the services side, this was driven by financial services, insurance, and healthcare, while on the goods side, it was driven by new cars and pharmaceuticals.

On the other hand, the savings rate decreased once again, dropping from 4.5% to 4.1%, further confirming the sustained high consumer confidence among Americans.

Speaking of strong consumption, the durable goods report on Friday also reflected the same trend: Durable goods sales in April increased by 1.1% on a monthly basis, while expectations were for a decline of 0.8%. The month of March saw a revised increase of 0.1% to 3.3%. The significant increase in March was mainly driven by large orders for Boeing, but if we exclude defense aircraft and military equipment, durable goods sales actually declined. However, the April data showed a solid rebound. Excluding defense aircraft and technology, durable goods sales increased by 1.4% on a monthly basis, significantly higher than the 0.6% decline in March and the 0.2% decline in February. Among the largest contributors, manufacturing increased by 1.7% on a monthly basis, while machinery and equipment rose by 1.0%, and automotive and parts only experienced a marginal decline of 0.1%.

Other key data from last week:

The final reading of the University of Michigan Consumer Confidence Index for May rose to 59.2, surpassing the preliminary figure of 57.7.

The initial jobless claims in the United States were 229,000, lower than the expected 245,000, with the previous value revised to 225,000. As of the week ending on May 13th, the continued jobless claims stood at 1.794 million, below the expected 1.8 million, with the previous value at 1.799 million.

The annualized quarter-on-quarter real GDP growth rate for the first quarter in the United States was revised from 1.1% to 1.3%. Personal consumption expenditures (PCE) annualized quarter-on-quarter growth rate was revised from 3.7% to 3.8%, while the core PCE (excluding food and energy) annualized quarter-on-quarter growth rate was revised from 4.9% to 5%.

The preliminary Markit Manufacturing PMI for May in the United States was 48.5, below the expected 50, with the previous value at 50.2. The Services PMI was 55.1, higher than the expected 52.5, with the previous value at 53.6. The Composite PMI was 54.5, exceeding the expected 53, with the previous value at 53.4.

Key events this week:

Monday: Memorial Day in the United States and Spring Bank Holiday in the United Kingdom, stock markets closed in both countries.

Tuesday: US Consumer Confidence Index for May.

Wednesday: House of Representatives vote on the debt ceiling.

Thursday: US ADP Employment Report for May.

Friday: US Nonfarm Payrolls for May (consensus is that the labor market is starting to cool), Senate vote on the debt ceiling.

Earnings reports in the US include HP on Tuesday, Salesforce, C3.AI, and Chewy on Wednesday, Dollar General, Macy’s, Bilibili, Lululemon, and Dell on Thursday.

Our Commentary:

The period from June to August is a crucial time window, as four major contradictions will become very apparent (here, we will only discuss the United States; future articles will cover topics such as Japan’s monetary policy, inflation in Europe, and progress in China).

Contradiction 1: Currently, the market expects that within three months of reaching a debt ceiling agreement, approximately $500 billion to $700 billion of new US Treasury bonds will be issued. This represents a negative liquidity drain that should, at the margin, suppress the performance of risk assets.

Possible sources of funds to absorb the issuance of new Treasury bonds include money market funds and reverse repurchase agreements (RRPs), as well as a decline in bank deposits. If these indicators show a decline, it would be seen as a positive sign, suggesting that the liquidity drain has been offset.

Additionally, it should be noted that raising the debt ceiling comes at the cost of reducing government spending over the next two years, although the scale is unlikely to significantly alter the economic outlook.

Contradiction 2: In the stock market, almost every industry’s giants are becoming larger, including technology, banking, energy, retail, healthcare, and defense, among others. This is why we see the market capitalization-weighted S&P index rising, while the equal-weighted S&P index is falling. This trend has been particularly pronounced since March. As this rally is driven by AI as the core driver, the short-term benefits in terms of efficiency or performance may not be reflected across a broad range of industries. There is a possibility of a bubble forming in the AI and technology sectors, especially considering that the P/E ratios of large technology companies are already more than double those of ordinary companies. The market is faced with the question of whether it can still justify investing in stocks with increasingly expensive valuations.

Contradiction 3:

In recent times, there has been a significant increase in hawkish comments from Fed officials, accompanied by sustained strong economic data. As a result, interest rate futures for the second half of 2023 have been consistently declining. Earlier this month, market predictions pointed to a potential rate cut of nearly 100 basis points, but now it is expected that there won’t be any rate cuts (aligning with the Fed’s March dot plot). This rapid shift occurred just last week, and its ongoing impact can be considered as still not fully realized.

Contradiction 4:

Despite the optimistic sentiment in the stock market, there was still a significant inflow of funds into U.S. money market funds last week (+$39.9 billion, the highest in five weeks). This indicates the strong attractiveness of fixed-income assets and suggests that this appeal will remain stable in the coming months, even amid fading expectations of interest rate cuts.

In conclusion, most stocks have not participated in the upward trend, and the current trend is heavily influenced by the technology sector, particularly companies closely associated with AI and chip technologies. The dominance of a few large-cap tech stocks may leave the market vulnerable, and any setbacks for major tech indices like “MAGMA” or “NYFANG,” such as disappointing earnings or changes in industry regulations, could have significant implications for the entire market.

There is also the possibility of more stocks following the upward trend of big tech, which would sustain the bull market in the long run but would require solid earnings data to support it. While AI has indeed reduced investors’ reliance on interest rate changes, it can be expected that several companies will attempt to capitalize on the AI concept in the coming months. However, it will take time to observe which industries can genuinely benefit from AI. Any stock price increases that are not backed by performance or increased dividends are vulnerable.

For example, according to Factset data, only 110 companies in the S&P 500 mentioned artificial intelligence in their latest conference calls.

For example, even the so-called innovation-focused ARKK has significantly underperformed NYFANG:

The development of the AI field currently feels like there is a large number of investors who have not fully participated in it. While related companies may have high valuations, they are still far from being in an outrageous situation. We expect to witness the evolution of AI-related investment targets from being expensive to potentially reaching bubble-like or even meme-like levels in the coming months. For instance, last week, the WSB community showed exceptional excitement towards AI concepts.

This sentiment is likely to spread to the cryptocurrency market as well because both cryptocurrencies and AI are targets with significant adoption potential. However, concerns about liquidity and ongoing regulatory pressure may limit the extent of their gains in the cryptocurrency market.

website: ldcap.com

medium：ld-capital.medium.com



zkSync, an Ethereum Layer 2 scaling solution based on ZK Rollups, launched its mainnet, Fair Onboarding Alpha, on February 16, 2023. During this phase, only registered projects were allowed to test the network, and it was not open to end users. On March 24, 2023, zkSync Era, previously known as zkSync 2.0, was opened to the public, while zkSync 1.0 was renamed zkSync Lite.

Now, let’s explore the development of the zkSync ecosystem after two months since its launch.

1.TVL (Total Value Locked)

The TVL of zkSync Era experienced steady growth in the first three weeks after launch. However, the growth stagnated in mid-April and started to recover since mid-May. The current TVL is $283 million, with a 9.5% growth in the past week. It represents 3.29% of the overall Layer 2 TVL and ranks fourth.





2.On-chain Activity

According to browser data, zkSync Era has processed approximately 21 million on-chain transactions since its launch, with 1.7 million unique addresses. Due to the impact of the Arbitrum airdrop, zkSync gained significant on-chain activity right after its launch. Initially, the number of daily active addresses fluctuated in the range of 60–80k, but it dropped to around 30k in early May. However, it experienced a sharp increase driven by various activities and airdrops.

On May 11, OKX Wallet introduced Cryptopedia, an all-in-one DApp exploration and airdrop interaction platform, with zkSync Era as the theme for its first phase. They set up an exclusive section for zkSync Era interactions. Users who completed the interaction tasks had the chance to receive potential airdrop rewards and participate in a draw for five different rarity levels of NFTs jointly designed by OKX Wallet and zkSync. This activity significantly increased the on-chain activity of zkSync Era. Additionally, OKX enabled deposits and withdrawals of assets on the zkSync Era mainnet on May 20.

zkApes, a metaverse project on zkSync Era, launched the $ZAT airdrop on May 10 and later shortened the time frame for claiming the airdrop to one week. Before the deadline on May 17, the on-chain activity of zkSync Era reached a new high. On the day the airdrop ended, the number of addresses holding $ZAT tokens was 655,000, surpassing USDC and becoming the second-largest token in terms of addresses held on zkSync Era, following ETH.

On May 21, the ERA Name Service, a domain platform on zkSync Era, conducted an airdrop of $ERA tokens, with 43,500 addresses participating in the event.



3.Cross-chain Funds

The official bridge data also reflects a similar level of activity. Due to the stimulation from the Arbitrum airdrop, there was a significant increase in active addresses during the first three weeks after the mainnet launch. From the mid to late April until early May, there was a relatively lower number of active addresses. However, from mid-May onwards, the data started to show growth again, indicating an increase in activity.



4.Ecosystem Projects



According to Defillama statistics, the current top five projects in terms of TVL in the zkSync Era ecosystem are all decentralized exchanges (DEXs).

SyncSwap is a platform that offers trading, liquidity mining, and a launchpad (not yet launched) feature. Currently, 85% of the TVL is concentrated in the USDC/ETH pool, with an APR of 25%.

SyncSwap plans to issue 100 million SYNC tokens (not yet listed) on its platform. On April 10th, they launched the “SyncSwap Loyalty Program” for trading mining activities. During the genesis epoch, a total of 900,000 SYNC tokens were allocated to participants. The genesis epoch lasted for 30 days and concluded on May 10th.

Users were able to earn 1 ySYNC for every $1 in trading fees generated. During the genesis epoch, users minted a total of 1.18 million ySYNC tokens (equivalent to generating $1.18 million in trading fees). The 900,000 SYNC tokens were then distributed based on the average holding of ySYNC tokens, resulting in approximately 0.76 SYNC tokens for each ySYNC. Currently, the activity is paused after the genesis epoch.



iZUMi Finance is a multi-chain one-stop Liquidity as a Service (LaaS) protocol that currently supports ETH, Arbitrum, Polygon, and zkSync Era networks.

iZiswap, utilized by iZUMi, employs an innovative Discretized Liquidity AMM (DL-AMM) mechanism, similar to Trader Joe’s liquidity book mechanism. However, DL-AMM was introduced earlier without garnering widespread discussion like the liquidity book. DL-AMM allocates liquidity to specific fixed prices to further enhance capital efficiency. Additionally, iZiswap Pro offers trading through an order book mechanism.

LiquidBox is iZUMi’s liquidity mining solution based on Uniswap V3 LP. Project teams can provide incentives for LPs within specific value ranges through LiquidBox. Users who stake their V3 LP tokens in the iZUMi protocol receive corresponding incentives within the designated range.

The protocol’s data on defillama may differ significantly from its official website. The following graph depicts the TVL and trading volume as displayed on the official website.



The token IZI was launched in December 2021 and has been listed on exchanges such as Bybit, KuCoin, and Gate. After experiencing a prolonged period of decline, IZI saw a significant rebound in April this year after its listing on zkSync.



Mute is one of the first DEXs on the zkSync Era. In addition to trading and providing liquidity, Mute has introduced features such as the Amplifier for yield enhancement, Bonds, and DAO governance. Users can purchase bonds (Bonds) using MUTE/ETH LP at a discounted price with a 7-day lock-up period for MUTE tokens. MUTE token has been listed on Bitget, and its price spiked upon the zkSync Era mainnet launch but has since followed a trend of oscillating decline. The current major TVL (Total Value Locked) is concentrated in the USDC/ETH Pool, with an APR (Annual Percentage Rate) of 28%.

Velocore is the first (ve,3,3) DEX built on Solidly and Velodrome on the zkSync Era. It conducted private and public sales on its launchpad platform on April 3rd and 4th, 2023. The private sale had a hard cap of 90 ETH, while the public sale had a hard cap of 450 ETH. It achieved oversubscription rates of over 500% and 1814% respectively, with fundraising prices of 0.0000207 ETH and 0.0000229 ETH, equivalent to approximately $0.037/$0.041. The price surged to around 6x and is currently maintaining around 2x returns.

SpaceFi is a cross-chain platform that connects the Cosmos and Ethereum Layer2 ecosystems. It integrates Evmos and zkSync and offers products such as DEX, NFT, Launchpad, and Spacebase. Spacebase is an on-chain community, and creating/joining Spacebase can increase mining rewards. Currently, there are 18 Spacebases created, and around 30,000 people have joined the spaces. On May 6th, SpaceFi adjusted the economic model of its platform token SPACE, reducing the maximum supply from 600 million to 100 million and burning 40 million initial supply. The current circulating market capitalization of SPACE is only $780,000, and the trading volume is also relatively low.

Zigzag is a decentralized order book exchange and the first DEX on zkSync 1.0. It currently supports zkSync Lite and Arbitrum. On March 3, 2023, over 100,000 users received an airdrop of the platform token $zz, which accounted for 34% of the total token supply. The Zigzag team has also developed a decentralized betting platform called zkasico, where users can bet using tokens such as USDC, USDT, ZZ, and ETH.

Nexon, now renamed Eralend, was one of the first lending protocols to launch on zkSync Era. Based on the token model announcement, 61% of the tokens will be allocated for community incentives, 10% for IDO, 15% allocated to DAO, 12% for the team with a 6-month lock-up period, and 2% for advisors. Due to the token’s delayed launch and competition from other protocol activities, Eralend’s TVL growth has been slow, currently only around $2.5 million.

Reactor Fusion is currently the largest lending protocol in terms of TVL on zkSync Era and one of the few projects with its native token. The TVL is around $3.43 million and it currently supports ETH and USDC assets.

UniDex is a derivatives DEX protocol founded in April 2022. Initially launched on the Fantom chain, it has expanded to other public chains and Layer 2 solutions like Optimism and zkSync Era. Currently, the TVL is $3.87 million, with the TVL on zkSync Era accounting for approximately $1.6 million.

Onchain Trade is a spot and derivatives DEX protocol built on zkSync Era. It has a relatively small TVL of $670,000. Its native token is OT, which had an initial farm offering (IFO) in March 2023 at a public sale price of $0.15. After listing, the token briefly surged to around $1 but has since declined and is currently trading at around $0.18.

Cheems is a meme project on zkSync Era. From May 4th to 6th, holders with wallet balances greater than 0.01 ETH or holding $PEPE or $AIDOGE tokens on zkSync Era could claim $Cheems tokens. Around 65,000 addresses participated in the claim, and currently, there are approximately 51,000 addresses holding the token. The circulating market capitalization is $27 million, and the current price still reflects a significant return compared to the initial listing.

website: ldcap.com

medium：ld-capital.medium.com

[Summary]

Stablecoins: The total market capitalization of the stablecoin sector continued to shrink, declining from $137.5 billion at the beginning of 2023 to $129.9 billion. Within the sector, the market capitalization of USDC has been consistently decreasing, falling below $30 billion and returning to September 2021 levels. On the other hand, USDT’s market share has continued to grow, reaching a market dominance of 63.85%. The introduction of crvUSD stablecoin had moderate interest, with collateral worth less than $10 million.

LSD: The staked ETH in the beacon chain grew by 0.51% compared to the previous week, approaching the next growth phase (where the staked ETH increases from 1,800 validators per day to 2,025 validators per day) when the number of validators reaches 589,824. The current staking rate for ETH stands at 17.29%.

Ethereum L2: There was no significant change in the overall TVL (Total Value Locked) of Layer 2 solutions in the past week, with a total locked amount of $8.74 billion. Among the Layer 2 solutions, Arbitrum TVL experienced a slight decline but still holds a 65.7% market share of Layer 2 TVL. However, when looking at the number of ETH bridged, the four major L2 solutions are closely matched, with starknet having the highest amount bridged, reaching 6,647 ETH, indicating funds gradually flowing into ZK-based Layer 2 solutions.

DEX: The overall trading volume in the crypto market has been declining since April, with DEX trading volume reaching its recent peak in March at $133.5 billion. In April, it dropped to $73.7 billion, and as of May 22nd, it reached $51 billion. However, the spot trading volume from DEX to CEX (centralized exchange) reached a historical high of 21.84%. Additionally, there has been notable growth in trading volume on some Layer 2 DEX platforms.

Derivatives DEX: Since May, the overall trading volume of derivatives DEX has been consistently declining. The daily trading volume of major protocols has dropped over 50% compared to April, and the open interest has decreased by around 20%. The decline in trading volume has led to reduced protocol revenue and decreased protocol yield, resulting in a slight 5% decline in TVL.

RWAs: The peak cumulative borrowing amount for RWAs (Real-World Assets) was reached in May 2022 at $1.4 billion. Since the beginning of May, there have been no significant changes in RWAs data, with the current active loan volume at $512 million.

【Stablecoin Track】

The total market capitalization of the stablecoin sector has been consistently shrinking, declining from $137.5 billion at the beginning of 2023 to $129.9 billion. Since the USDC anchoring incident on March 8th, the market capitalization of USDC has been on a downward trend, while the market share of USDT has continued to increase. According to defillama data, as of May 21st, the market capitalization of USDC has dropped to $29.41 billion, while USDT has exceeded $82.98 billion, with USDT holding a market share as high as 63.85%.

Source: Defillama, LD Capital

According to data from Circle’s official website, as of May 18th, the total supply of USDC was $29.6 billion, with a total reserve of $29.7 billion. The market capitalization has fallen back to the level seen in September 2021. In the past week, the issuance of USDC was $1 billion, while the redemption reached $1.4 billion, resulting in a decrease of $400 million in circulation.

Source: Circle Official Website, LD Capital

Since the deployment of the mainnet on May 4th, the number of addresses holding the Curve stablecoin crvUSD is only 33. The net borrowing of crvUSD is approximately $4.7 million, with collateral value of around $6.52 million. On May 18th, the crvUSD UI was officially deployed, resulting in a 243% increase in collateral value compared to before the UI deployment. Currently, only sfrxETH is supported for collateral minting, with future support for stETH.

Source: Dune Analytics, LD Capital

Since the official launch of the MakerDAO lending protocol Spark on May 9th, the total collateral value is $7.46 million, with net borrowed funds amounting to less than $1 million.

【LSD】

In the past week, the staking amount of ETH in the beacon chain has increased by 0.51% compared to the previous period, approaching the next growth range. The current staking rate of ETH has reached 17.29%*. The staking amount of ETH in the past week reached 18,514,148 coins, with a 0.51% increase compared to the previous period. The number of validators has reached 578,573, and when it reaches 589,824, the maximum daily increase in ETH staking validators will rise from 1,800 to 2,025 validators per day, entering the next growth range. This situation is expected to occur within the next 7 days, with an estimate of 9 days.

Image: Continuous Growth in Beacon Chain Validators

Source: LD Capital

*The calculation is based on ETH Locked/ETH Supply; the numerator includes the staked ETH in the beacon chain, the ETH deposited in the beacon chain but not yet activated for validation, and the ETH rewarded by the beacon chain.

Image: ETH Staking Yield Falls Compared to Last Week

Source: LD Capital

The three major LSD protocols have shown steady growth, with Lido experiencing a decline in staked ETH due to a large withdrawal by Celsius. This week, Lido’s ETH staking decreased by 2.82% (excluding the impact of the 428,000 stETH withdrawal by Celsius, Lido actually grew by 3.64%), Rocket Pool grew by 7.48%, and Frax grew by 11.70%, all surpassing the overall growth rate of ETH staking. Rocket Pool’s Minipool queue is at 1,631, and the dynamic deposit pool remains at zero balance, with TVL growth determined by the deposit side. Frax’s CR has increased to 94.75%.

There are discussions within the Lido community regarding staking dividends, and the execution of the proposal carries uncertainties. The proposal suggests allocating 20%-50% (subject to governance adjustment) of the protocol’s revenue for direct distribution or buyback of $LDO tokens to stakers. Currently, Lido’s annual revenue is approximately $30 million, assuming operating expenses of $15 million, leaving $15 million for dividends. The current market capitalization is around $1.866 billion, corresponding to a PE ratio of 124 times. This proposal is still in the discussion phase and has not entered the voting stage. Due to regulatory issues, reconciling various interests, and divergent community opinions on the introduction of DCF valuation for dividends at the current stage, the execution of this proposal carries significant uncertainties.

Lybra Finance has shown outstanding performance in LSDFi, but its sustainability remains uncertain. The Lybra protocol’s TVL has increased by 225% in the past 7 days, and the price has increased by 565%. However, it is important to note that the current surge in TVL is primarily driven by the price-TVL spiral caused by the speculative nature of the token and the underlying imbalance of risk and reward within the protocol. Additionally, the protocol’s single-asset staking is less than the emission, and the circulating supply is in an inflationary state.

It is also necessary to pay attention to the impact of the increasing “risk-free rate” brought by ETH staking on lending protocols. Traditional lending protocols using the deposit-and-lending model are experiencing a shrinkage in their deposit pools and an increase in borrowing rates. On the other hand, lending protocols based on CDP models are relatively less affected.

【Ethereum Layer 2】

The overall TVL (Total Value Locked) of Layer 2 solutions on Ethereum has remained relatively stable in the past week, with a total locked amount of $8.74 billion.

Source: l2beat.com, LD Capital

Arbitrum’s TVL has slightly declined but still holds a market share of 65.7% in the Layer 2 TVL. Optimism’s TVL has seen a minor increase, occupying a market share of 20%. zksync era’s TVL has shown a recovery in growth since mid-May, capturing a market share of 3.24%. Starknet’s TVL has maintained a steady growth since the beginning of May, currently locking $54 million, accounting for less than 1% of the market share.

Source: LD Capital

Source: duneanalytics, LD Capital

In the past week, the Total Value Bridged for Arbitrum, Optimism, Starknet, and Zksync has become comparable. Among them, Starknet has the highest bridge with 6,647 ETH, while Arbitrum has seen a significant decline compared to the previous week. Zksync has shown some recovery.

Recap of Layer2 Events in the Past Week

1. Optimism Mainnet Upgrade — Bedrock

The Bedrock upgrade for Optimism’s mainnet is scheduled to take place on June 7th, 00:00 UTC. According to official documentation, the Bedrock upgrade brings the following five improvements:

(1) Cost Reduction: Bedrock aims to lower costs by optimizing data compression strategies. While the specific range of cost reduction has not been provided, the removal of Gas fees related to EVM execution when submitting data to L1 is expected to provide an additional 10% reduction in costs.

(2) Shortened Deposit Confirmation Time: Previous versions of the protocol required up to 10 minutes for deposit confirmation. With Bedrock’s improved handling of L1 reorgs, this confirmation time is expected to be reduced to within 3 minutes.

(3) Improved Proof Modularity: Bedrock abstracts the proof system from the OP Stack, allowing rollups to choose between fraud proofs or validity proofs.

(4) Enhanced Node Performance: The upgrade replaces the “one transaction per block” model with the ability to include several transactions in a single rollup “block,” significantly improving node software performance.

(5) Ethereum Equivalence Enhancement.

2. As OP approaches its one-year anniversary, on May 31st, the circulating supply of OP will increase.

Optimism tweeted that in the two weeks leading up to this date, there may be a significant amount of on-chain transfers in preparation for the distribution.

According to the official provided table, the unlocked OP quantity for the next year starting from May 2023 is 913 million tokens, accounting for 21.26% of the total circulating supply, which is 2.7 times the current circulating amount. It is worth noting that early core contributors and investors will experience their first unlock.

According to the token unlock data, early core contributors and investors will unlock 81.6 million and 73.01 million OP tokens, respectively, on May 31st, 2023, accounting for 45.8% of the current circulating supply. This may result in significant selling pressure.

3.On May 18th, Radiant Capital passed the ARB distribution proposal

“RFP-18: Strategic Application of ARB Allocation for Radiant DAO Treasury” with a 89% approval rate. The Arbitrum Foundation granted 3,348,026 ARB tokens to the Radiant DAO treasury, which will be distributed as follows:

40% of ARB (1,339,210 tokens) will be airdropped to new dLP stakers on Arbitrum and BSC chains for a period of 6 months to 1 year. The first snapshot was completed on May 18th, and the second snapshot will be announced within the next 30–60 days. Eligible dLP holders must lock their tokens on Arbitrum or BNB Chain for 6–12 months between the two snapshots.

30% of ARB (1,004,408 tokens) will be distributed over the next 52 weeks to all dLP stakers on Arbitrum.

30% of ARB (1,004,408 tokens) will be reserved for strategic purposes in the future.

The ARB rewards provided by RFP-18 have a total value of approximately 2.8 million and will increase the dLP yield, incentivizing longer-term (6–12 months) locking of new dLP tokens and enhancing RDNT liquidity.

4.Starknet Foundation announced the results of the Starknet Early Adopter grant (EAG) program.

The EAG program has a total budget of 10,000,000 STRK tokens, accounting for 0.1% of the initial token supply of STARK (10 billion tokens). The EAG committee will distribute grants to early developers through multiple rounds of selection. In the first round of the EAG program, 104 projects applied and 67 projects were selected. Projects that launched on the mainnet before April 5th can unlock 100% of the granted tokens. Projects that were only deployed on the testnet before that date can unlock 25% of the granted tokens, with the remaining 75% distributed within 2 months after the mainnet launch.

【DEX】

The overall trading volume in the cryptocurrency market has gradually declined since April. DEX trading volume reached a recent high of $133.5 billion in March, dropped to $73.7 billion in April, and stood at $51 billion as of May 22nd. However, Dex to Cex Spot trade Volume reached a historic high of 21.84%.

In addition, the Total Value Locked (TVL) has also decreased from its recent peak. Dex Combined TVL was $14.8 billion at the beginning of 2023, reached a recent high of $19.4 billion in mid-April, and currently stands at $17.2 billion.

Here are the basic data for DEXs in various ecosystems:

Ethereum

Source: LD Capital

ETH L2/sidechain

Source: LD Capital

BTC L2/sidechain

Source: LD Capital

Alt L1

Source: LD Capital

Project Weekly Recap:

Maverick, an AMM with customized liquidity strategies, captured $20 million TVL on Ethereum and $2.6 million TVL on Zksync Era. It ranks among the top five in 24-hour trading volume on Ethereum and has a relatively low Mcap/TVL ratio, indicating higher capital efficiency of Maverick’s customized liquidity AMM.

【Derivatives DEX】

Since May, the trading volume of Derivatives DEX has been steadily declining. The daily trading volume of major protocols has dropped over 50% compared to April, and open interest has decreased by approximately 20%. The decline in trading volume has resulted in decreased protocol revenue and a 5% slight decrease in TVL.

Image: Daily Trading Volume Chart of Derivatives DEX in the Liquidity Pool Model

Image: Daily Trading Volume Chart of DYDX in the Order Book Model

Both the trading volume and the number of active users of the top protocol GMX and DYDX are lower than in the months of March and April. GMX reached its user peak in February, with daily active users exceeding 2,500. It reached its trading volume peak in March, surpassing $10 billion. There was a slight decline in April, followed by a significant drop in May, where the trading volume level was comparable to December 2022, and the daily active users decreased to 1,200.

Image: Monthly Trading Volume and Daily Active Users Chart of GMX

DYDX’s monthly trading volume follows a similar pattern to GMX. The trading volume exceeded $40 billion in March and began to decline afterward. In April, it reached $30 billion, and from May until now, it stands at $1.5 billion, indicating a significant decrease. In terms of active users, during epoch 21, the number of users holding margin on the platform was 4,300, but it decreased to 2,900 in epoch 22, suggesting that many users withdrew their margins and left the trading market.

Image: Monthly Trading Volume Changes of DYDX

The decline in trading volume has resulted in a simultaneous decrease in revenue and a significant drop in the yield rate of fund pool DEXs. GMX’s staking yield rate has decreased from the previous 6% to 3%, and the staking ratio has dropped from its peak of 80% to 77%. The yield rate of GLP has declined from the range of 20%-25% to 10%-15%, and the funds in the GLP pool have experienced a slow decline, decreasing from a peak of $695 million to the current $665 million. The gDAI pool of Gains Network has also seen a decrease in yield rate to the range of 3%-5%.

It’s worth noting that despite the overall decline in trading volume, Kwenta has experienced an increase in trading volume, with May’s trading volume surpassing that of April. This is mainly attributed to its trading incentives program, which started on May 3rd, offering protocol tokens and OP tokens as incentives to its trading users. In a market with low overall sentiment and a decline in trading users, Kwenta’s trading incentives have attracted more users and captured a larger market share.

Image: Monthly Trading Volume Changes of Kwenta

【RWAs】

The peak cumulative borrowing amount for RWAs was reached at $1.4 billion in May 2022. Since the beginning of May until now, there have been no significant changes in the data for the RWAs sector, with the current active loan volume standing at $512 million.

Image: Active Loan Volume by Protocol

Source: rwa.xyz, LD Research

The top 5 active protocols are Maple Finance, Centrifuge, Clearpool, Goldfinch, and TrueFi. Apart from Clearpool, there have been no significant growth in data for the other protocols this week.

Image: Active Loan Data by Protocol

Source: rwa.xyz, LD Research

According to Defillama data, Clearpool’s TVL reached a low point in February 2023, at approximately 2.7 million USD. On April 21st, Clearpool’s TVL was 7.96 million USD, and as of May 21st, it has reached 17.46 million USD, representing a monthly growth rate of 119.3% and a weekly growth rate of 12.7%.

The significant growth over the past few months can be attributed to the protocol attracting three new borrowers: Portofino (launched on March 9th), Fasanara (launched on March 30th), and Alphanonce (launched on April 26th). Additionally, the protocol introduced credit risk premium parameters in April.

Image: Clearpool TVL

Source: Defillama, LD Research

website: ldcap.com

medium：ld-capital.medium.com

In the first half of last week, there was significant uncertainty in the market regarding debt negotiations. However, in the latter half of the week, concerns eased as McCarthy repeatedly confirmed the potential for bipartisan agreement over the weekend. Risk appetite increased significantly, with equity assets experiencing initial suppression followed by a rebound, while gold and cryptocurrencies saw an initial rise followed by a decline.

In the stock market, particularly the large-cap technology sector, price movements last week displayed signs of panic buying as investors worried about missing out on the next bull market.

All three major U.S. stock indices closed higher, with the Nasdaq rising over 3%, the S&P 500 gaining 1.65%, and the Dow Jones Industrial Average increasing by 0.38%. In terms of sectors, the technology sector surged by 4.19%, communication services rose by 3.06%, and technology stocks continued to lead the market. Utilities declined by 4.36%, and real estate fell by 2.40%.

Net long positions in Nasdaq 100 futures (held by asset management companies and leveraged funds) surged last week to the highest level since May 2022. Net long positions in the S&P 500 remained unchanged, while net positions in the Russell 2000 index remained slightly bearish.

On Friday, the trading volume of bullish options on the Nasdaq index reached its highest level in nearly 10 years, since 2014. The ongoing surge in artificial intelligence (AI) hype in the market continues to drive trend trading demand and “animal spirit” behavior in related market sectors.

The Skew index for the S&P 500 experienced a significant decline later last week, which could indicate a reduced level of market concern about future downturns.

The options market indicates that the debt ceiling is still not priced in for risk, making the upcoming June FOMC meeting on June 14, 2023, the next significant event.

In terms of interest rates, the yield curve for government bonds shifted upward this week, creating a situation of short-term decline and long-term rise. The 2-year Treasury yield rebounded from under 4% to nearly 4.3%, while the 10-year Treasury yield increased from 3.44% to 3.68%. The one-month Treasury yield, on the other hand, declined from 5.7% to 5.5%

The Shanghai Composite Index in China saw a slight increase of 0.4%, while the German stock index surged nearly 2%, reaching a new all-time high. The Japanese stock market also experienced a significant increase of 4.4%, reaching a new high since 1990.

The U.S. Dollar Index (DXY) also rose by 0.48% to 103.20. Oil prices showed a slight rebound, rising by 2.54% and closing at $71.82 per barrel. However, gold declined by 1.5% to $1979 per ounce.

In the cryptocurrency market, there was significant volatility last week. Bitcoin (BTC) experienced a slight decrease of 0.58%, while Ethereum (ETH) saw a small increase of 0.21%.

The Total Cryptocurrency Market Cap declined from $11.26 trillion to $11.19 trillion, representing a 0.6% decrease over the past seven days. The Total Cryptocurrency Market Capitalization (Excluding Bitcoin) decreased from $604.3 billion to $600.1 billion, a 0.69% decline over the same period.

Among cryptocurrencies with a market capitalization exceeding $100 million, there was a global resonance surrounding the AI concept. The decentralized graphic rendering network token, RNDR, topped the list with a 37% increase, followed by MASK (+18%), AGIX (+14%), and SNX (+13%). The largest decreases were seen in TON (-8%), SUI (-6%), and SOL (-6%).

The Total Stablecoins Market Cap contracted by 0.41% to $129.47 billion, compared to $137.56 billion at the beginning of the year.

Review of Major Macro Events Last Week:

1.Several Federal Reserve officials delivered speeches, signaling a hawkish stance and briefly raising expectations of interest rate hikes.

2. However, Fed Chair Powell clarified on Friday, suggesting a possible pause in rate hikes, which led to a decline in market expectations.

3. The debt ceiling crisis negotiations faced twists and turns. House Speaker McCarthy and President Biden assured no default would occur, but the expected weekend agreement fell through, dashing hopes of a breakthrough before Monday’s market opening. Negotiations will continue this week, with President Biden and Speaker McCarthy meeting on Monday evening.

4. The G7 communiqué on Sunday expressed support for Ukraine and called on China to exert pressure on Russia to cease military aggression. It also emphasized that China, acting in accordance with international rules, would be in line with global interests. The G7 stated it does not seek policies to harm China or impede its economic development, nor does it seek “decoupling nor turning inwards.” Furthermore, President Biden indicated over the weekend that G7 should establish a hotline with China, expecting relations with China to improve “soon” following a dispute earlier this year involving alleged spy balloons that derailed bilateral relations. China expressed strong dissatisfaction with the communiqué, with the Chinese Embassy in the UK urging the G7 to abandon Cold War mentality and stop interfering in other countries’ internal affairs.

5.In terms of individual stocks, last week Tesla held its shareholders’ meeting, during which Elon Musk hinted at two new car models and agreed to test advertising. Home Depot reported overall weak financial results, while Walmart’s financial report reflected continued strength in consumer demand. Target’s financial report was in line with expectations, and its business adjustments showed initial signs of effectiveness. Netflix’s advertising-supported version surpassed 5 million monthly users, resulting in a significant increase in its stock price. Meta announced the development of an AI chip. The Japanese government reached an agreement with Micron to provide financial assistance for the manufacturing of next-generation storage chips.

website: ldcap.com

medium：ld-capital.medium.com

Author: Jaden Fan、Jinze Jiang、LD Capital Research

Summary:

Miners’ sustainable earnings issue has emerged, and the Bitcoin community is facing a potential computing power crisis. The development of the Bitcoin smart network ecosystem can effectively enhance network usage and solve the problem of miners’ sustainable income. However, network congestion severely hampers the development of the Bitcoin network ecosystem, highlighting the importance of Layer 2 (L2) solutions. Among these, Stacks is the most thriving in the Bitcoin second-layer network projects and is about to receive a significant update by the end of 2023.

This article will introduce the mechanism of Stacks and two important DeFi protocols in its ecosystem: ALEX and the Arkadiko Protocol.

Each time Bitcoin block rewards halve, miners’ earnings also halve. As transaction fees contributed by Bitcoin transactions account for less than 5% of miners’ income, the computing power system has always relied on doubling the Bitcoin price. As Bitcoin’s market value rises, and volatility gradually decreases, the mining reward after halving may gradually fail to cover the computing power costs. Hence, Bitcoin needs a sustainable income source. With the explosion of applications, Ethereum’s ecological applications have already solved the problem of sustainable income, but due to Bitcoin’s block time and smart contract limitations, it cannot generate sustainable income.

The Bitcoin NFT protocol, Ordinals, has opened the prelude to the Bitcoin ecosystem’s explosion. Network usage has increased, and transaction fees have soared to early 2018 levels. As of May 11, the number of Ordinals BRC20 tokens broke through 14,000, and the number of inscriptions forged surpassed 5.8 million times, leading to a corresponding increase in miners’ earnings. The growth of Bitcoin network’s daily transaction fee income in mid-2019 and 2021 was due to the overall market’s high activity, while this time, the transaction growth comes from innovative developments in the Bitcoin ecosystem, with BTC’s daily transaction fees reaching a maximum of over 600 BTC.

Image: Total daily transaction fees on the BTC network, calculated in BTC.

Source：Blockchain.com, Trend Research

However, the capacity and speed of the BTC network have restricted the development of related transaction activities. If BTC has an L2 layer like the ETH ecosystem to create more use cases and fees, it could greatly increase the income of network miners and maintain the growth of computational power.

As the BTC halving approaches, the popularity of the BTC L2 concept continues to rise.

Given the current block production speed of the Bitcoin network, the halving is expected to occur in May 2024. BTC halving has always been one of the hottest events in the market. As the halving time approaches, more capital will focus on Bitcoin, but due to its large market capitalization, investing in Bitcoin can only yield market Beta returns. L2 projects that release BTC liquidity and expand the BTC application layer could very likely become the preferred targets for funds seeking Alpha returns.

Stacks is the most thriving project in the BTC second-layer network, and it’s set to welcome a major update by the end of 2023.

Due to the high difficulty of technical development, there have always been relatively few L2 projects on BTC, and market enthusiasm has been low. While the Lightning Network is well-known, it focuses on P2P payments and is not a direct competitor to Stacks. Stacks is currently the most thriving project in the BTC L2 concept. At the end of 2023, the Nakamoto upgrade that Stacks will undergo will bring a comprehensive improvement to the network performance, and it will launch a crucial product — SBTC. Given the upcoming BTC halving cycle, there is a possibility that Stacks could attract excessive market funds.

Background Event:

Image: STX price trend

Source: TradingView, Trend Research

On February 21, 2023, the BTC price broke through the $25,000 mark for the first time in seven months. The Ordinal Punks, based on the Bitcoin NFT protocol Ordinals, set off the boom of BTC NFT projects. According to the Twitter information of the bot Ordinal Punk Sales, an Ordinal Punk that was minted at a price of 0.01 BTC once sold for as high as 9.5 Bitcoins, worth more than $240,000.

Ordinals is a Bitcoin NFT protocol, launched by Casey Rodarmor on January 21, 2023. Its core technical point is to uniquely identify the smallest unit of Bitcoin, satoshi, by adding specific content to the script of taproot script-path transactions, thus enabling traceability. A satoshi with specific content can be understood as an NFT on the Bitcoin network. Using Ordinals doesn’t require Bitcoin side chains or second-layer networks, and it can be used without making any changes to the Bitcoin network.

Subsequently, user @domodata believed that when the information attached in the Ordinals protocol is set to a unified standard, the Ordinals protocol could not only issue non-fungible tokens (NFTs) but also fungible tokens (FTs). Therefore, on March 8, @domodata created the first experimental BRC20 standard token ORDI through the Ordinals protocol. As of May 10, the historical highest price of ORDI exceeded $29, and there were over 14,000 types of BRC20 tokens. The cumulative number of inscriptions forged by Ordinals reached up to 5.7 million times, with a single-day peak of 400,000 times on May 7. Moreover, the main types of Ordinals are images and text. The outbreak of text-type (BRC20) tokens on April 23 significantly increased the usage rate of the Bitcoin network.

Image: BRC20 Tokens

Source: https://brc-20.io/， Trend Research

Image: Number of Ordinals Inscriptions Forged

Source: Dune.com, Trend Research

Image: Types of BTC Inscriptions Forged

Source: Dune.com, Trend Research

The popularity of BTC NFT and BRC20 has also led to an increase in transaction fees on the Bitcoin chain, and miner earnings have grown correspondingly. The peak of single-day transaction fees in USD has already leveled with the bull markets at the end of 2017 and April 2021. Ordinals has brought a new trend, but BRC20 and BTC NFT are not based on actual use cases. Whether the trading volume of BTC NFT and BRC20 will disappear from public view after the heat subsides still needs time to verify.

Image: Daily BTC Transaction Fees in USD

Source: Blockchain.com, Trend Research

At the same time, what comes along is the congestion of the Bitcoin network, with the number of unconfirmed transactions reaching nearly 400,000. Bitcoin developers Erik Aronesty and Ali Sherief both initiated discussions on “whether it’s necessary to reject non-standard Taproot transactions” to address the problem of Bitcoin network congestion. Most of the community opposed this proposal. On May 7, the founder of the cross-chain project Interlay proposed the BRC21 standard for cross-chain assets from Ethereum and other chains to the Bitcoin chain, but the congestion of the Bitcoin network is one of the key obstacles to the development of the Bitcoin ecosystem.

Image: Bitcoin Network Status (May 10, 2023)

Source: mempool.space, Trend Research

The phenomenon of increased miner fees caused by the issuance of BTC NFT and the boom of BRC-20, the issue of Bitcoin network congestion, and the direction of Bitcoin network ecosystem development — these all deserve our reconsideration of the long-established concept of BTC L2 and its future development prospects.

BTC Layer2

Historical Discussions

The second layer network (BTC L2) solution for Bitcoin was born to address Bitcoin network scalability and high transaction fee problems. As early as 2015, Joseph P oon and Thaddeus Dryja proposed the concept of the Lightning Network, which is currently the most well-known project. The Lightning Network, by establishing payment channels, realizes fast and low-cost Bitcoin transactions, greatly improving the scalability of the Bitcoin network. Currently, the number of nodes and application scenarios of the Lightning Network are rapidly developing.

The Lightning Network primarily solves the issues of slow BTC payment speed and high costs, but it does not address the lack of native application building for BTC. Thus, during the same period, the concept of Bitcoin sidechains (Sidechain) was also proposed. Blockstream first proposed and developed a sidechain called the Liquid Network, which went live in 2018. Another protocol that launched around the same time was RSK (Rootstock), which is more famous than Liquid.

Due to the massive workload and high technical difficulty in developing BTC-based L2, RSK and Stacks gradually became among the few projects in BTC L2 that could enable application building on the Bitcoin network.

Around 2019, Ethereum network projects were thriving, while the BTC network was languishing. The community began to discuss whether we really need BTC L2, or whether we just need a good BTC cross-chain protocol to release BTC’s liquidity. The Bitcoin anchored token protocol witnessed an explosion, with the current largest BTC anchored token protocol being born during this period. As subsequent developments have shown, both BTC-anchored tokens and BTC-based stablecoins have encountered issues:

The most significant issue is security and reliability. As these protocols often merely lock BTC in multi-signature addresses, the security and cooperative relationships of the signatories become potential risks, deterring users with large amounts of assets from using anchored token schemes.

Lack of native application scenarios in the Bitcoin ecosystem, heavily dependent on Ethereum. The importance of a reliable BTC L2 network is undeniable. It will provide the underlying technical framework for more native and secure Bitcoin anchored tokens, as well as provide an environment for the development of Bitcoin second-layer applications. It is key to transforming BTC from a passive income asset to an active income asset.

Since 2015, different solutions such as Drivechain, RGB Protocol, and Statechains have been proposed. This report will focus on Stacks for analysis.

Here are several important proposals for Bitcoin scalability projects in history:

Source: LD Capital

Stacks Project Introduction

Project Overview and Roadmap

Stacks is a smart contract layer for Bitcoin, aiming to allow smart contracts to use Bitcoin as an asset and settle transactions on the Bitcoin blockchain without the need for trust.

The initial version of Stacks was launched in early 2021, introducing Bitcoin transaction settlement, adopting the Clarity language for smart contract design, and supporting atomic asset swaps with BTC. The goal of the Stacks layer is to transform BTC into a productive asset rather than a passive one, enabling various decentralized applications to enhance the Bitcoin economy.

While Stacks does not directly call itself a Sidechain, we believe that Stacks essentially still builds a new chain outside the Bitcoin chain, with an independent governance structure and transaction model. However, unlike the usual Sidechain which bridges assets only through cross-chain bridges, Stacks integrates with the Bitcoin main chain by submitting anchoring transactions on it. These anchoring transactions contain a digest of block header information on the Stacks chain and some additional information and are broadcast to the Bitcoin network to ensure their immutability. Moreover, the project allows applications and smart contracts to use BTC as their asset or currency, settling their transactions on the Bitcoin main chain.

Therefore, it can be defined that Stacks is an innovative Sidechain model. Compared with the Rollup scheme of ETH, which is the so-called “native Layer2”, both bundle multiple transactions into a batch and submit it to the blockchain for verification. This approach can effectively reduce the number of transactions on the blockchain, thus improving overall performance. The main difference is:

Verification Mechanism: Stacks uses PoX (Proof of Transfer) consensus algorithm, while Optimism Rollup uses PoS (Proof of Stake) consensus algorithm.

Security: After ETH switches to the POS mechanism, the miner and the validator are the same role, and the validation nodes on the Rollup chain need to pledge a certain amount of ETH as a security guarantee. In Stacks, however, miners and transaction validators are two roles. Transaction validators need to pledge STX tokens (mining BTC), and miners need to pledge BTC on the Bitcoin main chain (mining STX).

2018 Q4 Mainnet launch

2018 Q4 Official wallet Hiro Wallet released

2019 Q2 Submitted $50 million to SEC, applying for compliant token issuance

2019 Q2 Stacks 2.0 white paper released

2019 Q2 Introduced Clarity contract development oracle

2019 Q3 Became the first SEC compliant public fundraising project

2019 Q3 Raised $23 million through token issuance

2020 Q1 Implemented Proof of Transfer (POX) consensus mechanism

2020 Q2 Stacks 2.0 testnet launched

2020 Q2 Submitted development report to SEC

2020 Q4 After the launch of Stacks 2.0, STX is no longer considered a security under U.S. law (SEC did not publicly agree with this view)

2021 Q2 Released Stacks Accelerator ecological development project

2021 Q2 Released Stacks expansion plan Hyperchain

2021 Q4 Audited Clarity contracts

2022 Q2 Released version 2.05.0.2.0

2023 Q1 Stacks 2.1 version released

2023 Q1 Launched Hiro developer platform

2023 Q4 Major update, Nakamoto network released

2023 Q4 Major update, SBTC released

2.The Architecture of Stacks and How It Works

Stacks’ technical architecture includes a core layer and subnets, with developers and users being able to choose between the two. The Stacks mainnet is highly decentralized but has a low throughput, while subnets are less decentralized but have a higher throughput. Given that the miners/operators of a subnet can require high network bandwidth among the mining pools, such as using data center nodes, they can even whitelist the subnet mining pools to ensure high performance.

Image: Stacks Architecture

Source: https://stx.is/nakamoto

The Stacks core layer interacts with the Bitcoin layer based on the PoX (Proof of Transfer) mechanism. PoX is a staking system similar to PoS, and their interaction process is as follows:

Image: Interaction process between different roles in Stacks

Source: stx.is, Trend Research

STX miners participate in leader elections by sending transactions on the Bitcoin blockchain. A verifiable random function (VRF) is used to randomly select the leader for each round (giving more weight to higher BTC bids), who then writes new blocks on the Stacks chain.

STX holders can participate in consensus and earn BTC rewards through a process known as “Stacking.” This process involves users locking their STX for a reward cycle (approximately two weeks), running or supporting a full node, and sending useful information on the network via STX transactions. STX holders who actively participate in Stacking will receive Bitcoin rewards for that cycle.

PoX miners bid on the Bitcoin layer to become the leader of the next block. They participate in the bidding by spending Bitcoin and earn STX tokens as a reward.

Once PoX miners win the leader bid, they start creating a new block and add it to the Stacks layer. This process is achieved through chain anchoring, which binds information in the Stacks blockchain with information on the Bitcoin blockchain.

Within the Stacks layer, the new block contains all the latest transactions and state changes. These transactions and state changes are broadcasted to the entire network and are verified and confirmed by other nodes.

Once a new block is confirmed, it’s added to the Stacks blockchain, and all relevant parties can see the latest state.

The interaction between the Stacks core layer and the Bitcoin layer is achieved through a process called “chain anchoring.” Chain anchoring is the process of binding information from the Stacks blockchain to the Bitcoin blockchain. This process ensures that all transactions and state changes occurring in the Stacks network can be traced back to the Bitcoin blockchain and can be proven to be recognized and protected by the Bitcoin network.

Specifically, each Stacks block contains a hash that points to the previous Stacks block and a hash that points to the previous Bitcoin block. This hash is generated by combining the hash of the previous Bitcoin block with the hash of the previous Stacks block. As a result, each new Stacks block includes a hash pointing to the previous Bitcoin block at its header, thereby binding the two networks together.

Here’s an example:

Let’s say Alice is a Stacks PoX (Proof of Transfer) miner who wants to become the leader of the next block. She can participate in a bidding process on the Stacks network by spending Bitcoin (BTC). The higher her bid, the greater her chances of becoming the leader. This bidding process takes place on the Stacks chain, while the new block is written to the Bitcoin layer.

Once Alice wins the leader bidding, she starts creating a new block and adds it to the Stacks layer. As a reward, Alice receives a certain amount of STX tokens. These STX tokens are composed of transaction fees paid by other Stacks users and, due to the PoX mechanism, obtained by Alice spending BTC.

In summary, PoX differs from Bitcoin’s PoW (Proof of Work) consensus mechanism, but it utilizes already mined BTC as security instead of mining power and uses STX tokens instead of BTC as miner rewards.

Nakamoto Upgrade

The Nakamoto Upgrade is the next major upgrade for Stacks, scheduled for release in Q4 of 2023. This upgrade is significant as it introduces five important features, with the most notable being the security protection of Stacks transactions by the Bitcoin network. This feature enhances the security and reliability of Stacks transactions and transforms it into a true Layer 2 solution rather than an independent sidechain with its own state. Additionally, it introduces decentralized, bi-directional Bitcoin anchoring (sBTC), which has the potential to unlock a “Bitcoin DeFi market” worth hundreds of billions of dollars. Furthermore, the upgrade brings faster block times of 4–5 seconds and support for programming languages like Solidity, greatly improving network performance and reducing barriers for developers to enter, thus providing the conditions for ecosystem projects to flourish.

According to the information provided in Stacks’ December whitepaper regarding the Nakamoto Upgrade, the more detailed contents are as follows:

1. Shared Network Security with BTC: Enables Stacks transactions to benefit from Bitcoin’s finality of confirmation. After approximately 100 Bitcoin blocks or approximately one day, transactions on the Stacks layer will be protected by the hash power of the entire Bitcoin network. This means that to reverse these transactions, an attacker would need to attack the entire Bitcoin network. These transactions settle on the Bitcoin network and possess Bitcoin’s finality. Additionally, the Stacks layer forks simultaneously with the Bitcoin network, so any state on the Stacks layer automatically follows Bitcoin’s forks.

2.sBTC: Introduces a new decentralized, non-custodial Bitcoin-pegged asset called sBTC, allowing smart contracts to run faster and cheaper without compromising security. This enables Stacks layer contracts to write to the Bitcoin network with trust in anchored transaction. Stacks already supports BTC atomic swaps, enabling Bitcoin addresses to own and move assets defined on the Stacks layer. Implemented examples of trustless atomic swaps between Bitcoin L1 and the Stacks layer are Magic swaps and Catamaran swaps. Furthermore, users can own Stacks layer assets, such as STX, stablecoins, and NFTs, on Bitcoin addresses and transfer them via Bitcoin L1 transactions.

3.Clarity Language: Clarity is a secure and decidable language for provable smart contracts. With Clarity, developers can output execution results before executing, determining what a contract can and cannot do. Clarity greatly enhances the security of on-chain smart contracts. For example, with Clarity, it is possible to determine the balance of your account after a signature operation or a transfer before confirmation. As of December 2022, over 5,000 Clarity contracts have been deployed on the Stacks layer.

4.Bitcoin State Reading: Enables full reading of Bitcoin chain data, supports reading Bitcoin transactions and state changes, and executes smart contracts triggered by Bitcoin transactions. Bitcoin reading capabilities allow for synchronization of Bitcoin L1 and L2 network data.

5.Fast Block Times and Custom Subnets with Multi-Language Support: The current block time is 10 minutes, but with the upgrade and Byzantine consensus, block times can reach 4–5 seconds, breaking the 10-minute block time limitation of Bitcoin. Transaction hashes will be written to Bitcoin for network security with each Bitcoin block. Additionally, scalability layers such as subnets can make different trade-offs between performance and decentralization compared to the Stacks mainnet. Subnets can support other programming languages and execution environments, such as Ethereum’s Solidity and EVM, enabling all Ethereum smart contracts to utilize Bitcoin-anchored assets and settle on the Bitcoin chain.

SBTC

SBTC is a core product of the Nakamoto network upgrade. In the absence of native assets on the Layer 2 (L2) network, the financial ecosystem of the L2 network cannot operate. SBTC addresses this issue by enabling decentralized Bitcoin lending, Bitcoin-backed stablecoins, and more. Compared to current BTC-pegged token solutions, SBTC offers a more decentralized and native anchoring approach, which can gain a significant share in the BTC-pegged token market and greatly increase the Total Value Locked (TVL) and user base of the Stacks network.

Key features of SBTC include a decentralized set of signers as validators, which dynamically change and overcome the centralization challenge of limited maximum signers (15) and the inability to change signers in BTC multi-signature addresses. On the other hand, as the core asset of the Stacks L2 network, the disadvantage is the lack of incentives in the mainstream applications of the ETH ecosystem, while the advantage is gaining incentives from all DeFi applications on the Stacks network. Finally, the market value of SBTC has imaginative potential through the issuance of stablecoins based on SBTC.

Figure: SBTC determination/unlocking process

Source: Stacks whitepaper, Trend Research

The basic principles of BTC-pegged assets are as follows:

1. Lock-Mint: Lock BTC on the BTC chain and mint anchored assets on the target chain.

2.Burn-Unlock: Burn anchored assets on the target chain and release BTC on the BTC chain.

Due to the lack of Turing completeness on the BTC chain, the locking of BTC on the BTC chain requires the involvement of a custodial account managed by a custodian. When a Burn transaction occurs, the Unlock process must be manually completed by the custodian.

BTC-pegged token application chains with Turing completeness (e.g., WBTC on the ETH chain) can choose to deploy BTC light node contracts on the target chain. When users submit Lock transactions to the light node contract, it can verify the contract and execute the Mint action. Alternatively, relying on custodians to verify Lock transactions and execute Mint is also an option.

The key point in the design of BTC-pegged assets is the custodian mechanism, which determines whether the anchoring solution is centralized or decentralized and affects the security of the assets.

The specific process of Minting and Burning SBTC is as follows:

When a user wants to convert BTC to SBTC, they need to send BTC to a multi-signature address and initiate a transaction on the Stacks network. This transaction triggers a smart contract that sends BTC to the multi-signature address and creates a corresponding amount of SBTC assets on the Stacks network. When a user wants to convert SBTC back to BTC, they need to send a message to the smart contract and initiate another transaction on the Stacks network. This transaction triggers another smart contract that burns the corresponding amount of SBTC assets and sends the user the corresponding amount of BTC.

Source: LD Capital

Analysis of BTC-pegged Tokens on the Ethereum Chain

Figure: BTC-pegged Tokens on the Ethereum Chain

Source: dune.com Trend Research

2020–04–01: 2,500 BTC

2022–05–01: 334,541 BTC (+133.8X)

The DeFi Summer and the chase for Total Value Locked (TVL) led to rapid growth in BTC-pegged tokens on the Ethereum chain. The peak circulating market value of BTC-pegged tokens accounted for approximately 1.57% of the total BTC market value. WBTC had the largest market share at 83%, followed by HBTC at 11.5%. Centralized BTC-pegged tokens accounted for over 95% of the market share, while in decentralized solutions, REN BTC had the largest scale with a share of around 2%. In November 2020, REN BTC briefly reached a market share of over 15%.

Comparison between Stacks and RSK

Stacks and RSK are both Bitcoin-based smart contract platforms aimed at expanding the functionality and use cases of Bitcoin. Here are some advantages of Stacks compared to RSK:

Deeper connection to Bitcoin: The connection between the Stacks layer and the Bitcoin mainchain is more profound and tight. Specifically, the Stacks layer utilizes a technology that enables smart contract functionality, allowing Stacks to directly use Bitcoin as its asset or currency and settle transactions on the Bitcoin mainchain. This design creates a closer integration with the Bitcoin mainchain and better utilizes the security and stability of Bitcoin.

More efficient smart contract execution: The Stacks layer adopts a new smart contract programming language called Clarity, which aims to improve the reliability, security, and auditability of smart contracts. Clarity language offers advantages such as conciseness, clarity, predictability, and ease of auditing, making smart contract execution more efficient and reliable.

Better decentralized governance: The Stacks layer employs a decentralized governance model, allowing community members to participate in platform decisions. Going forward, the Stacks layer will continue to advance decentralized governance and provide more opportunities for community engagement. On the other hand, RSK governance is conducted through a governance council composed of five seats representing community participation.

Wider ecosystem support: The Stacks ecosystem is actively growing and has attracted many notable projects and companies to join. For example, Blockstack PBC (now renamed Hiro Systems) is one of the most significant projects within the Stacks ecosystem, and it has developed many applications based on the Stacks platform. The Stacks ecosystem aims to provide developers with a range of tools and resources to build decentralized applications.

Token Economic Model

The total supply cap for the STX token is 1.818 billion, with a current circulating supply of approximately 1.36 billion.

The genesis block of the Stacks cryptocurrency contained 1.32 billion STX tokens. These STX tokens were distributed through several issuances in 2017 and 2019. The 2017 issuance had a price of $0.12 per STX, the 2019 issuance had a price of $0.25 per STX, and the SEC-compliant issuance in 2019 had a price of $0.30 per STX.

The distribution of mining rewards is as follows: 1,000 STX per block for the first 4 years, 500 STX per block for the next 4 years, 250 STX per block for the subsequent 4 years, and then a permanent distribution of 125 STX per block. The STX allocated to founders and employees follow a 3-year unlocking schedule.

https://gaia.blockstack.org/hub/1Eo6q4qLMcSSpkhoUADxRAGZhgUyjVEVcK/stacks-zh.pdf

Figure: STX Token Allocation

Source: stacks-zh, Trend Research

Stacking Rewards: Stacking is a staking mechanism where users can secure the network and earn STX rewards by staking their STX tokens. Stacking rewards vary based on the amount of staked STX and the overall network participation rate. Holders can choose different stacking periods to earn different rewards. Generally, longer stacking periods offer higher rewards. The reward size depends on the amount of tokens locked and the length of the stacking period. Participants receive their rewards at the end of the stacking period in the form of STX, which is stored in their wallets. The length of a stacking period is approximately 1,800 blocks, equivalent to around 2 weeks. At the end of each stacking period, participants can choose to continue stacking or exit.

Liquidity Mining: In addition to stacking rewards, users can earn STX by providing liquidity to the Stacks DEX (decentralized exchange) on the Stacks blockchain.

Governance: STX token holders have governance rights over the Stacks blockchain and can vote on proposals and changes to the network.

Burn Mechanism: A portion of transaction fees on the Stacks blockchain is burned over time, reducing the overall supply of STX tokens.

4.Network and User Status

Figure: Stacks TVL Changes

Source: defillama, Trend Research

Figure: Stacks Wallet Count

Source: stacksdata.info, Trend Research

Figure: Stacks Contract Deployments

Source: stacksdata.info, Trend Research

Compared to Layer 2 solutions on Ethereum, Stacks is still relatively small in terms of its volume, whether it’s Total Value Locked (TVL) or the number of active addresses.

In Q4 2022 and 2023, the number of Stacks network addresses experienced significant growth, mainly driven by BNS domain registrations and the vibrant BTC ecosystem.

The number of contract deployments has surged in the first half of 2023, indicating optimistic prospects for ecosystem development.

5.Huge Development Potential for BTC Layer 2 Projects

Currently, the amount of BTC bridged to the Ethereum network through various solutions is approximately 165,000 BTC, and the total BTC holdings in the top 100 marked addresses by Binance exchange is 375,000 BTC. BTC holders who are willing to take on the centralized custody risk show relatively high acceptance of BTC Layer 2 solutions. Based on this, it can be speculated that the Total Value Locked (TVL) of BTC Layer 2 solutions could reach the level of 500,000 BTC in an optimistic scenario.

On the other hand, the current total amount of BTC on Stacks is only around 2,700 BTC, which has not fully unlocked the potential value of BTC. This indicates that BTC Layer 2 solutions still have significant room for development. If the TVL of BTC Layer 2 can reach 500,000 BTC, it would unlock a value of $13.5 billion at the current BTC price, which is 3.7 times the TVL of Layer 2 solutions on Ethereum. Stacks, as the most thriving Layer 2 project in the Bitcoin ecosystem, could potentially be the biggest beneficiary.

The ratio of ETH TVL to ETH Layer 2 TVL (mainly Arbitrum and Optimism) is approximately 11.38.

The ratio of BTC TVL (BTC FDV) to BTC Layer 2 TVL (including Stacks and Rootstock) is approximately 17,074.

The ratio of ETH FDV to ETH Layer 2 FDV (mainly Arbitrum and Optimism) is approximately 11.72.

The ratio of BTC FDV to BTC Layer 2 FDV (including Stacks and Rootstock) is approximately 441.32.

Based on a simple comparison of TVL and FDV, BTC Layer 2 projects are relatively overvalued compared to Ethereum Layer 2 projects. This is mainly due to higher market expectations for BTC Layer 2 solutions.

Using the TVL/FDV values of the current Ethereum Layer 2 projects, Arbitrum and Optimism, as reference values, an estimation can be made for Stacks.

TVL predictions are divided into optimistic, neutral, and pessimistic scenarios. In the optimistic scenario, the TVL is projected to reach 500,000 BTC, which is the sum of Ethereum-crossed BTC and the BTC held in Binance-marked addresses. In the neutral scenario, it reaches the amount of BTC anchored on Ethereum. In the pessimistic scenario, it reaches 20,000 BTC.

Source: LD Capital

6.Team Members and Recent Updates

In the early stages, the main company behind Stacks was Blockstack PBC, which has since been renamed Hiro Systems PBC (referred to as Hiro). Muneeb Ali is the founder of Hiro and a key member of the Stacks project. The core team members have extensive experience in the field of distributed systems, including six Ph.D. holders in distributed systems and two scientists who have received the U.S. “Presidential Career Award.”

Core Members of the Stacks Ecosystem

Muneeb Ali, Co-founder of Stacks and CEO of Hiro, holds a Ph.D. in computer science from Princeton University and specializes in building full-stack solutions for decentralized applications. He has given talks at forums like TEDx, spreading knowledge about cryptocurrency, blockchain, and has authored numerous academic publications and whitepapers on related topics. He is currently active on Twitter, and much of the information regarding product updates and development plans can be sourced from Muneeb.

Jude Nelson, Chief Technology Officer (CTO) of Stacks, was previously an engineering partner at Hiro and obtained a Ph.D. in computer science from Princeton University. He was a core member of PlanetLab, a laboratory that received the ACM Test of Time Award for implementing and deploying planetary-scale experiments. His research has covered topics such as optical and storage systems, and Content Delivery Networks (CDNs). He has been using Vim for over ten years. In the past year, he has been one of the major contributors on the Stacks GitHub repository, with 1,273 contributions.

Aaron Blankstein, Chief Security Officer (CSO) of Stacks, joined the Blockstack engineering team after receiving his Ph.D. in 2017. He studied computer science at Princeton University and MIT. His research covers multiple topics, primarily focused on web application performance, caching algorithms, compilers, and applied cryptography. His research on CONIKS received the Caspar Bowden Privacy Enhancing Technologies Award in 2017. He has been using Emacs for over ten years. In the past year, Aaron has made 581 contributions.

7.Development and Ecosystem Project Status

Stacks was initially launched as an open-source project by Bitcoin builders, and the developers behind it have rich experience in building applications and protocols on top of the Bitcoin network. Currently, there are over 30 independent entities and developers contributing to the Stacks ecosystem, making it one of the most thriving ecosystems among BTC Layer 2 projects. As of March 2023, the official website lists a total of 88 projects, with a focus on 8 key projects.

Key Projects listed on the Stacks official website

Source: LD Capital

For specific project information, please refer to the official website: https://www.stacks.co/explore/discover-apps

According to the latest updates shared by Stacks founder Muneeb on Twitter in February 2023, the following tracks and projects were highlighted:

NFTs on Stacks L2: Projects such as Gamma.io and Satoshibles

Stacks Wallet Applications: Xverse and Hiro Wallet

DeFi on Stacks L2: ALEX and Arkadiko Protocol

As wallets and NFT marketplaces do not issue their own tokens, the focus here is on two DeFi protocols: ALEX and Arkadiko Protocol.

Alex Lab

Alex Lab is the leading DeFi application in the Stacks ecosystem, offering a wide range of product features, including a LaunchPad for token launches, lending and borrowing services, a decentralized exchange (DEX), an order book, and perpetual contracts. Additionally, Alex Lab maintains active interactions with other ecosystem participants, including wallet developers, and enjoys high recognition within the community. Considering that the development language in the Stacks ecosystem is Clarity, which presents a higher entry barrier for Ethereum or other ecosystem developers, Alex Lab has established a moat in the Stacks ecosystem in the short term. This leading position is expected to expand with the growth of other projects within the Stacks ecosystem.

Data Update Date: 2023–05–10

Source: LD Capital

Recent significant updates:

Product Launch: Order Book testnet has been launched.

Product Launch: Cross-chain perpetual contracts are set to be launched soon.

Product Plan: Alex Lab plans to support the Ordinals protocol and enable NFT trading on the Bitcoin network (specific plans to be announced on Medium in the coming weeks).

Token Release: The release of ALEX tokens is expected to halve after block height 103,825.

Funding: Completed a $2.5 million strategic round with participation from Trust Machines and Gossamer Capital.

Team:

Chiente Hsu, CEO — holds a Ph.D. degree and has been involved in quantitative investment. He previously served as Global Head of Credit Suisse Alpha Strategies and Global Head of Quantitative Investment Strategy Research at Morgan Stanley.

Rachel Yu, Co-founder — holds a Master’s degree in Science and is an alumna of Goldman Sachs and J.P. Morgan Asia. She led the institutional sales team in China. After successfully establishing a high-frequency data and machine learning trading company, she co-founded ALEX.

Chiente and Rachel have extensive experience in various domains of the financial industry. Alex Lab’s development team consists of experts with backgrounds in financial engineering, smart contract development, and cryptocurrency.

Product:

LaunchPad: Currently, two projects have conducted IDOs (Initial DEX Offerings) on the LaunchPad: ALEX on January 19, 2022, and BANANA (Bitcoin Monkey, similar to BAYC). As the Stacks ecosystem lacks projects with token launches, the LaunchPad feature has not demonstrated significant contributions to the ecosystem.

Figure: Alex Labs Trading Volume

Source: app.alexlab.co, Trend Research

Swap: Currently supports the exchange of 12 different tokens. The latest daily trading volume is $0.8 million. In February, with the increasing popularity of BTC L2, the daily trading volume significantly increased compared to January, reaching a peak of $3.5 million on February 19. The majority of the trading volume is concentrated in STX and ALX trading pairs. Subsequently, with the listing of the ALEX token on centralized exchanges, on-chain trading volume decreased. The lack of high market cap trading assets is not only a challenge for ALEX but also for the entire BTC L2 ecosystem. Due to the popularity of BRC20, Alex Labs will launch a BRC20 exchange.

Liquidity Pools: Supports 13 liquidity pools, with the largest pool being STX — ALEX.

Figure: Alex staking page

Source: app.alexlab.co/stake

Staking: Staking annualized rewards and the staking period are related to whether one chooses to compound the rewards automatically. From the chart, it can be seen that the total staked amount is 123 million tokens. The minimum staking period is approximately 4 days, and to achieve the maximum annualized rewards, staking for 100 periods (around 100 days) is required. Staking rewards can also be compounded automatically.

Farm: By staking LP Tokens from liquidity pools, users can earn ALEX rewards and APower, which is a metric for obtaining LaunchPad allocations. Currently, 5 LP Tokens are supported, with annualized rewards ranging from 34% to 57%.

Order Book Functionality: Currently in the Beta testing phase, the product’s UI design and user experience are smooth and well-designed.

Economic Model:

Total token supply of 1,000,000,000 tokens.

20% allocated to the foundation, distributed to the community reserve pool to support the ALEX ecosystem, early adopters, and future development.

50% reserved for community staking or providing liquidity tokens to earn $ALEX.

30% allocated to employees, advisors, early investors, and the founding team.

Alex Labs has set a cap on the annual circulation increase of ALEX for the community portion:

Figure: Annual circulation limit for the community portion

Source: docs.alexlab.co, Trend Research

Arkadiko Protocol

Arkadiko is a stablecoin protocol similar to MakerDAO. Its primary goal is to enhance asset liquidity on the Stacks network by enabling users to collateralize assets on Stacks and mint the stablecoin USDa, thereby promoting the development of USDa on the Bitcoin Layer 2 network.

Project Overview

Data Update Date: 2023–05–13

Source: LD Capital

Recent Major Updates:

Stacks 2.1 was released, and after integration with Arkadiko, users will be able to earn Stacking rewards while minting USDa using STX.

The stablecoin liquidity pool has been relaunched to increase the liquidity and stability of USDa.

In late February 2023, a new roadmap was released, indicating plans for a token economics upgrade to reduce Diko selling pressure.

Product:

Compared to Alex Lab, Arkadiko Protocol focuses primarily on stablecoins, with other functional modules serving as auxiliary features. In comparison to stablecoin projects on Ethereum, Arkadiko’s product performance is currently relatively modest. However, with the launch of SBTC on Stacks in the fourth quarter of 2023, it is expected to provide sufficient collateral for Arkadiko’s stablecoin minting and potentially enter a period of rapid growth.

SWAP: Currently supports trading for 7 pairs of tokens, with USDa, STX, and XBTC being the primary tokens. The total value locked (TVL) in the liquidity pool is $2.39 million USD, indicating a relatively small scale.

Borrow: Supports borrowing of USDa using STX, XBTC, and ALEX.

Stake: Supports staking of stDiko, USDa, and LP tokens from the liquidity pool. The annualized yield ranges from 50% to 76.03% for most tokens, with stDiko offering a 7.4% annualized yield, maintaining relatively high levels of yield.

Governance: 22 proposals have been completed thus far, with the latest ongoing proposal being the integration of Stacks 2.1.

Token Distribution:

Figure: Token Allocation

Source: Arkadiko Whitepaper, Trend Research

The total token supply is 100,000,000 tokens.

21% Team — Vested over 4 years with monthly unlocking after a 6-month lockup period.

12% Strategic Funding — Vested over 4 years with monthly unlocking after a 6-month lockup period.

17% Arkadiko Foundation Treasury — Tokens held by the foundation with release specifics based on purpose.

50% Ecosystem Incentive Pool — Incentives for users providing liquidity to the protocol.

Figure: Token Release

Source: Arkadiko Whitepaper, Trend Research

The initial weekly release is approximately 1.3 million DIKO, followed by a 2% reduction every two weeks. Currently, the circulating supply is 35,902,590 tokens, accounting for 35.9% of the total token supply.

Conclusion

Stacks Labs is currently the most prosperous Bitcoin Layer 2 project in terms of ecosystem development, despite having lower TVL and active address data compared to Ethereum Layer 2 projects. The Bitcoin Layer 2 space has significant potential for growth. The upcoming Nakamoto upgrade in Q4 2023 will introduce five important features. Of particular interest is the enhancement of security for Stacks transactions through the protection of the Bitcoin network. This feature will make Stacks transactions more secure and reliable, establishing it as a true Layer 2 solution rather than an independent sidechain. Additionally, the introduction of decentralized and two-way Bitcoin anchoring (sBTC) has the potential to unlock a “Bitcoin DeFi market” worth hundreds of billions of dollars. The faster block times of 4–5 seconds and support for programming languages used in other networks, such as Solidity, greatly improve network performance and lower the entry barrier for developers, providing conditions for the ecosystem projects to thrive.

As the leading DEX product in the Stacks ecosystem, Alex Lab offers a rich product suite and provides a good user experience. The team demonstrates strong engineering capabilities and shows proficiency in capturing trends, as seen in their support for Ordinals NFT trading. The team has clear development directions.

However, Alex Lab currently faces two important challenges. Firstly, there is a lack of tradable assets compared to Ethereum and other ecosystems, resulting in lower TVL and active user numbers. Secondly, transaction confirmations are extremely slow, with a SWAP interaction requiring a wait of 4 BTC blocks, averaging 40 minutes. This issue is expected to be resolved with the Stacks Q4 upgrade, which aims to reduce block time to 4–5 seconds.

Overall, despite these challenges, Alex Lab remains an excellent product, and it is poised to benefit from the initial issuance and trading activities of various project tokens in the event of a Bitcoin Layer 2 breakout.

Arkadiko Protocol, as an early and continuously developed stablecoin project on Stacks, has a team with good technical capabilities and closely collaborates with Stacks official and existing ecosystem projects. However, the project currently relies mainly on STX as collateral, which has a relatively low market value. Additionally, the stablecoin USDA also faces challenges of an underdeveloped ecosystem and limited use cases. It is anticipated that with the release of Stacks SBTC, which will provide sufficient collateral for USDA, and the gradual enrichment of Stacks Layer 2 applications, USDA can gain a market share in the stablecoin market, particularly in the Bitcoin Layer 2 network.

website: ldcap.com

medium：ld-capital.medium.com

Author：Yuuki Yang、LD Capital Research

Introduction:

The NFT market in 2023 can be divided by the launch of Blur on February 14th. Before February 14th, the prices of NFT projects, trading platforms, and lending products were continuously rising. However, after the launch of Blur, the entire NFT market quickly turned bearish, with the NFT floor price continuously declining. The prices of trading platform tokens Looks and X2Y2 have dropped by 80% compared to their peak in February. Lending protocols like Bend and Jpeg have also entered a downward trend in adoption rate, TVL (Total Value Locked), and token prices due to the decrease in NFT collateral prices. How is the development of NFTFi currently? Recently, Blur has announced a new product called Blend, entering the NFT lending race. What impact might it have on the NFT ecosystem?

Summary:

The current NFT market lacks new narratives and new capital inflows, and high transaction fees lead to a continuous shrinking of funds within the NFT ecosystem. Since the market turned bearish in 2022, the core gameplay of NFTs still focuses on PFP (Profile Picture) projects, and the top projects have remained unchanged. The number of NFT traders continues to decline, and the market as a whole lacks new gameplay and new capital. The high intermediary costs of NFT transactions, including royalties and platform fees, result in a significant amount of funds being extracted by project creators and trading platforms. According to data from NFTGO, the estimated transaction costs of NFTs have reached 24% of the total market value of NFTs. From this perspective, it can partially explain why the listing of Blur provided ample liquidity to the NFT market but led to a rise and fall in the prices of NFT projects (high turnover leading to shrinking funds within the ecosystem; repricing of highly liquid assets). Overall, in the absence of new players entering the market, the continuous shrinkage of existing funds within the NFT ecosystem is one of the main reasons for the continuous decline in NFT prices. The entry of incremental capital, a decline in pseudo-buyer liquidity in the market, or a reduction in transaction costs are the indicators to observe for the stabilization of NFT prices.

Vicious competition among NFT trading platforms has reached the latter stage, but a turning point in the race has yet to be seen, and the concentrated selling pressure resulting from accumulated token deficits is a challenge for Blur. Currently, the NFT trading platform race is still in the stage of fierce competition, with mainstream platforms reducing their transaction fees to zero, reaching the most intense stage. The situation of new comprehensive NFT trading platforms seizing the market has improved significantly, but real trading demand from NFTs has yet to see growth, and the turning point of the overall race has not yet appeared. As for Blur, it has captured a significant market share by effectively incentivizing buyer liquidity, but the anticipated airdrop incentives mask the accumulated token deficits since the product’s launch. If the liquidity incentives of Blur are released in a concentrated manner in the future, it could have a significant impact on its price. According to current information, Blur Season 2 will airdrop over 300 million tokens, accounting for 65% of the current circulating supply. The key focus is whether Blur can launch an effective economic model to avoid massive token sell-offs while maintaining continuous binding with liquidity providers.

In a bear market, lending products lack real demand and await the overall recovery of the NFT market. RWA (Real-World Asset) equity-based NFTs, semi-fungible tokens, AI+NFT, and other directions may become new trends. The launch of Blend has had a significant short-term impact on the prices of Bend and Jpeg, but its impact on their businesses is currently minor. This is mainly because there is a lack of real demand for NFT lending, and the main driving force behind the growth of Blend’s business volume is point incentives. The high interest rate subsidy from Bend DAO and the positive premium of Peth over ETH in Jpegd also confirm the lack of demand for NFT lending. As for Blur, Blend’s lending product is currently an expense for the protocol rather than a revenue stream, and there is a significant valuation gap between the lending race and the trading race, so Blend’s role in boosting Blur’s token price is currently limited. Since the demand for lending products will continue to amplify with leverage in a bull market, the rise in underlying collateral prices and the expansion of collateral scope are important indicators to observe for the breakout of the lending race.

Risks: The increase in on-chain yields of ETH squeezes the demand for NFT lending, the concentrated release of Blur’s liquidity costs affecting prices, team and contract risks.

1. Lack of new capital and high transaction fees leading to the continuous decline in NFT prices

NFT currently lacks new narratives and new capital inflows, and high transaction fees result in a continuous shrinkage of funds within the NFT ecosystem. Since the market turned bearish in 2022, the core gameplay of NFTs still revolves around PFP (Profile Picture) projects, and there has been little change among the top projects. Specifically:

Over the past year, the number of NFT traders has been continuously declining. Since the systemic risk triggered by the collapse of Luna in May last year, the number of NFT sellers has consistently exceeded the number of buyers.

Figure 1: Continuous decline in NFT traders

Source: NFTGo, LD Capital

The high intermediary costs of NFT transactions, including royalties and platform fees, resulting in a significant amount of funds being extracted by project creators and trading platforms. According to data from NFTGO, the total market value of NFTs is 8.8 billion, with a total trading volume of 41.8 billion. In the total market value statistics, 45% is categorized as “Others” (non-mainstream NFTs), many of which lack active trading and are in illiquid states. The calculation excludes wash trading in the total trading volume. Under the condition of overestimated total market value and underestimated total trading volume, assuming a 5% transaction fee, the transaction costs of NFTs have reached 24% of the total market value of NFTs. From this perspective, it can partially explain why the listing of Blur provided sufficient liquidity to the NFT market but led to a rise and fall in the prices of NFT projects (high turnover leading to shrinking funds within the ecosystem; repricing of highly liquid assets). Overall, in the absence of new players entering the market, the continuous shrinkage of existing funds within the NFT ecosystem is one of the main reasons for the continuous decline in NFT prices.

Figure 2: Overall volume and price situation in the NFT market

Source: NFTGo, LD Capital

Figure 3: Rise in volume and fall in prices of NFTs after the launch of Blur

Source: NFTGo, LD Capital

Based on this perspective, the relevant indicators for predicting the turning point of NFT prices are: entry of new capital (new users entering or expansion of funds from existing users), Buyers > Sellers; a decrease in pseudo-buyer liquidity in the market or a reduction in transaction costs.

2.The turning point in the NFT trading platform race has not yet appeared, and the concentrated selling pressure resulting from accumulated token deficits is a challenge for Blur.

The profitability of NFTs is continuously declining, and NFT trading platforms are constantly innovating. In particular, Blur’s entry into the market has intensified the competition among NFT trading platforms. With its zero-fee policy and ample liquidity provided by the Bid Pool, Blur quickly captured the highest trading volume in the market. Even though Opensea swiftly adjusted its fees and optimized its product features, the impact was still unsatisfactory. Looksrare and X2Y2’s market share further declined, with their token prices dropping nearly 80% from their peak in February.

Figure 4: Distribution of trading volume among NFT trading platforms

Source: Dune, LD Capital

Currently, the fee structure of mainstream NFT trading platforms is as follows: After Blur rapidly seized the market with its zero-fee policy and high buyer liquidity, Opensea temporarily adjusted its transaction fees to zero and later reinstated them at 2.5%. However, Opensea transformed its original NFT aggregator, Gem, into a new product called Opensea Pro, which implements the same zero-fee policy as Blur and creates a similar frontend interface. Looksrare also adjusted its fee policy from 2% to 0.5% under the influence of Blur. The competition among NFT trading platforms has entered the most intense stage.

Figure 5: Fee structure of mainstream NFT trading platforms

Source: LD Capital

There is currently a significant divergence of opinions regarding Blur, the core subject of focus. Some investors believe that Blur has surpassed Opensea and become the leading NFT trading platform. They have strong confidence in the project team and investment team, and in anticipation of a promising future for the NFT market, they believe that Blur should command a higher valuation premium. On the other hand, some investors believe that Blur’s current zero-fee policy and its economic model based on point incentives are unsustainable. They see significant uncertainty in Blur’s long-term development.

Let’s first examine the differences between Blur and Looksrare, X2Y2 from a product perspective. Apart from the basic trading functions, Blur’s biggest success lies in incentivizing liquidity, particularly buyer liquidity. Looking back at the iterative history of NFT trading platforms, Looksrare was the first to adopt transaction mining to incentivize trading. X2Y2 initially focused on order book mining to incentivize seller liquidity but later switched to the same transaction mining approach as Looksrare. Subsequently, Looksrare began order book mining but incentivized both buyers and sellers, eventually transitioning to primarily incentivizing sellers. Finally, Blur emerged with a primary focus on incentivizing buyer liquidity.

The underlying logic behind this is that in the early stages of the economic model where transaction fees were charged and retained by the platform, designing an economic model that incentivizes transactions allows the team and token holders to earn high income. Looksrare initially generated substantial profits through this approach, but fundamentally, it was a disguised way of selling tokens. X2Y2 initially failed to grasp this point, resulting in minimal income for the team and treasury, and facing an unsustainable development situation. Consequently, they switched to transaction mining. However, transaction mining provides low incentives for genuine users, hindering the construction of network effects for the product. From a developmental perspective, Looksrare started incentivizing liquidity through order book mining, initially with equal incentives for both buyers and sellers. However, due to the nature of NFT trading where sellers pay fees and selling determines the floor price, incentivizing sellers is beneficial for pushing down the floor price. In a market where aggregators have become the entry point for buyers who primarily focus on floor prices, the simultaneous incentivization of both buyers and sellers was less effective than incentivizing sellers alone. As a result, Looksrare adjusted its order book mining model to primarily incentivize sellers.

It wasn’t until Blur launched in mid-February this year that it achieved great success by incentivizing buyer liquidity through the Bid Pool. This success is closely related to the stage of market development. Firstly, NFT trading platforms had already reached a point where they no longer charged fees. If Blur had continued with a transaction mining model that collected NFT transaction fees and provided token subsidies, it would have followed the same path as Looksrare and X2Y2. Of course, Blur’s ability to implement a genuine zero-fee policy is also related to its own resource endowment. The two rounds of funding received by Blur enabled it to forgo short-term team income and accelerate market capture. Secondly, the continued cooling of the entire NFT market shifted the pain point of trading from buying NFTs at low prices to selling them at the highest possible prices. At this stage, there was a significant power disparity between buyers and sellers, with the demand for buyer liquidity far outweighing the demand for seller liquidity. Blur’s incentivization of buyer liquidity perfectly aligned with this pain point. In an order book-based trading system, the level of incentives for both buyers and sellers needs to be adjusted according to the market stage, placing higher demands on Blur’s market sensitivity and agility.

Drawing on the development experience of DEXs and other trading platforms, the core competitiveness of an outstanding platform product capable of spanning cycles lies in its ability to construct cross-side network effects (i.e., multiple parties within the platform having a wide range of counterparties to choose from, thus overshadowing the similar functionalities and experiences of the platform) or forming strong binding interests with asset issuers, users, or liquidity providers, whether by one or multiple parties. From this perspective, in the NFT trading platform space, the construction of cross-side network effects, due to the high liquidity of on-chain users and asset issuers, has yet to materialize. Currently, Blur has bound a group of liquidity providers through point incentives, which is the core reason for its current success, but its sustainability needs to be observed.

From an economic model perspective, the biggest challenge for the core project Blur lies in how to handle the massive token distribution in Season 2. Blur has concealed its liquidity cost expenditure by relying on the expectation of token airdrops instead of traditional community incentives, thereby masking the token-level deficit of the platform since its launch in mid-February. According to current public information, Blur Season 2 will distribute tokens on a scale exceeding 300 million, accounting for 65% of the current circulating supply. If Blur fails to timely adjust its economic model to control token emissions and increase locking mechanisms, its secondary market price may face significant pressure. It is crucial to monitor whether Blur can introduce an effective economic model that avoids large-scale token sell-offs while maintaining continuous binding with liquidity providers. Additionally, it is important to note that on June 14th, there is a significant unlocking of approximately 200 million tokens, accounting for 42% of the current circulating supply. This includes approximately 1.2 billion tokens (26% of the circulating supply) unlocked by the team and approximately 80 million tokens (16% of the circulating supply) unlocked by investors.

Figure 6: On June 14th, Blur faces a large unlock of 200 million tokens.

Source：Token.Unlocks，LD Capital

3.Lack of Real Demand for Borrowing Products in the Bear Market, Waiting for the Overall Recovery of the NFT Market

Since mid-February, the declining prices of NFTs have resulted in a decrease in the adoption rate, Total Value Locked (TVL), and token prices of lending protocols such as Bend dao and Jpegd.

Figure 7: June 14th, Gradual Decline in Business Volume of Mainstream Lending Products Since Mid-February

Source: Dune, LD Capital

Paraspace has achieved good results in the NFT lending field despite the downward trend. Its introduction of U-based lending, Ape lending, and automatic compounding have made it a strong competitor to Bend dao. Since mid-February, while the prices of NFTs denominated in USD have been continuously declining, the price of ETH has been rising. This has resulted in users suffering greater losses when borrowing ETH by pledging NFTs compared to borrowing USDT. Previously, Bend dao only offered ETH lending, while Paraspace provides both ETH and USDT lending, capturing a significant amount of TVL with its diversified product structure (Paraspace has recently encountered issues of user fund misappropriation and team control disputes).

It is worth noting that the upgrade of ETH to Ethereum 2.0 has brought about a risk-free yield of approximately 5% on ETH. This is expected to impact the ETH deposit pools of lending products, leading to continuous shrinkage until interest rates reach equilibrium. This is also the unfavorable situation faced by NFT lending products represented by Bend dao. However, Bend dao recently passed a proposal to add a stablecoin lending pool to withstand industry risks and competition in the field.

As a CPD lending protocol, Jpegd is less affected by the increase in risk-free yield on ETH. It reduces the long-term liquidity incentive costs of the protocol by continuously accumulating CVX to gain governance rights over Curve. However, the integration of Jpegd with Curve and the complexity of its product features significantly increase the protocol’s complexity. Additionally, using Jpegd incurs higher gas fees. Currently, Jpegd, through its combination with Curve, has somewhat reduced the long-term operational costs of the protocol but has made the product structure slightly more complex.

Recently, the launch of Blend, the NFT lending product by Blur, has caused ripples in the NFT lending field. Since the launch of Blend, the prices of Bend and Jpeg tokens have experienced significant declines, while the prices of NFTs have started to recover. However, the price performance of Blur itself has been poor. Specifically:

Blend fundamentally differs from the point-to-pool lending model of Bend dao and Jpeg. It is a peer-to-peer lending product with no loan maturity date. It incorporates an innovative refinancing auction mechanism designed under the assumption of rational lenders. It achieves various enhancements in user experience, such as no external oracle feeding, no maturity date, and the ability for lenders to exit at any time while protecting the interests of borrowers.

Due to Blur’s strong influence in the NFT market combined with the multiple innovations of the Blend product, the TVL of Blend has rapidly increased since its launch. From the perspective of outstanding loans, two days after the launch of Blend, the outstanding loans reached $16.58 million, which accounted for 73% of Bend dao’s outstanding loans at that time. As a result, the prices of Bend and Jpeg tokens were impacted and experienced rapid declines. However, it is worth noting that while Blend’s business expanded rapidly, the TVL of Bend Dao, Jpegd, and Paraspace did not decline. From this perspective, Blend’s growth in the NFT lending market is driven by the protocol’s expenditure through incentivizing demand with points, rather than being driven by genuine lending demand to generate profits. Considering the significant valuation gap between the NFT lending and NFT trading platform sectors, from the perspective of MC (Market Capitalization), Blur’s MC is currently $21 million, while the leading NFT lending protocol Bend dao has an MC of only $4.49 million and Jpegd has an MC of only $13.7 million, indicating a significant difference in magnitude. Therefore, at the current stage, Blend has not made a significant contribution to the price increase of Blur.

Regarding the Blend lending product, caution should be exercised as the motivations of most borrowers are to earn Blur points, and the actual volume of funds on the lending side is insufficient. Borrowers’ collateral is frequently subject to refinancing auctions initiated by lenders, resulting in borrowers bearing excessively high borrowing interest rates or losses due to liquidation of their NFTs.

Conclusion

In summary, lending products are essentially tools for taking long positions on asset prices. They can be used for leverage during bull markets and as alternative liquidity exit channels during bear markets. The recovery of NFT prices complements the development of lending products, and the improvement of lending infrastructure helps sustain NFT prices. However, the real driving force behind the NFTFi ecosystem’s prosperity and the demand for lending products comes from the explosion of underlying assets and the amplification of lending product demand. Currently, it is worth paying attention to new directions such as equity-based NFTs driven by RWA, semi-fungible tokens brought by EIP-3525, and new applications of AI+NFT.

website: ldcap.com

medium：ld-capital.medium.com

Author: Yilan Liu, Jinze Jiang, Drake Zhang, LD Capital Research

Introduction

In recent years, the traditional financial market has witnessed rapid growth in index-based products, such as ETFs, with Smart Beta ETFs exhibiting a higher inflow rate than regular index ETFs. The asset management industry has gradually shifted its focus from conventional index products to more innovative index product series, including ESG ETFs, actively managed ETFs, and thematic ETFs. Among them, active ETFs in the equity market have made significant breakthroughs, attracting off-exchange products to actively transform and becoming a hotbed of active product development in recent years. Global index providers continue to innovate and improve their index systems to meet new market demands, driving the industry towards refined, diversified, and profound development, while fostering continuous innovation in index-based products. Compared to the traditional financial market, crypto index-enhanced products are still in a very early stage. With the overall market capitalization of the crypto market growing, the market space for structured products utilizing index enhancement is expected to increase rapidly. We believe that the market size and current status of US stock index funds and index-enhanced funds/ETFs can provide valuable insights into the development path of crypto index-enhanced funds. We also believe that crypto index-enhanced funds can achieve excess returns that meet the diverse needs of investors with different risk preferences through various enhanced strategies, such as multi-factor quantitative stock selection models, subjective market timing models, sector rotation models, or index futures derivative-enhanced models.

Scale and Development Trends of Regular Index ETFs and Index-Enhanced Funds/ETFs in Hong Kong and US Stock Markets

Between 2015 and 2023, both regular index ETFs and index-enhanced funds/ETFs in the Hong Kong and US stock markets experienced steady growth. However, the scale of index-enhanced funds/ETFs, representing actively managed ETFs, has shown a faster growth trend, increasing tenfold over an eight-year period. By 2023, the scale of index-enhanced funds/ETFs have reached nearly one-third of that of regular index funds.

Table 1: A Comparison of the Total Scale of Regular Index ETFs and Index-Enhanced Funds/ETFs in Hong Kong and US Stock Markets from 2015 to 2023.

Source: VettaFi, Statista

In traditional financial markets, there is a trend where the scale of index funds in the US stock and Hong Kong stock markets can even surpass the market capitalization of the corresponding indices. However, in the crypto market, the scale of index funds/ETFs is far from reaching its market capitalization. With the increasing interest of traditional investors in cryptocurrency asset management products, the development prospects for cryptocurrency index funds and exchange-traded funds (ETFs) are vast.

Table 2: A Comparison of Market Capitalization in the US stock market, Hong Kong stock market, and the cryptocurrency market, along with the corresponding scale of index funds/ETFs.

Source: VettaFi, Statista

Characteristics of Index-Enhanced Funds’ Active Management

Index funds aim to generate returns (β returns) by tracking the characteristics of an index, such as tracking error, market capitalization style, valuation style, industry weight allocation, and individual stock weight allocation.

On the other hand, index-enhanced funds seek to achieve additional returns beyond the market (α returns) through active management by fund managers. They aim to minimize losses compared to the benchmark index during market downturns and capture higher returns compared to the tracked index during market upswings. Over the long term, index-enhanced funds strive for stable compounded performance.

Regarding index tracking, index-enhanced funds have a broader range of indices they can track. They can track broad-based indices, single-industry indices, or other thematic indices. In the current market environment of the US and Hong Kong stocks, popular choices for index-enhanced funds to benchmark against on the β side include the S&P 500, Nasdaq-100, Russell 2000, DJIA, HSI, and HSCEI.

Approaches to Enhancing Index Fund Returns

With ongoing financial market innovations, index-enhanced funds can employ various strategies to achieve excess returns and enhance their overall performance. The “enhanced” portion of index-enhanced funds’ returns can be achieved through strategies such as multi-factor quantitative stock selection models, subjective market timing models, sector rotation models, and index futures derivative-enhanced models. These are commonly utilized approaches in current index-enhanced products.

Quantitative Multi-Factor Enhancement Strategies

The objective of quantitative multi-factor enhancement strategies is to select stocks by simultaneously utilizing multiple factors to achieve better returns. These factors span various dimensions, including technical factors (market dynamics and technical indicators), macro factors, statistical data mining (machine learning, deep learning), and fundamental factors. Fundamental factors may include company financial stability, dividend yield, valuation, among others.

Table 3: Common Multi-Factor Stock Selection Enhanced Index Funds in the US Stock Market.

Using Invesco S&P 500 High Dividend Low Volatility ETF (SPHD) as an Example

SPHD tracks the S&P 500 High Dividend Low Volatility Index and utilizes a multi-factor stock selection strategy, focusing on stocks with high dividend yield and low volatility. It selects the top 50 securities with the highest dividend yield and low volatility from the S&P 500 Index. The component stocks are weighted by dividend yield, with an individual stock weight cap of 3% to ensure diversification. To maintain its low volatility objective, the fund rebalances semi-annually, reassessing stock selection based on updated dividend yield and volatility indicators. Due to its low volatility, this ETF generally outperforms the broader S&P 500 Index during bear markets but may lag behind in strong bull markets.

The enhanced portion of SPHD’s returns comes from overallocation to high dividend and low volatility stocks. However, SPHD has significantly underperformed the S&P 500 benchmark in the past year, primarily due to sectors with high dividend yield, such as finance, energy, airlines, and tourism, being heavily impacted during the pandemic. High dividend stocks in these sectors may have performed poorly during the pandemic. In particular, the financial sector, which accounts for 26% of SPHD’s portfolio, has been severely affected by recent banking crises. The underperformance relative to the benchmark has led to a significant decline in its assets under management (AUM).

Strictly speaking, SPHD and QUAL are considered passive management funds with some enhancement strategies. These enhancement strategies aim to optimize specific factors within the portfolio, but the overall investment strategy of the funds remains focused on tracking specific indices. On the other hand, QARP not only uses passive management to track an index but also employs some enhancement strategies and active management to select the constituents of its portfolio, making it a more typical actively managed fund.

When implementing a quantitative multi-factor enhancement strategy, factors’ weights and the number of holdings in the portfolio need to be considered. Different factor weights and portfolio holdings can be used to achieve different investment objectives based on actual circumstances. For example, using more factors related to financial stability and earnings stability to invest in defensive stocks or employing more market momentum and technical indicators factors to invest in growth stocks.

Subjective Market Timing Enhancement Strategy

Subjective market timing, as an investment strategy, can be subdivided into multiple methods, including technical timing, fundamental timing, macro timing, sentiment timing, and event-driven timing. These methods are based on different analytical and decision-making factors, aiming to identify market trends, values, and opportunities to better determine to buy, sell, or adjust portfolio decisions.

Technical Analysis Timing: Technical analysis is a method that identifies potential market trends by studying historical price and volume data. Investors can utilize technical analysis tools such as trendlines, moving averages, and relative strength indicators to determine market direction, strength, and reversal points, thereby identifying buying or selling opportunities.

Fundamental Analysis Timing: Fundamental analysis focuses on factors such as a company’s financial condition, competitive advantages, and industry position. Investors can conduct in-depth research on a company’s fundamentals to evaluate its value and growth potential. When the market price undervalues a company’s true value, investors can buy, and when the market price overvalues a company’s true value, investors can sell.

Macro Economic Analysis Timing: Macro timing enhancement strategies are based on analyzing the impact of macroeconomic data on market trends to achieve more accurate asset allocation. These strategies typically involve analyzing factors such as interest rates, inflation, monetary policies, and geopolitics. For example, during an economic expansion, investors may increase their stock investments, while during an economic recession, investors may reduce their stock investments or shift to safer assets. Fund managers adjust portfolio strategies based on their outlook and expectations of the global macroeconomic conditions, potentially generating excess returns from macro timing compared to passive index funds that simply track benchmarks.

Market Sentiment Analysis Timing: Market sentiment analysis focuses on the influence of investor sentiment and psychological factors on market prices. Investors can utilize market sentiment indicators (such as fear/greed indices, investor confidence indices, etc.) to assess whether the market is overly pessimistic or overly optimistic and make timing decisions accordingly. Buying during periods of excessive pessimism and selling during periods of excessive optimism may help investors achieve excess returns. Sentiment strategies are becoming increasingly popular, and other sentiment indicators include the AAII sentiment index, VIX, market breadth indicators, put/call ratios, etc.

Event-Driven Timing Strategy: Event-driven strategies focus on specific events (such as mergers, spin-offs, and restructurings) that can impact company value. By anticipating and analyzing these events, investors can determine the timing for buying or selling.

Using Pacer Trendpilot US Large Cap ETF (PTLC) as an example, Pacer Trendpilot US Large Cap ETF (PTLC) is an exchange-traded fund (ETF) based on the US stock market that employs an active timing strategy. Its objective is to adjust exposure to US large-cap stocks based on market trends to achieve relatively stable investment returns.

The fund primarily tracks the S&P 500 Index and utilizes a trend-following timing strategy based on moving averages. When the S&P 500 is above its 200-day moving average and has closed above its five-day moving average for the last five trading days, the fund fully invests in the S&P 500 Index. When the S&P 500 is below its 200-day moving average, the fund allocates 50% of its assets to the S&P 500 Index and 50% to short-term US Treasury bonds. When the five-day moving average of the S&P 500 stays below its 200-day moving average for five consecutive trading days, the fund invests entirely in short-term US Treasury bonds.

Observing the performance of Pacer Trendpilot US Large Cap ETF (PTLC) in specific market environments, such as the bull market in 2017, the volatile market in 2018, and the market turbulence caused by the COVID-19 pandemic in 2020, reveals the characteristics of an enhanced timing fund. In 2017, the S&P 500 Index achieved a high annual return of approximately 21.8%. In that year, PTLC generated a return of approximately 20.4%, slightly lower than the benchmark index. While PTLC captured some gains in the rising market, its performance was slightly below the S&P 500 Index due to management fees and trading costs.

In the volatile market environment of 2018, the S&P 500 Index experienced significant fluctuations, with substantial gains at the beginning of the year followed by a notable decline by the end, resulting in a total annual decline of approximately 4.4%. In comparison, PTLC performed relatively well in 2018, with an annual return of approximately -3.7%, achieving a certain level of loss mitigation relative to the benchmark index.

In early 2020, the COVID-19 pandemic triggered significant market turbulence globally. The S&P 500 Index experienced a rapid decline of approximately 34% but subsequently witnessed a strong rebound, ending the year with a gain of approximately 16%. PTLC exhibited relatively weaker performance during this year, with an annual return of approximately 11.5%. While the fund mitigated losses to some extent during the market downturn through its timing strategy, its performance lagged behind during the subsequent rebound, resulting in a lower annual return compared to the benchmark index.

Therefore, in rising markets, PTLC’s performance is similar to the benchmark index. In declining markets, the fund’s timing strategy may help mitigate losses, but due to tracking errors, it may not consistently outperform the benchmark in all market conditions.

Sector Rotation Enhancement Strategy

The sector rotation enhancement strategy involves rotating allocations among different sectors based on their position in the business cycle before market trends emerge. It aims to increase exposure to sectors expected to outperform by allocating more to industries experiencing an upward trend (“overweight”) and reducing allocations to underperforming sectors (“underweight”). By deviating from the tracking index’s sector allocations, the strategy aims to achieve excess returns compared to the index’s performance.

Table 4: Common Industry Rotation Stock Selection Enhanced Index Funds in the US Stock Market.

Using PDP (Invesco DWA Momentum ETF) as an example, PDP aims to track the performance of the Dorsey Wright Technical Leaders Index using a relative strength strategy. It selects and weights investments in 30 U.S. stocks that exhibit the highest relative strength. Assuming that the technology sector performs the best in the market and has high relative strength, PDP would select stocks that perform the best within the technology sector.

To execute the strategy, PDP periodically rebalances its holdings to ensure continued investment in the technology stocks with the highest relative strength. If the market environment changes and the relative strength of other sectors begins to rise, such as the consumer goods sector, PDP may adjust its holdings and allocate investments to the new top-performing sector based on the updated relative strength data and market trends.

Overall, PDP’s strategy execution method is based on the stock selection using relative strength and adjustments based on market performance and trends. The selection criterion is relative strength, which refers to performance relative to other stocks or sectors. The portfolio is periodically rebalanced. The two funds in the table have outperformed benchmark performance over a one-year time frame, but have shown relatively weaker performance year-to-date (YTD).

Derivative Enhancement Strategy

Derivative enhancement strategies involve using derivatives such as options, futures, swaps, etc., to enhance portfolio performance. These strategies typically involve considerations of leverage, risk hedging, and speculation.

Some derivative enhancement strategies based on the US stock market include:

Index Futures Investment: If there is a discount between stock index futures contracts and the spot index, one can invest in stock index futures to simulate a portion of the index position and gain enhanced returns from the negative premium convergence. By allocating a portion of funds to stock index futures to track the underlying index, the remaining idle funds can be invested in fixed-income or arbitrage strategies to generate relatively stable returns.

Calendar Spread: Exploiting the price difference between futures contracts with different expiration months of the same index for arbitrage. When the forward contract has a higher premium compared to the nearby contract, one can establish a long position in the nearby contract while simultaneously establishing a short position in the forward contract. Over time, the price difference between these two contracts may converge, resulting in excess returns.

Inter-market Arbitrage: When there are pricing differences between two highly correlated markets (such as commodities, interest rates, exchange rates, etc.), one can establish a long position in one market while simultaneously establishing a short position in the other market. Over time, the pricing differences between these two markets may converge, resulting in enhanced returns.

Options Strategies: Options are another common derivative. For example, one can enhance the returns of existing stock investments by selling covered calls. In this strategy, the fund holds a certain amount of stock and sells an equivalent number of call options. This allows the fund to collect option premiums and increase overall investment returns. However, the risk of this strategy is missing out on potential gains if the stock price exceeds the exercise price of the options.

Pairs Trading: This strategy involves two stocks from the same industry or with high correlation. When the price difference between the two stocks exceeds historical normal levels, one can establish a long position in the relatively undervalued stock while simultaneously establishing a short position in the relatively overvalued stock. Over time, the price difference between these two stocks may converge, resulting in excess returns.

Taking ProShares UltraPro Short QQQ ETF (SQQQ) as an example of an index-enhanced fund using derivative strategies based on the US stock market,

ProShares UltraPro Short QQQ ETF (SQQQ) aims to provide daily returns that are -3 times the performance of the Nasdaq-100 Index. This inverse leveraged ETF is designed for experienced investors who anticipate a short-term decline in technology and large-cap stocks within the Nasdaq-100. To achieve its investment objective, SQQQ utilizes financial instruments such as swaps, futures contracts, and options to gain short exposure to the Nasdaq-100 Index. As a result, SQQQ can magnify returns when the underlying index declines, but it can also amplify losses when the index rises.

Specifically, in the swap strategy, SQQQ obtains short exposure to the Nasdaq-100 Index by entering into swap agreements with other financial institutions. Under the swap contracts, SQQQ agrees to exchange the returns of the underlying asset (such as the Nasdaq-100 Index) at a fixed price over a specified period. This allows SQQQ to gain short exposure to the Nasdaq-100 Index without actually holding the stocks.

In the futures contract strategy, SQQQ obtains short exposure to the Nasdaq-100 Index by selling Nasdaq-100 Index futures contracts. Through this approach, SQQQ agrees to sell the underlying asset (Nasdaq-100 Index) at a specific price on a future date. This strategy enables SQQQ to engage in short trading of the Nasdaq-100 Index without actually holding the stocks.

In the options strategy, SQQQ utilizes the purchase of put options to achieve short exposure. Put options grant SQQQ the right to sell the underlying asset (Nasdaq-100 Index) at a specific price on a future date. By purchasing put options, SQQQ gains profits when the underlying asset declines, thus achieving short exposure to the Nasdaq-100 Index. SQQQ executes these trades on multiple trading platforms and venues to ensure liquidity and obtain optimal prices. However, this ETF is generally considered a high-risk short-term investment and is not recommended for long-term holding.

Various enhanced strategies that track the same index provide investors with suitable risk exposures.

Even when tracking the same index, investors can choose index funds that offer different tracking strategies and leverage products based on their risk tolerance, investment objectives, and expected returns. Here are some introductions to a selection of products tracking the Nasdaq-100. Most of these products fall under passive management and aim to provide investors with different strategies to track the Nasdaq-100 Index for corresponding exposures and returns.

QQQ (Invesco QQQ Trust): As Invesco’s flagship product, QQQ is the most popular and well-known ETF (AUM 175,780 million) that tracks the Nasdaq-100 Index. It aims to replicate the performance of the index by investing in the same securities in the same proportions. The index includes the 100 largest non-financial companies listed on the Nasdaq stock market. QQQ is a market-cap-weighted ETF, which means the holdings are weighted based on their market capitalization.

QTR (Global X NASDAQ 100 Tail Risk ETF): The QTR aims to track the performance of the Nasdaq-100 Index while mitigating tail risk. The ETF invests in the same securities as QQQ but also holds put options on the Nasdaq-100 Index to hedge against significant market declines.

QQQM (Invesco Nasdaq-100 ETF): QQQM is a low-cost alternative to QQQ. It also tracks the Nasdaq-100 Index but with a lower expense ratio. The investment strategy and holdings are similar to QQQ, but with lower costs, making it more cost-effective for long-term investors.

QQQN (Invesco NASDAQ-100 Triple Q Disruptive Innovators ETF): QQQN is an ETF launched by Invesco. It aims to track the Nasdaq Q-50 Index, which includes non-financial companies ranked from 101st to 150th by market capitalization on the Nasdaq market. These companies are typically considered to be in the growth stages with innovative and disruptive technologies. QQQN provides investors with exposure to a group of potential growth-stage companies.

QQQA (ProShares Nasdaq-100 Dorsey Wright Momentum ETF): The strategy of QQQA aims to track the performance of the Dorsey Wright NASDAQ OMX CTA Momentum Index, which includes a momentum-based approach that selects stocks based on relative strength signals. Relative strength refers to the performance of individual stocks relative to the market or industry. Based on relative strength signals, stocks that perform well in the short term among the Nasdaq-100 Index constituents are selected. Using a momentum investment strategy, stocks are chosen and weighted accordingly based on their relative strength. Stocks with stronger performance will receive higher weights, while stocks with weaker performance will receive lower weights or may be excluded from the portfolio.

TQQQ (ProShares UltraPro QQQ): TQQQ aims to track the Nasdaq-100 High Beta Index and is a leveraged ETF designed to provide three times the performance of the Nasdaq-100 Index’s gains. It aims to track the overall performance of the entire Nasdaq-100 Index. Due to its leverage effect, TQQQ typically exhibits higher volatility and risk compared to the underlying index.

QQQX (Nuveen NASDAQ 100 Dynamic Overwrite Fund): QQQX is an actively managed fund based on the Nasdaq-100 Index. It adopts an overwrite strategy, which involves simultaneously holding the Nasdaq-100 Index constituents’ stocks and selling call options. The overwrite strategy aims to increase the portfolio’s income. In this strategy, the fund holds the stocks of the Nasdaq-100 Index while simultaneously selling corresponding call option contracts. If, on the expiration date, the price of the Nasdaq-100 Index is lower than the exercise price of the call options, the call options will expire unexercised, and the fund can retain the collected premiums. This allows the fund to generate additional income by selling call options when the market trend is stable or declining.

The objective of the overwrite strategy is to enhance the portfolio’s return through this additional income and partially mitigate the downside risk in the market. However, selling call options as part of the overwrite strategy also limits the potential gains of the portfolio in a rising market, as the fund may be restricted from fully benefiting from the price appreciation when the call options are exercised.

Conclusion

Compared to the equity ETF/Index Fund market in the US, the market for crypto index enhancement products is still in its very early stages. As the overall market capitalization of cryptocurrencies grows, there is a high potential for rapid expansion in the market for structured products that enhance crypto index performance. We believe that the various enhancement strategies used in US equity index funds and index enhancement funds/ETFs can be applied to the construction of crypto index enhancement funds. These strategies can include multi-factor quantitative stock selection models, subjective timing models, sector rotation models, or derivative-based strategies such as futures contracts to enhance returns. These crypto index enhancement funds can help investors with different risk preferences gain the desired risk exposure and achieve excess returns through these enhancement approaches.

website: ldcap.com

medium：ld-capital.medium.com

Guide:

Due to the imminent Shanghai upgrade, we believe it is necessary to reassess the future development of the LSD track and its impact on the entire on-chain ecosystem in light of recent data changes. This article overviews the LSD track in four parts: the overall growth space of the industry after the Shanghai upgrade, the selection of 4 types of staking solutions and different LSD protocols, the positioning of the DVT track, and the impact of LSD assets on other on-chain ecosystems.

Summary:

The increase in Ethereum’s staking rate will lead to an overall increase in protocol fees on the LSD track. In the long run, the David double-click on the LSD track is not over. The current Ethereum staking rate is 14.56%. Since the staking rates of other POS public chains are mostly over 60%, there is a large growth expectation for the increase in Ethereum’s staking rate.

Assuming the cost situation on the LSD track remains unchanged, we estimate that when the Ethereum staking rate rises to 29%, 44%, and 58%, the corresponding increases in LSD protocol fees will be 1.31 times, 1.55 times, and 1.76 times respectively. From a P/F valuation perspective, the current LSD track leader LDO has a 3.89 times P/F, which still has a large room for improvement compared to the valuation levels of old Defi protocols such as UNI with 7.12 times and AAVV with 10.35 times.

After the Shanghai upgrade, the relative market share of LSD protocols may change. In the medium term, pay attention to the track leader Lido and high-yield LSD protocols represented by Frax, and focus on Rocket Pool’s Atlas upgrade in the short term.

After the Shanghai upgrade, the exit of early nodes and the strengthening of user staking intentions will provide conditions for the competition between LSD protocols.

Lido has been tested in terms of popularity, fund scale, security, yield, liquidity, and composability, and its leading position is unshakable.

However, newcomers like Frax have achieved a combination with the Curve ecosystem through their self-holding CVX and dual-currency model design, which gives them a staking yield rate far higher than similar staking products, successfully completing the cold start and early growth of the product. In the future, with the popularization of yield aggregation products, the growth of high-yield products like Frax is expected to accelerate further. It should be pointed out that Frax’s high yield will decrease as its TVL increases. Based on current estimates, when its ETH staking reaches 200,000 coins, the staking yield will drop to 6%.

The recent Atlas upgrade of Rocket Pool is worth paying attention to. It reduces the minimum staking quantity of node operators’ ETH from 16 to 8, increases the protocol capacity while enhancing node incentives, and is expected to bring a large increase to its TVL.”

DVT products represented by SSV, Obol, and Diva are currently positioned as important basic infrastructure for Ethereum staking.

DVT products aim to ensure the stability of Ethereum block validation while improving the network’s degree of decentralization. They can reduce the operational costs of node maintenance teams and minimize security risks.

The development of SSV focuses on the construction of the operator network, with its token serving as a means of payment and governance certificate to capture protocol value.

Obol’s development emphasizes middleware adaptability, while Diva’s goal is to combine LSD and DVT modes to create a one-stop product, currently in the early stages of development.

Ethereum staking may spawn LSD assets (lsdETH) of the hundred-billion scale. As they reshape or impact traditional DeFi protocol income structures, second-layer products built around this new asset class may become the new α in the market.

The construction of liquidity for lsdETH/ETH could bring new business increments for DEXes like Curve and Balancer. Compared to Curve, Balancer currently sees more significant marginal changes. However, Ethereum staking yield can be seen as the on-chain, risk-free yield rate in coin terms. The emergence of this yield rate will increase the liquidity cost on-chain and bearish for deposit pool-type lending products, while CDP model lending is relatively less affected. At the same time, future re-staking, yield aggregation, principal-interest separation, and leverage protocol products built around this interest-bearing asset will benefit from the large scale of the underlying asset and achieve a higher business ceiling, making them worthy of continuous tracking and research.

Risks:

Regulatory risks, macroeconomic risks, risks of technology upgrades not meeting expectations

1. Overall Space of LSD Track

The growth in Ethereum’s staking rate drives an increase in miner income, leading to an overall rise in LSD track income. In the long run, track income valuation remains in a double growth range. The current Ethereum staking rate is 14.56%. Since the staking rates of other POS public chains are mostly over 60%, there is a large growth expectation for the increase in Ethereum’s staking rate. The following graph estimates that when Ethereum’s staking rate doubles, triples, and quadruples, rising to 29.12%, 43.68%, and 58.24% respectively, the corresponding increases in LSD protocol fees will be 1.31 times, 1.55 times, and 1.76 times. The calculation method, assumptions, and process are as follows:

Execution layer rewards are determined by the Priority fee. Due to the balanced setting of Ethereum’s fee mechanism, it is assumed that execution layer rewards remain unchanged (a conservative estimate, when network Gas fluctuates, execution layer rewards will rise sharply, such as the USDC de-pegging event on March 10 that led to a surge in on-chain transactions, Ethereum’s execution layer reward increased 4–6 times of the usual).

Consensus layer rewards are determined by Ethereum’s block rewards. The total block rewards are proportional to the square root of the total staking amount, and the consensus layer APR is inversely proportional to the square root of the total staking amount. The specific calculation formula is base_reward = effective_balance * (base_reward_factor / (base_rewards_per_epoch * sqrt(sum(active_balance)))).

With the current 14.56% staking rate corresponding to consensus layer rewards and execution layer rewards as the benchmark, the miner income situation when the staking rate reaches 2–4 times the current level is estimated based on the above two conditions. At the same time, assuming that the LSD protocol fee standard remains unchanged, the multiple of miner income growth with the increase in the staking rate is the LSD protocol fee growth multiple as follows:

Figure 1: Changes in Miner Income with the Staking Rate

Source： LD Capital Research

It’s important to note that the increase in Ethereum’s staking rate is a gradual process, and a decrease might even be observed in the 1–2 months following the Shanghai upgrade. Due to the restrictions on Ethereum validator node entry and exit, it can be inferred that the change in Ethereum’s staking rate is a slow process. Currently, the total number of Ethereum network validators is approximately 556,800, with 1,800 validator nodes admitted daily.

After the Shanghai upgrade, validator nodes are allowed to exit, and the daily exit quantity equals the entry quantity. Due to the early validator’s exit, there might be a slight decrease in Ethereum’s staking rate after the Shanghai upgrade.

The basis for this judgment is: currently, about 10.87 million ETH in the beacon chain participate in staking via the lsd protocol with centralized exchanges, providing secondary market liquidity. Since there is virtually no discount for various types of lsdeth/eth, the redemption scale based on the primary market’s pegging or profit requirements will not be large after the Shanghai upgrade.

The remaining approximately 6.95 million ETH are staked through Staking pools or individual staking, which lacks secondary market liquidity. Assuming that half choose to redeem after the Shanghai upgrade, a maximum of 57,600 ETH can be redeemed daily. Ethereum will face a full-load redemption situation within 60 days after the Shanghai upgrade.

Observing the current data on staking entry, the daily new staking ratio is generally one-third of the maximum possible staking ratio. Therefore, if the new staking ratio cannot reach the maximum load after the Shanghai upgrade, based on the above assumption, Ethereum’s staking rate may experience a slight drop within 1–2 months. After the redemption requirements based on pegging and profit are cleared, the growth will resume, and it may take 1–2 years for Ethereum’s staking rate to double.

source: https://ethereum.org/zh/developers/docs/consensus-mechanisms/pos/rewards-and-penalties/

2. The Complete Landscape of LSD Track

The LSD track can be expanded to Ethereum staking solutions and their derivatives, which include four types of Ethereum staking solutions competing for market share, DTV technology ensuring security while extending decentralization, and second-layer yield enhancement products and leverage protocols and index products born around the LSD staking certificate.

Figure 2: The Complete Landscape of LSD Track

Source: LD Capital Research

2.1 Among the Four Staking Solutions, LSD Holds the Highest Market Share and is Expected to Expand Further

Ethereum staking solutions are divided into four types, including individual staking, custodial staking, Liquid Staking Derivatives (LSD), and centralized exchange staking. Both LSD and centralized exchange staking have gained the majority of the market share due to their advantages, such as allowing participation with small capital, not requiring hardware infrastructure, and the ability to release liquidity again through staking certificates. From the perspective of the number of nodes, currently, LSD holds a market share of 33.4%, CEX holds 27.5%, custodial staking (Staking pool) holds 16.6%, and individual staking holds 22.5%.

Figure 3: Current Market Share of Various Staking Solutions

Source: beacon-chain， LD Capital Research

Let’s look at the basics of the four staking solutions:

Individual Staking: Requires at least 32 ETH and a dedicated computer, as well as the network and power conditions and methods to operate nodes. Users can obtain all the staking rewards and full asset control. Funds cannot be withdrawn before the Shanghai upgrade, but they can be withdrawn with restrictions after the upgrade.

Custodial Staking: Requires at least 32 ETH but no hardware infrastructure. Users obtain staking rewards by delegating their ETH to a node operator. During this process, users need to upload their signing key, allowing the service provider to validate on their behalf. Funds cannot be withdrawn before the Shanghai upgrade, but they can be withdrawn with restrictions after the upgrade.

Liquid Staking Derivatives (LSD): This does not require 32 ETH or hardware infrastructure. Users delegate their custom Ethereum to the LSD protocol, which pairs the user’s delegated Ethereum and chooses a node operator to stake it to earn staking rewards. Users typically need to distribute part of their earnings to the LSD protocol and the node operator. Funds can usually be withdrawn at any time on the secondary market through the liquidity of lsdETH, or leverage can be added to enhance returns. This solution currently has a high degree of centralization.

Centralized Exchange Staking: This does not require 32 ETH or hardware infrastructure, and even a chain wallet is not necessary. Users can obtain most of the staking rewards through staking services provided by centralized exchanges like Coinbase, with a small portion of the benefits being collected by the exchange. This solution has the lowest operation difficulty for users. Staking can usually be promptly withdrawn or exited on the secondary market through staking certificates, and leverage can be added through lending protocols to enhance returns. This solution currently faces significant regulatory risks and is the most centralized.

Figure 4: Comparison of 4 Staking Solutions

Source: LD Capital Research

However, it’s important to note that centralized exchange staking and LSD staking solutions are facing unresolved regulatory issues from the U.S. Securities and Exchange Commission (SEC). The question of whether staking operations are considered securities has yet to be definitively answered. The SEC previously targeted Kraken’s staking operations, but it has not yet materially affected Coinbase, Lido, and other key LSD protocols. The main reason for this is that Kraken did not disclose the destination of user funds at that time, operating in a ‘black box’ manner, while also promising returns far exceeding those of Ethereum staking, which led to regulatory crackdowns. However, from the perspective of the Howey Test, Kraken, Coinbase, Lido, and other LSD protocols are all participating in staking by managing user funds, with no essential differences. Therefore, the development of LSD operations currently faces uncertainty due to U.S. regulations.

From a product perspective, although staked Ethereum can be redeemed and withdrawn in the primary market after the Shanghai upgrade, the quantity is limited. Based on the current staking scale, up to 1800 nodes, corresponding to 57,600 ETH, can be withdrawn daily. Due to the LSD protocol’s solutions for small fund participation in staking, releasing liquidity of staking certificates, and enhancing returns through protocol combinations, it is still likely to occupy a major market share after the Shanghai upgrade. There may be a passive increase in the overall market share of the LSD protocol shortly after the Shanghai upgrade, due to the early redemption and profit exit of ETH from individual or custodial staking.

From the perspective of competition in the LSD protocol, current factors influencing the development of each LSD protocol include popularity, return rate, fund security, anchoring status, degree of decentralization, and combinability. These dimensions can be combined to analyze the similarities and differences between the mainstream LSD protocols on the market.

Lido is currently the largest Total Value Locked (TVL) LSD protocol, 13 times larger than the second-ranked Rocket Pool. Lido currently uses a whitelist mechanism to select operators, ensuring the smooth operation of staked nodes to avoid affecting the rate of return or causing fund penalties. At the same time, Lido achieves an annualized return rate of 4.5%-5% for its users through compounding at the execution layer, maintaining this relatively high level even after a 10% fee. This rate is second only to Frax among mainstream LSD protocols, surpassing Rocket Pool, StakeWise, Ankr, and others. It’s noteworthy that Lido will upgrade to version V2 in mid-May, introducing a staking routing module, allowing anyone to create staking nodes and connect to DVT, aiming to ensure network stability and security while increasing the degree of decentralization.

Rocket Pool’s uniqueness lies in its lack of entry permissions for staking nodes; anyone can become a node operator on this network by creating a Minipool. Currently, node operators need to deposit 16 ETH (with the remaining 16 ETH coming from user deposits) and also stake a minimum of 1.6 ETH worth of RPL Token as secondary funds subject to penalties. Rocket Pool currently provides RPL subsidies to node operators on the platform to encourage node deployment. Rocket Pool will undergo the Atlas upgrade within a month, the most significant upgrade since its launch, which will have a significant impact on its business development. The main content of the upgrade includes:

LEB16 — LEB8: The minimum stake for node operators will be reduced from 16 ETH to 8 ETH, greatly improving the current situation where Rocket Pool’s scalability is restricted by the node side. Theoretically, this improvement could double the protocol’s TVL and triple its deposit capacity. Once the scalability of the node side is opened up, the number of deposits in the dynamic deposit pool will become a leading indicator of Rocket Pool TVL growth.

Node incentives will further increase, excluding RPL incentives, LEB8 node rewards will be 25% higher than LEB16.

Tools will be introduced to allow Solo Stakers to migrate to the Rocket Pool platform without having to exit the validator.

The dynamic deposit pool will be optimized; when the ETH required by the Minipool queue exceeds the 5000 ETH limit, the deposit pool’s upper limit will also increase.

Frax Ether’s characteristic is its current high staking return rate. The staking yield of sfrxETH has been maintained at 7%-10% due to Frax’s dual currency model of frxETH and sfrxETH. frxETH and ETH form LP in the Curve pool to gain CRV returns using Frax’s own CRV governance resources, and all staking returns are distributed to sfrxETH. Overall, the high yield of Frax Ether compared to other liquidity staking products comes from an additional layer of CRV rewards. This CRV reward contributes to the overall system’s return enhancement and depends on the proportion of the frxETH/ETH gauge pool, the TVL of the Frax Ether system, and the CRV/ETH price ratio. According to current estimates, when the staked amount of Frax Ether reaches 200,000 ETH, the staking return of sfrxETH will drop to around 6%.

The aforementioned three mainstream LSD protocols have established three main ETH staking models. The remaining smaller LSD protocols mainly aim to improve and tweak some user pain points of these three major protocols. For instance, Stafi and Stader address the issue that currently Rocket Pool node operators need to stake 16ETH, resulting in low capital utilization efficiency and operators being forced to increase their RPL risk exposure. These two only require node operators to stake 4 ETH, and they provide a solution that doesn’t increase the risk exposure of protocol tokens for node operators. However, it’s important to note that blindly reducing the proportion of ETH staked by node operators could potentially increase the risk of user fund loss. Moreover, unlike Rocket Pool, Stafi is currently facing pressure to grow its user funds.

Chart 5: Comparison of the 3 Major LSD Protocols

Source: LD Capital Research

Currently, from the perspective of protocol valuation, whether it’s FDV/Revenue or FDV/TVL, Lido is at a relatively low level. However, LDO currently only has governance rights while RPL and FXS both have corresponding token empowerments, so they should enjoy a corresponding valuation premium.

Frax currently holds about 3.5 million CVX, making it the largest holder in the CVXDAO.

Chart 6: Valuation Comparison of Different LSD Protocols

Source: LD Capital Research, Token Terminal

Decentralization and security assurance are the core tenets of Ethereum, and on this basis, Distributed Verification Technology (DVT) emerged. Current Ethereum staking solutions are all faced with the contradiction between decentralization and stable node operation. Represented by Lido and Rocket Pool:

Lido currently selects qualified operators through a whitelist to ensure the effectiveness of block generation and the traceability and safety of funds, to avoid losses caused by node downtime or failure. However, this approach makes Lido somewhat centralized.

Rocket Pool, on the other hand, binds the interests of both the node and the user through joint staking and further ensures user’s funds safety by pledging RPL tokens as collateral. This undoubtedly increases the cost of operating nodes on the Rocket Pool platform. At present, Rocket Pool is trying to balance this by using RPL to incentivize nodes, but this undeniably increases protocol expenditure and limits its scalability.

DVT products, through technical solutions such as fragmenting verification private keys and rotating leadership nodes, transform the one-to-one relationship between operator and node to a many-to-one state, enhancing system security and robustness from a network architecture perspective and allowing a higher degree of decentralization.

The specific principle is as follows:

DVT consists of four key parts: Distributed Key Generation (DKG), Shamir’s Key Sharing for BLS signatures, Multi-Party Secure Computation, and the IBFT consensus layer:

Distributed Key Generation (DKG) is the first step in implementing DVT. It fragments a validator’s private key into 3n+1 parts, with multiple fragments corresponding to multiple operators. DKG technology is the cornerstone of DVT products.

Shamir’s Key Sharing for BLS signatures complements DKG, aiming to achieve multi-party aggregate signatures, that is, combining fragmented block signatures into a single signature. Since DKG allows the fragmented private key to be held by multiple parties, when a signature is needed, the signatures of multiple people are aggregated into one. The fragmented private key and multi-party aggregate signature form the backbone of the entire DVT product.

Multi-Party Secure Computation (MPC) distributes the split keys securely among the nodes to perform validator duties and verify network information, without having to reconstruct the validator key on a single device, thus eliminating the risk of centralizing private keys during computation. The Istanbul Byzantine Fault Tolerance (IBFT) consensus algorithm randomly selects a validator from the DVT nodes as the leading node, responsible for block proposals and other tasks. If the majority of nodes in a single cluster agree that the block is valid, it is added to the blockchain. If the leading node goes offline, the algorithm will reselect a leader within 12 seconds to ensure system stability.

In summary, DVT fragments verification keys through DKG, distributing them to different operators, achieves multi-party aggregate signatures through BLS private key sharing, ensures data security through Multi-Party Secure Computation, and ensures nodes will not maliciously block or affect overall profits due to offline through IBFT leadership node rotation. Ultimately, it allows multiple operators to run a single validator node, rather than the current industry standard of individual operation, greatly enhancing the overall system robustness.

3.1 Comparison of DVT Products on the Market: SSV.Network, Obol Labs, and Diva

SSV.Network has built an operator network based on DVT and is the fastest developing product in the DVT sector. It has received a donation of $188,000 from the Ethereum Foundation and a donation of $100,000 in LDO tokens from Lido. SSV.Network is the only entity to have issued tokens at this time, with its token, SSV, mainly used as a means of payment in the network and for governance. Stakers in the SSV network need to pay operational fees to the node operators, with the specific fees determined by each operator based on operational costs and market competition. At the same time, operators currently need to pay a quarter of their network income to the SSV treasury (the fee standard is determined by the DAO), and all the aforementioned payment processes require the use of SSV tokens. SSV plans to hold a community meeting on March 30 to discuss the timing of the mainnet launch.

Obol Labs is committed to building a staking middleware, Charon, that allows any node to participate in the operation of the distributed validator cluster (DV cluster). Obol has also received a donation of 100,000 USD worth of LDO tokens from Lido DAO and has completed a series A financing of 12.5 million USD, led by Pantera Capital and Archetype, with participation from Coinbase, Nascent, Block Tower, and others. In terms of development progress, Obol is currently in the Bia public testnet stage, and is expected to launch the Circe testnet in June of this year, followed by the mainnet launch; in terms of development progress, it is slightly behind SSV.

Diva is a new product in the DVT track, which has completed a seed round of 3.5 million USD, led by A&T Capital, with participation from Gnosis, Bankless, OKX, and others. It aims to combine LSD and DVT modes to create a one-stop product for liquidity staking and distributed validation.

4. Development trends of the LSD track and its impact on the current mainstream tracks

Following the Shanghai upgrade, Ethereum staked on the Beacon Chain can be withdrawn, which enhances users’ willingness to participate in staking and promotes an increase in the staking rate, thereby expanding the scale of the interest-bearing asset, lsdETH. Therefore, in the future, not only might there be an increasing number of liquidity staking protocols, but DeFi products revolving around the lsdETH asset will also embark on a new growth curve.

Decentralized exchanges: The construction of lsdETH liquidity is the most important part of the LSD protocol. lsdETH/ETH, as similar assets, have their best choice for liquidity construction being Curve and similar products. If more and more LSD protocols emerge in the future, issues surrounding the construction of different types of lsdETH liquidity might trigger a new round of Curve war. It is worth pointing out that currently, the cost of constructing liquidity in the Balancer ecosystem is lower than Curve, and since Balancer’s base is smaller, from the perspective of marginal changes, the prosperity of lsdETH will have a greater impact on the Balancer ecosystem than Curve (relevant protocols include Aura, Convex, Balancer, Curve).

Lending protocols: The market demand for using lsdETH to leverage will drive lending businesses based on this asset category. Currently, there are two main types of leverage demands:

Yield enhancement through revolving loans, represented by AAVE, where stETH is used as collateral to borrow ETH, with a maximum LTV of 90%, and a maximum of 10x leverage without considering intermediate costs. However, this model faces the issue of high ETH borrowing rates (after the Shanghai upgrade, the interest rate of AAVE’s ETH deposit pool may equalize with the ETH staking interest rate, making the borrowing rate of ETH in AAVE higher than the staking rate, which would make the current demand for revolving loans disappear). The core reason is that the ETH borrowing rate needs to cover the depositors’ cost. In the future, stablecoins pegged to ETH may be minted in the form of CDPs, replacing the depositor’s cost with a more efficient liquidity cost, enhancing protocol composability while better meeting users’ demands for leverage-enhanced returns (relevant protocols include AAVE, Compound).

Increase the overall risk exposure of the investment portfolio by borrowing stablecoins against lsdETH, which can operate through both normal lending and CDP models (relevant protocols include Fraxlend, MakerDao).

Principal and interest separation and other derivatives: As an interest-bearing asset with a floating interest rate, lsdETH can give birth to financial derivatives such as principal and interest separation and interest rate swaps. Principal and interest separation products can enable shorting future interest rates (selling interest tokens and buying principal tokens, low leverage, typically used to lock in returns in advance), longing future interest rates (selling principal tokens and buying interest tokens, high leverage, typically to satisfy speculative demand), and yield enhancement. Before the outbreak of LSD, the underlying interest-bearing assets of derivatives such as principal and interest separation were mainly concentrated on stablecoin LPs. Since these assets are smaller in scale compared to lsdETH and have lower yields, there is also the issue of liquidity splitting. Thus, the emergence of lsdETH as an asset will greatly promote the business development of principal and interest separation products (relevant protocols include Pendle, Element, Sense).

Re-staking: The concept of re-staking was proposed by Eigenlayer. Eigenlayer is a protocol that modifies the Ethereum client at the base level, allowing validators to re-stake their ETH rights and verify other protocols, such as oracles and data availability modules. It is worth noting that while Eigenlayer gives staked ETH a second layer of yield, it sacrifices some of the token’s liquidity and requires users to bear additional AVS (Actively Validated Services) security, adding a layer of slashing risk to Restaked ETH.

Figure 7: Overview of downstream products based on lsdETH.

Source: LD Capital Research

website: ldcap.com

medium：ld-capital.medium.com

Author: Jinze Jiang, Drake Zhang, LD Capital Research

Introduction

Grayscale Ethereum Trust (ETHE) is the largest publicly traded Ethereum product on the US stock market, with a holding of over 3 million ETH. However, its current secondary market trading price compared to the net asset value (NAV) is at a nearly 50% discount. In our previous report, we analyzed the reasons for the discount and premium of this product, as well as several scenarios in which the discount might narrow. Based on the cyclical rotation pattern, we believe that if betting on a potential bull market, ETHE may have better elasticity compared to ETH spot. However, we also found that historical data analysis shows that ETHE’s risk-reward metrics are not ideal, with risk-adjusted returns, maximum drawdown, and volatility performing worse than ETH/USD. This implies that if one is prepared to hold ETHE for the long term, specific return enhancement strategies might be needed; otherwise, if a bull market does not arrive quickly, its performance carries the risk of being weaker than the broader market.

In the second installment of this series, we will explore how to build an index enhancement strategy for ETHE. This will allow investors to obtain the long-term Beta return value of the asset while engaging in appropriate active management to achieve Alpha returns, thus improving the experience of holding the asset in the long run.

Risk and Return Overview of Grayscale ETHE

First, let’s analyze the key characteristics of the core target of this strategy, Grayscale ETHE:

The table above presents statistics on the price performance of ETHE and ETH-USD from 01/01/2020 to 04/30/2023, calculated on a monthly return basis. ETHE’s performance is worse than that of ETH spot in terms of alpha coefficient, maximum drawdown, value-at-risk, and risk-adjusted return, among other risk metrics. However, the right-skewed, fat-tailed distribution of its returns implies that its positive fluctuations have greater potential:

Return Performance: Grayscale ETHE has an arithmetic average monthly return of 8.91% and an annualized return of 178.48%, while the arithmetic average monthly return of Ethereum spot is 10.60% and its annualized return is 235.03%. From this perspective, Ethereum spot outperforms Grayscale ETHE. In terms of geometric average return, Grayscale ETHE’s annualized return is 40.03%, while Ethereum spot’s annualized return is 120.08%, indicating that Ethereum spot has better long-term investment performance.

Risk Performance: Grayscale ETHE’s monthly and annualized standard deviations are 38.16% and 132.18%, respectively, higher than Ethereum spot’s 29.01% and 100.48%. This indicates that Grayscale ETHE has larger price fluctuations and relatively higher risk. Additionally, Grayscale ETHE’s maximum drawdown is -89.60%, higher than Ethereum spot’s -77.96%, further illustrating Grayscale ETHE’s higher risk.

Risk-Adjusted Return: Sharpe Ratio and Sortino Ratio are metrics used to evaluate the risk-adjusted return of investments. As seen in the table, Grayscale ETHE’s Sharpe Ratio is 0.8, while Ethereum spot’s Sharpe Ratio is 1.25; Grayscale ETHE’s Sortino Ratio is 1.72, while Ethereum spot’s Sortino Ratio is 2.69. This indicates that, when considering risk, Ethereum spot’s return performance is superior to that of Grayscale ETHE.

Market Correlation: The table’s Beta coefficient shows that Grayscale ETHE’s beta is 0.9, which implies that Grayscale ETHE has relatively higher systematic risk (ETH). However, the Alpha coefficient shows that Grayscale ETHE’s annualized alpha is -8.14%, indicating that after adjusting for market risk, Grayscale ETHE did not achieve positive returns during the statistical period.

Profit and Loss Ratio: Grayscale ETHE’s profit and loss ratio is 1.46, slightly lower than Ethereum spot’s 1.48, which means that their performances in terms of profits and losses are not significantly different.

Profit and Loss Cycle: In terms of positive return cycles, Grayscale ETHE has 23 positive return cycles out of 41 cycles, accounting for 56.10%, while Ethereum spot has 26 positive return cycles out of 41 cycles, accounting for 63.41%. This indicates that Ethereum spot has more profitable cycles.

Value-at-Risk (VaR): Grayscale ETHE’s historical VaR (5%) is -38.01% and its analytical VaR (5%) is -53.85%, while Ethereum spot’s historical VaR (5%) is -30.15% and its analytical VaR (5%) is -37.11%. This suggests that at the same level of confidence, Grayscale ETHE’s potential maximum loss is greater than Ethereum spot’s.

Conditional Value-at-Risk (CVaR): Grayscale ETHE’s CVaR (5%) is -44.36%, while Ethereum spot’s CVaR (5%) is -43.67%. This implies that under the worst-case scenario, Grayscale ETHE’s losses could be comparable to those of Ethereum spot.

Upside Capture Ratio and Downside Capture Ratio: Grayscale ETHE’s upside capture ratio is 86.74%, while its downside capture ratio is 117.95%. This indicates that Grayscale ETHE captures lower gains during market upswings and experiences greater losses during market downturns.

Return Distribution Shape: Grayscale ETHE’s excess kurtosis is 0.46, and skewness is 0.84; ETH’s excess kurtosis is -0.37, and skewness is 0.27. This suggests that Grayscale ETHE’s return distribution exhibits a more pronounced peak relative to a normal distribution, indicating a higher probability of extreme returns (positive or negative). Additionally, its positive skewness implies a right-skewed distribution with larger positive extreme returns. This may signify that Grayscale ETHE has higher investment risk but potentially higher returns during positive market fluctuations.

Why does ETHE, which is also based on ETH spot as its underlying asset, consistently underperform?

This is mainly due to its unique product, market structure, and changes in the market environment, which led to a premium over NAV (2019–2021) followed by a discount (2021 onwards). The nearly 90% decline in price from premium to discount has weighed on overall risk-return indicators.

The reasons behind the negative/positive premium are the Grayscale ETHE Trust’s non-redeemable fund product structure. Factors contributing to the positive premium include higher accessibility of the product compared to ETH spot, making ETHE more suitable for traditional financial institutions and retail investors than self-custody of private keys; balance sheet accounting, tax advantages, and helping investors bypass compliance issues. Reasons for the negative premium include the non-redeemable fund structure, limited arbitrage opportunities, discounted opportunity costs, and the impact of competitive products.

For more analysis, see the first report in the series: “50% Off ETH: Opportunity or Trap? A Deep Dive into Grayscale Trust.”

Principles of Index Enhancement Fund Strategy

Fundamental concepts and ideas related to ETHE index enhancement:

Index enhancement strategy is an investment portfolio management approach that seeks to amplify the returns of a base portfolio or index and outperform the index in terms of returns or risk metrics.

The strategy requires ETHE to be the cornerstone position, allocating no less than 60% of funds to ETHE spot, with the remaining funds allocated to cash, fixed-income products, US-listed blockchain and cryptocurrency-related stocks, and options derivatives of these stocks.

Index enhancement combines elements of active and passive management. Due to the active management aspect, the investment introduces the risk of the strategy manager’s subjective judgment, whereas passive index funds only need to worry about market risk.

Establishing a portfolio based on ETHE focuses on the excess returns generated from betting on the narrowing of the secondary market price and NAV of ETHE. However, given ETHE’s poor historical return statistics, we need to improve the holding experience during the holding process by:

Diversification: Include assets with relatively low correlation, stable returns, and lower volatility in the portfolio to offset the poor risk-return ratio, such as cash, fixed-income products, US-listed blockchain and cryptocurrency-related stocks, and options derivatives of these stocks.

High Position: As ETHE has higher return potential during positive market fluctuations, maintaining a high overall position for ETHE avoids missing out on extreme upswings. Under non-significant risk situations (e.g., Ethereum trust crisis, Grayscale financial crisis), the allocation should not be less than 80%.

Derivative Enhancement: Using options strategies in stock enhancement is more advantageous than merely holding the underlying. Excess returns are mainly derived from capturing options pricing volatility premiums and constructing more targeted investment strategies with complex options strategies.

Margin Trading: Margin trading can enhance the index through two aspects: using owned stocks or ETFs as collateral for financing to increase leverage when bullish; and lending out owned stocks to generate returns through securities lending. If ETHE supports margin trading in the future or stocks in the stock enhancement part support it, this could be an alternative strategy.

Initial Coin Offerings (ICOs): With improvements in the regulatory environment, more traditional brokers are entering the crypto asset trading business. It is possible that crypto assets will have initial offerings on regulated brokerage platforms in the future. Historically, returns from ICOs and IDOs have been considerable, and at that time, our holdings could be used for ICO participation along with a small amount of cash.

Specific methods

Since 4 and 5 are currently difficult to implement, focusing on 1 to 3, we need to:

Select an Index: Mainly track the ETHE index, with ETH/USD as a reference index. Since it is a single asset and not a traditional broad-based index enhancement, the focus should be on controlling volatility and drawdowns when providing extra value through active management for the more concentrated “narrow-based” index.

Fund Allocation: To ensure the portfolio performance does not significantly deviate from the benchmark index, at least 60% of funds should be allocated to ETHE, ideally maintaining a weight of 80–90%, with the weight of return-enhancing funds ranging from 10% to 20%.

Stock Enhancement: As ETHE shares are currently traded on the OTCQX market, a so-called over-the-counter (OTC) market where securities usually have limited trading activity and no standard options market, it is not possible to use brokerage platform balances as collateral for covered call option selling strategies or margin trading. Therefore, the primary focus of enhancement should be the preferential allocation of selected blockchain and cryptocurrency-related stocks.

Table 1: Major US-listed blockchain or cryptocurrency-related stocks

Table 2: Major blockchain or cryptocurrency-themed ETFs listed in the US and Canada

The criteria for selecting investment targets are:

Companies with a clear business plan in the crypto ecosystem or indirectly benefiting from the development of the cryptocurrency industry, including crypto mining companies, mining equipment/chip suppliers, crypto financial service companies, or other financial institutions primarily serving crypto-related clients, and metaverse business companies;

Or fund products whose primary investment strategy focuses on digital currency spot or its derivatives;

Or shares of fund products investing in the aforementioned two categories.

Why choose crypto stocks:

Based on the moderate correlation between crypto stocks and crypto assets, establish crypto market exposure through a safe, convenient, and compliant approach.

The correlation between crypto stocks and crypto assets typically ranges between medium (0.40) and significant (0.90). Furthermore, historically, the beta value of many crypto companies’ stock prices and cryptocurrencies is greater than 1. This amplified risk exposure can make crypto stocks an effective tool for gaining exposure to price fluctuations in the crypto market. In addition, not only ETHE, but some crypto funds (such as BITW) also have a market value lower than NAV due to similar structural issues, which can also be used to bet on the return of discounts.

Table: Monthly Return Correlation of Major Crypto Stocks and ETH, ETHE (05/01/2021–05/04/2023):

Note: The statistical period is constrained by the COIN stock only being listed for trading in May 2021; CASH represents cash.

Derivative Enhancement

Option enhancement mainly focuses on the covered call strategy based on the owned stock/ETF spot positions, that is, selling an equal number of call options with a certain out-of-the-money degree, which can achieve excess returns relative to the spot market in the case of a market decline or steady rise.

At the same time, after combining macro, technical, and industry fundamental factors, adjustments can be made to the covered call strategy. For example, using a ratio call spread. In the case of a suitable term structure, a calendar spread can be executed.

When portfolio protection is needed, option structures can be formulated based on the level of implied volatility. For example, when the implied volatility is relatively high and the wings are higher than the at-the-money (ATM) options, a put spread collar structure can be chosen.

Option Enhancement Strategy Example

It is important to note that the details of volatility changes, such as skew and term structure, will affect the specific option structure. These indicators need systematic real-time tracking. Below are some illustrative diagrams of option structures:

Subjective Timing

Macro level, technical, and industry fundamental analysis for partial spot position timing is also a source of excess returns, but overall, as an ETHE enhancement strategy, position timing should be downplayed.

Specifically:

Macro timing: A comprehensive judgment of the overall future trend of the digital currency market is made by analyzing macro, policy, economic cycles, and other factors.

Industry timing: Company/project research, event-driven, multi-factor stock selection, etc.

Technical timing: Using graphic technical analysis to judge the trend’s sustainability and make appropriate position adjustments around key resistance and support levels.

The unquantifiable macro judgment and event-driven aspects are the core differences reflecting the strategy manager’s expertise. For example, Ethereum 2.0 upgrade (Shapella) concluded on April 13, 2023. However, a point many people overlook is that a large amount of ETH withdrawal will not occur immediately, and it may take more than five days to arrive. Therefore, if the price rises within a few days after the upgrade’s completion, it may be appropriate to consider reducing positions or selling some call options to harvest volatility value. The chart below shows the ETH spot price, which surged around April 13, then consolidated for five days before quickly falling.

The main purpose of the above strategies is:

Long-term holding of core crypto market assets — ETH is the core infrastructure of mainstream Web 3 applications. In addition to serving as a channel for fiat wealth liquidity spillover and portfolio diversification like BTC, it will also have additional α brought by Web 3 ecosystem applications.

Timing operations without affecting cornerstone positions — Timing operations do not affect the high position of ETHE, avoiding missing the tail-end abnormal upward trend.

Focusing on the alpha of stocks — Carefully selecting more outstanding companies will yield excess returns higher than the market average in the long run.

Capturing volatility returns — Transforming black swan risks and fluctuations during the bull-bear transition into long-term bullish “alpha” for the index through options.

Empirical Study

Next, we will conduct an empirical analysis of the proposed index-enhanced fund strategy based on Grayscale ETHE, using historical data to evaluate the effectiveness and feasibility of the strategy.

Based on the historical market data from January 2020 to April 2023 and the following alternative targets (where OPRE is used to simulate the return of the option part), we perform monthly return statistics. Then, we apply conditional constraints on the highest and lowest proportions of each asset allocation. We obtain optimized portfolio allocations based on three methods:

Maximum Sharpe Ratio Optimization — Finding the optimal risk-adjusted portfolio on the efficient frontier based on mean-variance.

Minimum Variance — The minimum portfolio risk (measured by variance or standard deviation) among a set of assets.

Maximize Returns under a Given Annual Volatility Target of 100% — Seeking to maximize the expected return of the portfolio under a given risk level.

The performance of each portfolio is shown in the table below, where the black ETHE line and the unoptimized reference portfolio 1 blue line can be used for comparison:

The table below shows the performance comparison of four optimized portfolios, including the maximum Sharpe ratio, minimum variance, maximum return under 100% volatility, and a single asset Grayscale Ethereum Trust (as a benchmark). It can be seen that the optimized portfolios outperform the simple holding of ETHE on almost all risk-return indicators, with the maximum Sharpe ratio portfolio being superior to other portfolios in terms of returns, risk control, and risk-adjusted returns:

These data can be observed from the following aspects:

Returns: Over the given period, the maximum Sharpe ratio portfolio has the highest final balance of 60,653, significantly outperforming other portfolios and the benchmark asset. The minimum variance portfolio and the maximum return portfolio under 100% volatility have final values of 42,977 and 45,878, respectively, which are also higher than the benchmark asset’s 31,840. This shows that the optimized portfolios have better returns than the single asset.

Risk: In terms of standard deviation, the minimum variance portfolio has the lowest risk level (99.02%), while the benchmark asset has the highest risk level (133.75%). In terms of maximum drawdown, the minimum variance portfolio and the maximum return portfolio under 100% volatility have lower maximum drawdowns (at -80.44% and -80.63%, respectively) compared to the benchmark asset’s highest maximum drawdown (at -89.60%). This indicates that the optimized portfolios also perform better in risk control.

Risk-adjusted returns: Sharpe ratio and Sortino ratio measure the expected returns per unit of risk and per unit of downside risk, respectively. Looking at these two indicators, the maximum Sharpe ratio portfolio performs the best (Sharpe ratio of 0.96, Sortino ratio of 2.06), which means that in terms of risk-adjusted returns, this portfolio is superior to other portfolios and the benchmark asset.

Relative returns and risk: Active return, tracking error, and information ratio measure the excess return, risk, and risk-adjusted excess return of the optimized portfolio relative to the benchmark asset, respectively. Looking at these three indicators, the maximum Sharpe ratio portfolio performs the best: active return of 30.19%, information ratio of 0.92 (ratio of active return to tracking error). This indicates that the maximum Sharpe ratio portfolio also has an advantage in performance relative to the benchmark asset, and this portfolio can achieve a certain excess return while assuming moderate risk.

Note: The optimization is based on the monthly return statistics of the selected portfolio assets within the given time period. The optimization results cannot predict which allocation will perform best outside the given period, and the actual performance of the portfolios constructed using the optimized asset weights may differ from the given performance targets.

Conclusion

In summary, the relatively poor risk-return ratio of ETHE can be enhanced through different allocation methods. The simulated portfolios outperform the benchmark asset ETHE in terms of returns, risk control, and risk-adjusted returns. Investors can choose an investment method suitable for their own risk preferences and investment goals, thereby improving their portfolio experience and striking a balance between maximizing returns and minimizing risk.

website: ldcap.com

medium：ld-capital.medium.com

Abstract

In 2023, the cryptocurrency market rebounded sharply from last year’s deep bear market. Many individuals may have missed the opportunity to invest. At this time, the Grayscale Trust shares, which still have a discount of about 50% compared to its net asset value (NAV), are particularly attractive.

Based on the position of Ethereum as a core Web3 infrastructure, we are bullish on Ethereum Trust (ETHE), a Grayscale Trust product, rebounding in performance in the potential bull market.

ETHE has a long history of trading at a premium or discount, with the reasons for the positive premium including a lock-up period for subscriptions, higher accessibility than ETH spot, and lower costs for traditional financial institutions and retail investors compared to self-custody of private keys.

The current reason for the long-term discount is mainly due to the product’s inability to be redeemed directly, similar to the structure of a closed-end fund. Additional reasons include: Restrictions on arbitrage opportunities, forced liquidation by large speculators, discounting of opportunity costs, and the impact of competitive products.

After the discount trend formed in mid-2021, the market’s expectation for ETHE to return to parity has become increasingly longer. According to our calculations, it once exceeded 14 years at the end of last year, and now it has fallen to about 10 years. We believe that this expectation is still too long, and the implied recovery time may fall to less than 2 years when optimistic expectations arrive, which is more reasonable.

There are seven situations that can lead to a narrowing or even disappearance of the discount, including open redemption of ETH spot (divided into two cases: redemption exemption from SEC and approval of ETF conversion application), obtaining redemption exemptions, product dissolution and liquidation, Grayscale’s own buyback, development of arbitrage strategies and improvement of market confidence, and reduction of opportunity costs to help repair the discount.

Since the birth of ETHE in 2019, the product has not yet gone through a complete “cycle.” We believe that a complete cycle should follow the pattern of premium, parity, discount, parity, and premium. Currently, ETHE has only completed half of the cycle. We believe that if you bet on the potential bull market, ETHE has better resilience. Its performance since the beginning of the year, which is 1.7 times that of ETH, proves this point.

However, historical data shows that ETHE’s risk-return ratio is subpar, as shown in Table 1, ETHE is almost weaker than ETH/USD in all aspects. This means that if you are ready to hold ETHE for a long time, you may need to adopt some targeted profit-enhancing strategies. Otherwise, there is a risk that its performance will be weaker than the market if the bull market does not quickly arrive.

Summary

In 2023, the cryptocurrency market has once again become the focus of investors’ attention, with BTC and ETH leading the global asset class in terms of price increases. However, many investors are still unable to recover from the bear market mindset and have missed investment opportunities. But under the Grayscale Trust, investors can still receive a discount of nearly 50% on purchases of GBTC and ETHE products.

As we believe that the Ethereum network (ETH) will be the core infrastructure of mainstream Web 3 applications in the future, in addition to being able to absorb traditional capital outflows like BTC, it will also have the potential to benefit from Web 3 ecosystem applications. Therefore, this article will focus on the discount phenomenon and potential investment value of the Grayscale Trust product ETHE, and discuss in detail the possible scenarios in which this phenomenon may be reduced or even disappear, as well as the reasons why institutional investors are suitable for entering the cryptocurrency market. In addition, we will analyze the legal structure and potential risks of this product.

The Grayscale Bitcoin Trust was launched as early as September 2013 and is legally designated as a grantor trust. The grantor, who created the trust, is the owner of the assets and property in the trust and retains full control over its assets, which is similar in practice to a closed-end fund. Under this special structure, it allows investors to indirectly own the assets in the trust fund by purchasing beneficial interests. Like closed-end funds, grantor trusts typically do not allow investors to redeem their shares at any time.

The Grayscale Ethereum Trust (ETHE) (formerly known as the Ethereum Investment Trust) (“Trust”) is a statutory trust in Delaware, established on December 13, 2017, and listed for trading in July 2019, adopting the same trust structure as GBTC.

The benefit of using a trust structure is that since the trust does not trade, purchase, or sell ETH or its derivatives on any exchange, it can avoid being regulated by the corresponding regulatory agencies. This makes it easier to launch the product, although it is still unclear whether ETH belongs to the CFTC or the SEC.

First, let’s briefly look at the main differences between ETHE and ETH:

Different investment methods

ETHE is a listed trust fund that is regulated by the US Securities and Exchange Commission (SEC), making it easier for institutions to manage their balance sheets. ETHE trades through a regular securities account, which is easier and cheaper than trading on a cryptocurrency exchange. ETHE can be part of an individual retirement account (IRA) and 401(K) (US retirement benefits plan), enjoying investment tax benefits. There is also no need to learn how to manage cryptocurrency wallets, nor to worry about risks such as accidentally losing private keys or wallet exploits.

Different supply

There is no limit to the total supply of ETH. The supply of ETHE depends on Grayscale’s issuance plan.

Different market demand

Since ETHE is an investment product, its market demand is different from that of ETH. Some institutional investors and individual investors may be more willing to invest in ETHE, while ordinary cryptocurrency traders may be more willing to trade ETH.

Others

ETHE investors cannot currently redeem underlying ETH assets or their equivalent in dollars from Grayscale; ETHE charges a management fee of 2.5% of the net asset value annually; ETHE cannot participate in on-chain activities such as DeFi mining.

Topic 1: Why is there a significant discount?

In theory, the price of ETHE should fluctuate around the value of its ETH holdings. But in reality, its secondary market price is not fully reflected by the market. Since its listing in 2019, ETHE has historically maintained a premium over ETH for a long duration, exceeding 1000% at the beginning of its listing in 2019. However, since February 2021, ETHE has entered a discount, which has continued to this day.

Figure 1: Historical premium/discount of ETHE and ETH price trends

Source: Graysacle, Trend Research

Grayscale’s crypto trust shares are similar to closed-end funds, which has led to a very limited market supply in the early stages. Secondly, due to the immaturity of the cryptocurrency market, many investors do not know how to buy and store cryptocurrency. Therefore, Grayscale’s crypto trust funds, which can be purchased directly on US stockbroker platforms, are bought at a premium.

As can be seen, the absolute value of the premium of ETHE reached its highest point on June 21, 2019. Until the first discount appeared in February 2021, ETHE traded at a premium on the secondary market. After February 2021, as the market entered a bull market and more index products that track the price of Bitcoin/Ethereum were launched, investors had greater investment options. ETHE began trading on the secondary market at a relatively fairer price compared to its NAV.

On June 29, 2021, GBTC’s application to convert to an ETF was rejected by the SEC, and an hour later, Grayscale sued the SEC, which further widened the discount of ETHE. From mid-2021 to the end of 2022, as the overall cryptocurrency market peaked and weakened, large speculators, led by several failed crypto companies such as Three Arrows Capital (3AC) and BlockFi, were forced to sell fund shares due to high leverage or financial difficulties. Even though the market was at a discount, these speculators could not wait, further expanding ETHE’s discount.

Figure 2: Discount/premium changes since the first appearance of discounts in early 2021 vs. ETH price trend.

Source: Graysacle, Trend Research

Figure 3: Correlation between ETHE and ETH prices has been very high for most of the time.

Source: Tradingview, Trend Research

In summary, the reasons behind the premiums/discounts of Grayscale’s ETHE Trust are due to the fund’s structure where assets cannot be immediately redeemed. The reasons for premiums include higher accessibility to the product compared to ETH spot, making ETHE more suitable for institutional and retail investors in traditional finance who do not want to manage their own private keys; balance sheet accounting treatment, tax advantages, and helping investors bypass compliance-related issues. The reasons for negative premiums are related to four factors: Fund structure where assets cannot be directly redeemed, restrictions on arbitrage opportunities, discounted opportunity costs, and the impact of competitive products. These will be discussed in more detail in the following sections.

1. Fund structure where assets cannot be directly redeemed

According to legal documents, only authorized participants (AP) authorized by Grayscale can directly purchase and redeem ETH from Grayscale. APs must meet certain eligibility and regulatory requirements, including being registered brokers or dealers, and must meet specific regulatory standards. According to the rules, each trust share is grouped by 100 shares, and APs need to purchase at least one group at a time and can only exchange it with ETH spot.

So far, there are only two APs. Before October 3, 2022, Genesis Global Trading, Inc. under DCG was the only AP, and after October 3, 2022, Grayscale Securities took over as the other sole AP of the trust.

Therefore, it can also be understood that Grayscale plays the role of the primary dealer, and other investors can only purchase the shares flowing out of their hands. Therefore, although some institutions may be able to purchase ETHE at original price in the primary market, they are not direct subscribers. According to the rules, they have no right to request redemption. As for why these institutions do this, there may be two main reasons: one is to see the arbitrage opportunity in the secondary market, and the other is to treat Grayscale as a custodian to avoid the risk and cost of managing their private keys.

Currently, the trust fund does not have a share redemption plan in operation, so APs and their clients cannot redeem shares through the trust fund. Therefore, participants cannot use the arbitrage opportunities generated by the deviation of the secondary market price from the net asset value per share of the trust’s ETH holdings. This makes it difficult for the price difference to recover when a discount occurs. If direct redemption is possible, market participants can purchase trust shares at a low price in the secondary market and then redeem higher-value ETH from the fund, pushing the discount to narrow.

2. Restrictions on arbitrage opportunities

The inability to directly subscribe and redeem ETF shares creates restrictions on arbitrage opportunities. This does not pose a significant obstacle during a bull market when ETHE is trading at a premium, but becomes more apparent during a bear market when it trades at a discount.

In traditional ETF markets, arbitrage opportunities arise when demand for an ETF increases or decreases and the market price deviates from its net asset value. Such mispricing is often corrected quickly through arbitrage.

There are two main types of arbitrage: basic arbitrage, which is aimed at ETF shares that can be subscribed and redeemed quickly, and CTA strategy arbitrage, which is aimed at ETFs that cannot be subscribed and redeemed quickly.

Basic arbitrage

In the case of a premium, investors will subscribe to ETF shares from the fund issuer and then sell them on the secondary market for arbitrage purposes; this will decrease the demand/price of the ETF.

In the case of a discount, investors will buy the ETF on the secondary market and then redeem them for a higher value from the fund issuer; this will increase the demand/price of the ETF.

CTA strategy arbitrage

For ETFs that are difficult to subscribe or redeem in a timely manner, one can bet on the price difference between the underlying assets and the ETF shares. When the premium reaches a certain level, investors will go long on the underlying assets and short the ETF shares; when the discount reaches a certain level, investors will short the underlying assets and go long on the ETF shares.

The implementation of this strategy is affected by the price convergence trajectory. In the case of ETHE, because price regression depends mainly on regulatory judgments rather than certain operations of market participants (such as subscription / redemption), uncertainty is high, resulting in a higher tolerance for market price differences.

Figure 4: ETHE historical discount/premium rate vs. circulating share quantity

Source: Grayscale, Trend Research

From figure 4, it can be seen that after Spring 2021 where the premium narrowed, the forward arbitrage space disappeared, the buying power of new trust shares also subsequently stopped.

There is also a classic case of a similar closed-end fund that cannot be redeemed in the traditional market. This is the stock of Berkshire Hathaway, the stock of the legendary trader, Warren Buffett. As an investment company, Berkshire Hathaway’s stock price may be affected by the price fluctuations of the company’s equity holdings in its investment portfolio. However, ordinary investors cannot demand that Berkshire Hathaway redeem its assets or apply for new shares in the company at any time.

However, for several decades, the stock of Berkshire Hathaway has been traded at a premium higher than its net asset value, mainly due to the successful investment record and market positioning of the company’s founder, Warren Buffett. However, at certain times, the premium of its stock may decline, reflecting changes in the market’s view of the company.

For example, in March 2020, the stock of Berkshire Hathaway fell by about 30%, resulting in a significant discount in the trading price of the company’s stock. This discount may mainly reflect market concerns surrounding COVID-19 and Berkshire Hathaway’s exposure in epidemic-affected industries such as tourism, aviation, and finance.

Returning to ETHE: After the primary suscription, ETHE can only circulate on the secondary market after holding for at least 6 months. Therefore, the path of forward premium arbitrage does exist but requires more time. However, after ETHE first appeared at a discount in February 2021, investors’ primary market purchase behavior stagnated. This is obviously because the backward discount arbitrage requires redemption support, while the timetable for Grayscale to open this is unclear. In the case where the investment strategy of ETHE has no greater advantages than holding spot positions, its closed-end shares are difficult to return to a premium like the stock of Berkshire Hathaway.

Secondly, as the overall cryptocurrency market peaked and weakened, institutional sellers, such as Three Arrows Capital (3AC) and BlockFi, several large speculators led by failed cryptocurrency companies, previously made large purchases and waited six months to sell for profit from the huge premiums of GBTC and ETHE. Later, due to high leverage or financial difficulties, they were forced to sell fund shares even if the market was trading at a discount at that time. For example, it can be seen from publicly available information that DCG was forced to sell about 25% of its ETHE holdings at half price earlier this year due to financial problems, which amplified the discount of ETHE.

Figure 5: Comparison of the performance of ETHE and ETH from the mid-high point in 2021 to the end of 2022:

Source: Tradingview, Trend Research

3. Discounted Opportunity Cost

Table 1: ETHE Related Legal/Financial Information (As of March 31, 2023)

Source: Grayscale, Trend Research

Source: Grayscale, Trend Research

The management fee for Grayscale’s Ethereum Trust is 2.5% of the net asset value (NAV) annually. Grayscale deducts the estimated accrued but unpaid fees of the trust from its ETH holdings daily in public data, so the amount of ETH represented by each ETHE share gradually decreases, as shown in the graph below.

Graph 6: Number of ETHE shares in circulation (left) vs. the amount of ETH held by the trust per share (right)

Source: Grayscale, Trend Research

If we disregard other risks, today’s discount can be understood as a discounted opportunity cost. Therefore, based on the secondary market discount rate X and the holding opportunity cost Y, we can calculate the implied market expectation of the time T required for redemption or NAV parity recovery. We assume that the potential growth expectation of NAV is 0 and:

Holding Opportunity Cost + 10-year US Treasury Yield + 2.5% Management Fee, then: (1-Y)^T=1+X

Therefore, T=ln(1+X)/ln(1-Y)

Graph 7: Historical discount rate of ETHE vs. Implied market expectation for redemption (recovery to parity) time (unit: years)

Source: Grayscale, Trend Research

From the chart above, it can be seen that the market’s expectation for ETHE to return to parity has become longer since the formation of the discount trend in 2021. At the end of last year, it exceeded 14 years due to regulatory crackdowns and a quiet market. Now, it has fallen to around 10 years. However, we believe that this expectation is still too long. It is reasonable to expect that the implied recovery time may fall below 2 years when optimistic expectations arise. The most pessimistic outcome may take more than 10 years to liquidate and dissolve, as Mt.Gox’s asset liquidation took 9 years.

4. Impact of Competitive Products

Before 2019, there were few competitors to Grayscale’s trust products in the market. On February 18, 2021, the Purpose Bitcoin ETF, a Canadian fund that directly invests in Bitcoin, officially began trading and quickly accumulated over $1 billion in assets within a month. Its management fee of 1% is less than half that of GBTC, and its ETF structure can more closely track Bitcoin, making it more attractive than Grayscale’s products.

Just two months later, on April 17, the Canadian regulatory agency approved three Ethereum ETFs at the same time, namely the Ethereum ETF (ETHH) from Purpose Investments, the Ethereum ETF (ETHR) from Evolve Capital Group, and the Ethereum ETF (ETHX) from CI Global Asset Management, all of which were listed on April 20. According to the official websites of the three companies, there is a slight difference in the management fees of the three Ethereum ETFs, with CI Global’s management fee at 0.4%, Evolve’s at 0.75%, and Purpose Investments’ at 1%. On the first day of listing, Purpose’s Ethereum ETF attracted CAD 26.46 million (approximately USD 21.32 million) in funds, Evolve’s ETHR raised CAD 2.22 million (approximately USD 1.79 million), and CI Global’s ETHX had an asset size of CAD 2.25 million (approximately USD 1.81 million).

Three days later, on April 23, the fourth Ethereum ETF in Canada began trading on the Toronto Stock Exchange. It was jointly launched by Canadian digital asset management company 3iQ and investment company CoinShares, and offers trading of Canadian dollar shares (ETHQ) and US dollar shares (ETHQ.U).

In addition, there are more ETH futures ETFs, related stocks, listed companies holding ETH, mining and asset management businesses, etc. The increasing market share of these diversified investment channels weakens Grayscale’s trust products’ scarcity to traditional financial institutions and retail investors, becoming a competitive factor that Grayscale must consider.

Topic 2: When discounts may be reduced or eliminated

There are seven situations that can cause discounts to narrow or even disappear, including the opening of ETH spot redemptions (divided into two situations of obtaining SEC exemptions through redemption and ETF conversion application approval), obtaining redemption exemptions, product dissolution and liquidation, Grayscale’s own repurchases, the development of arbitrage strategies and the improvement of market confidence, and the decrease in opportunity costs that contribute to discount repairs.

1. Improvement of regulatory environment — ETF application approval

According to Grayscale’s latest FORM 10-K filing released at the end of 2022, they still believe that their trust can carry out redemption plans after obtaining SEC approval for ETF conversion. Although the SEC has rejected the application to convert GBTC to an ETF, a federal appeals court judge in the United States questioned in March of this year whether the agency’s decision was correct, as it had previously approved Bitcoin futures ETF products.

It should be noted that Grayscale currently only applied for ETF conversion for the Grayscale Bitcoin Trust (GBTC) and has not yet announced plans to convert the Grayscale Ethereum Trust (ETHE) into an ETF. However, recent progress is undoubtedly positive. At the most recent hearing held on March 7th of this year, Grayscale argued that the standards applied by the SEC were inconsistent, as they had approved the application for Bitcoin futures ETFs but had consistently rejected applications for spot Bitcoin ETFs.

Grayscale believes that since the underlying assets of these two products are the same and their prices are derived from Bitcoin, Wall Street regulators should treat these products similarly, though that is not the case. Grayscale claims that the regulator’s behavior is arbitrary and capricious, and therefore violates federal law. The SEC responded that it has been applying the same standards, but the products are actually different. According to the SEC, the Bitcoin futures market is regulated by the CFTC, which makes it different from spot BTC ETFs, which they believe are unregulated.

Before the hearing, Bloomberg analyst Elliot Stein believed that the SEC had the upper hand in the lawsuit, and their chances of winning were much higher than those of the GBTC issuer because the court tends to defer to federal agencies as they are experts in their respective fields. However, after hearing the latest arguments, Elliot Stein believes that Grayscale has a 70% chance of winning. If GBTC is approved, it will also directly benefit the sentiment of ETHE. However, it should be noted that unlike BTC-based futures ETFs that have been approved for listing by the SEC, no funds based on Ethereum have been approved for listing yet, which is related to the disputed legal status of Ethereum.

2. Improvement in regulatory environment — becoming a registered investment company or being classified as a commodity

Grayscale Ethereum Trust (ETHE) is a registered investment trust, not a registered investment company. Specifically, it is established as a trust under the laws of a specific state and is registered under the exemption provisions of the 1933 Securities Act with the US Securities and Exchange Commission (SEC). This means that ETHE is not required to comply with certain requirements under the 1933 Securities Act, such as disclosing information to the public and registering.

However, if the SEC determines that the trust needs to register as an investment company under the Investment Company Act of 1940, Grayscale believes that in this case, the trust structure could be dissolved and its shares may be converted to stocks, but this is only speculation and will ultimately depend on the specific circumstances of the company and regulatory opinions, as well as exchange rules.

In addition, if ETHE is classified by the CFTC as a commodity investment portfolio, it would need to comply with the relevant provisions of the Commodity Exchange Act (CEA) and register and be regulated by the CFTC. This is also a possible regulatory direction.

3. Obtaining redemption exemptions

Grayscale once provided a redemption program, but it was halted in 2016 after the SEC accused Grayscale Trust of violating Regulation M. Specifically, the SEC was concerned that Grayscale Trust may conduct share redemptions while creating new shares, which could affect market prices and lead to market manipulation, insider trading, or unfair trading practices. Therefore, Grayscale suspended the GBTC redemption program, and subsequent trust funds such as BCH and ETHE also followed this operation to ensure that their trading practices comply with applicable regulations and regulatory requirements.

As Grayscale does not currently believe that the SEC will consider continuous redemption programs, the trust has not sought regulatory approval from the SEC.

However, it is not ruled out that they may actively seek this exemption in the future, although the timing and probability of success are uncertain. Moreover, developing redemption assets would reduce Grayscale’s income as a trustee, so currently there may be insufficient motivation for them to actively pursue an exemption.

If such an exemption is obtained and Grayscale agrees to redemption, a redemption program can be implemented. The redemption program will provide authorized participants (APs) with arbitrage opportunities when the Trust’s share value deviates from the value of ETH holdings, minus fund expenses and other liabilities. This arbitrage opportunity may be monopolized by APs or transferred to clients, and it is currently unclear because only Grayscale’s affiliated companies serve as exclusive APs, which may raise concerns about unfair competition.

4. The relationship between discount and market sentiment, the development of arbitrage strategies, and market confidence.

In the previous section, we discussed the problem of the discount not closing significantly due to the use of arbitrage being blocked. However, on the other hand, due to the existence of CTA strategies, even if it cannot be redeemed at present, arbitrage traders may still compress the discount when the overall cryptocurrency market is on a positive trend. Since the birth of ETHE in 2019, the product has not yet experienced a complete “cycle”. We believe that a complete cycle should follow the pattern of premium → parity → discount → parity → premium. Currently, the ETHE product has only completed the first half of the cycle.

Figure 8: Annual Return ETHE Vs. ETH (it can be seen that ETHE’s long-term performance on an annual basis is inferior to ETH).

Source: Grayscale, Trend Research

Figure 9: Monthly Return ETHE Vs. ETH (it can be seen that ETHE has greater elasticity than ETH in the short-term).

Source: Grayscale, Trend Research

As can be seen from the comparison of annual and monthly returns in the above figures, 2019–2022 belongs to the “premium → parity → discount” cycle, which can be understood as a bubble-bursting cycle. ETHE does not have excess returns during this period, and investment is not a good choice. However, due to the fact that the ETHE product has greater elasticity than ETH itself, it should create better positive returns in the future “discount → parity → premium” repair cycle. In fact, this can be clearly seen from the performance comparison in the past three months this year, where the increase in ETHE is 1.7 times that of ETH.

5. Inability to Convert ETFs nto Final Trust Liquidation

If Grayscale is unable to obtain redemption exemptions or approval for ETF conversion and this situation persists for too long, the continuous fees deducted by the fund management may cause dissatisfaction among investors, and Grayscale will face significant pressure to liquidate and dissolve the trust. Once liquidation is confirmed, the discount on NAV in the secondary market may quickly recover.

In fact, Alameda Research, a subsidiary of the bankrupt FTX, has already sued Grayscale Investments and its owner DCG Group in March 2023, attacking Grayscale for charging high fees and refusing to allow investors to redeem from GBTC and ETHE. Alameda claims to be suffering “hundreds of millions of dollars in losses” due to this structure. Similar situations may become more and more frequent over time.

In addition, according to the declaration document, the main situations that may trigger the early termination and liquidation of the ETHE Trust include:

Federal or state regulators in the US requiring the Trust to close or force the Trust to liquidate its ETH, or seize, confiscate or otherwise restrict the Trust’s assets;

If CFTC or SEC, FinCEN and other regulatory agencies believe that the Trust needs to comply with specific laws and regulations, Grayscale may choose to dissolve the Trust to avoid unnecessary legal liability and financial risk;

Grayscale believes that the Trust’s assets and fees are not proportional to the risks, costs, and returns;

The Trust license is revoked;

Anything that stops the Trust from accurately figuring out the Index Price, or if it’s just too difficult for the Trust to do so;

Anything that makes it difficult or impossible for the Trust to convert Ethereum into U.S. dollars;

The custodian resigns or is dismissed and there is no replacement candidate;

The Trust becomes insolvent or bankrupt.

6. Grayscale’s Self-Repurchase

In the event of an extreme scenario where Grayscale is willing to buy back all outstanding shares in the market at a cost below NAV and decides to privatize or liquidate the Trust, such an operation is obviously profitable. Announcing a large repurchase plan can help boost market confidence and may be conducive to narrowing the discount.

Grayscale’s parent company, Digital Currency Group, announced a total of up to US$1 billion in Trust share repurchase plans in 2021–2022. However, GBTC still trades at a price below NAV, which may be because the scale of repurchase is relatively insignificant compared to the overall asset management scale of hundreds of billions of dollars, although secondary market repurchase helps to narrow the price spread.

In addition, in Grayscale CEO Michael Sonnenshein’s year-end letter to investors in 2022, he mentioned that if the GBTC ETF is not realized, one of the methods for investors to unlock it is a tender offer, such as repurchasing no more than 20% of the outstanding shares of GBTC. If this happens, it should consider all of its trust products, and the discount on ETHE may also narrow.

7. Opportunity cost reduction

According to our discussion in Topic 2, the current discount can be understood as the present value of opportunity cost. Therefore, if Grayscale reduces management fees or the risk-free interest rate in the market drops, it will help narrow the discount based on the same expected time for the recovery of parity. In fact, Grayscale’s CEO Sonnenshein mentioned the possibility of reducing fees in March this year.

Even if the expected period of 10.5 years remains unchanged, simple simulations can be conducted:

If the 10-year government bond and management fees both decrease by 1 percentage point, the opportunity cost is an annualized 3.91%, which can help narrow the discount from -47.3% to -34.2%;

If they both decrease by 1.5 percentage points, the opportunity cost is an annualized 2.91%, and the discount may narrow to -26.7%;

If they both decrease by 2 percentage points, the opportunity cost is an annualized 1.91%, and the discount may narrow to -18.35%.

Figure 10: Simulation of discount narrowing that may be caused by a drop in the risk-free interest rate.

Source: Graysacle, Trend Research

Topic 3: Why is it suitable for professional investors to bet on the cryptocurrency market

1. Grayscale’s digital currency trust products have advantages in accessibility, balance sheet management, cost advantage compared to self-custody of private keys, and investment tax advantages. As of now, ETHE is still the only “stock” in the US market that uses Ethereum spot as its main asset.

Specifically:

Accessibility: Grayscale’s digital currency trust shares can be traded through common US stock brokers, which means that investors can buy and sell these products more easily. In contrast, trading through cryptocurrency exchanges or other channels may involve more risks and fees.

Balance sheet management: Grayscale’s digital currency trust products are a type of security product, which means that professional investors do not have to worry about how to manage their digital assets on the balance sheet and can more easily incorporate them into their investment portfolios.

Custody cost advantage: Compared to self-custody of private keys for digital currencies, Grayscale’s digital currency trust products may have lower costs. For example, when buying digital currency on-chain, investors may need to bear higher learning costs and network fees. There may also be a risk of leakage when safeguarding private keys, with the possibility of completely irretrievable assets once lost. When buying and selling Grayscale’s digital currency trust products, investors only need to pay commissions and fees related to securities transactions.

Investment tax advantages: According to US tax law, Grayscale’s digital currency trust products are considered securities products and may enjoy the same investment tax benefits as other securities products. For example, if an investor sells Grayscale’s digital currency trust products after holding them for more than a year, they may be eligible for lower capital gains tax rates.

2. If betting on a potential bull market, ETHE has higher elasticity:

Since the rebound of the bull market since the end of 2022, ETHE has increased by up to 107%, far higher than ETH’s 61%, which shows that a considerable number of pessimistic factors have been taken into account during the discount cycle. Therefore, when the market rebounds, ETHE has greater elasticity than ETH and is a better bet for the bull market.

Figure 11: Comparison of the rise since the end of 2022 between ETHE and ETH.

Source: Tradingview, Trend Research

Theme 4: Risks of ETHE investment

1. Policy and regulatory risks

The recognition of ETH or any other digital asset as a “security” may have an adverse impact on the value of ETH and the stock;

Any jurisdiction that restricts the use of ETH, verification activities or the operation of the Ethereum network or digital asset markets may have an adverse impact on the value of the stock;

Regulatory changes or interpretations may require the Trust to register and comply with new regulations, which may result in additional expenses for the Trust;

Because Grayscale’s affiliated companies are the only entities that can create or destroy fund shares, the number of issuances and redemptions may not be efficiently adjusted based on market demand due to regulatory restrictions or technical reasons, which could result in significant deviations of the secondary market trading price from NAV.

2. Statistical risks

Historically, the risk-return ratio of ETHE has been poor, as shown in Table 2, with ETHE performing weaker than ETH/USD in almost all aspects. This means that if you plan to hold ETHE for the long term, you may need to implement targeted profit-enhancing strategies. Otherwise, there is a risk that its performance may be weaker than the market if the bull market does not arrive quickly.

Table 2: Risk and Return Metrics (Jul 2019 — Mar 2023)

Source: Tradingview, Trend Research

Return: Whether it’s the arithmetic or geometric mean monthly or annualized return, ETH outperforms ETHE. In particular, the annualized return for Ethereum reached 150.24%, while Grayscale Ethereum Trust was only 102.18%. In terms of annualized geometric mean return, Ethereum reached 62.90%, while Grayscale Ethereum Trust was -11.12%.

Risk-adjusted returns: Looking at risk-adjusted return indicators such as the Sharpe ratio, Sortino ratio, and Treynor ratio, ETHE’s performance after adjusting for risk is weaker than that of ETH.

Volatility: ETHE’s volatility (standard deviation) is higher at 137.75%, which means investors may face greater price volatility risk. In contrast, ETH has lower volatility at 100.48%.

Maximum drawdown: ETHE’s maximum drawdown reached -89.6%, higher than Ethereum’s -77.96%, which means that in past performance, ETHE suffered greater losses at its worst.

Active returns and information ratio: ETHE’s active returns were -74.02%, and the information ratio was -0.73, which means that compared to Ethereum, Grayscale Ethereum Trust’s performance in active management is poor. Although this can be attributed mainly to price fluctuations in the secondary market as the fund’s holdings did not decrease due to active trading.

In the second article of the series, we will discuss how to enhance returns for ETHE to ensure that it can withstand bull and bear markets.

website: ldcap.com

medium：ld-capital.medium.com

This article will explore the performance of lending, trading protocols, and decentralized stablecoin systems that were most affected by the USDC de-peg crisis, as well as potential trading opportunities.

Overview of the USDC De-Peg Crisis

USDC is a centralized stablecoin pegged to the US dollar and issued by Circle and Coinbase. When Silicon Valley Bank (SVB) filed for bankruptcy on March 11, 2023, Circle’s partial cash reserves were frozen at the bank, lowering market confidence in USDC and triggering substantial runs and selloffs. USDC’s price fell from $1 to $0.878, with significant price differences compared to other stablecoins such as DAI and BUSD. Following, USDC prices returned to near-normal levels on March 13 as market panic gradually subsided in response to the joint rescue plan of the Federal Reserve, Treasury Department, and FDIC.

Chart: Major events in the USDC De-Pegging Crisis and the price trends of related stablecoin tokens in the stablecoin race.

Source: Trend Research, Tradingview

In order to address this crisis, Circle took the following actions:

Negotiated with SVB to unfreeze some of the funds and transfer them to other banks.

Reduced the circulation of USDC by burning some, increasing market confidence in the adequacy of USDC reserves.

Collaborated with other stablecoin issuers to open a 1:1 exchange channel to ease market pressure.

Collaborated with centralized exchanges to suspend or limit USDC deposit and withdrawal services to prevent malicious arbitrage.

Throughout the USDC crisis, it triggered panic and volatility in the cryptocurrency market, affecting investor confidence and trading activity. During this period, certain segments of the market, including centralized stablecoin markets, decentralized stablecoins, on-chain lending, and DEX, all faced risks:

Centralized stablecoin market: The USDC crisis may damage its position and reputation in the centralized stablecoin market, first raising doubts and panic selling of all stablecoins, but later providing an opportunity for other competitors (such as TUSD, USDP, etc.) to seize its market share. At the same time, the panic period created low-risk arbitrage opportunities for stablecoins like BUSD and USDP that were not at risk of breaking their peg.

Decentralized stablecoins: The USDC crisis affected decentralized stablecoins (such as DAI, FRAX, MIM) that used USDC as their reserve or collateral, resulting in significant deviations from their peg and exposing them to liquidation risks and arbitrage opportunities. At the same time, it may stimulate innovation and development of decentralized stablecoins (such as sUSD, LUSD, RAI) that do not rely on Fiat reserves or collateral.

On-chain lending: On-chain lending platforms that utilize USDC as a lending asset or collateral, such as Aave and Compound, were impacted by the USDC crisis, which resulted in interest rate fluctuations, USDT liquidity depletion, or liquidation events. At the same time, Compound, which defaults to a USDC price of $1, faces greater risks.

DEX: DEXs (such as Uniswap, Curve) that use USDC as a trading pair or liquidity pool asset may experience price slippage or arbitrage opportunities as a result of the USDC crisis. Simultaneously, it may push DEXs to improve their trading efficiency and flexibility to adapt to market changes.

Synthetix

Synthetix launched in 2018 as a synthetic asset protocol and gradually transitioned into a decentralized liquidity supply protocol built on Ethereum and Optimism. Users can generate the stablecoin sUSD by staking the governance token SNX. The current size of sUSD is approximately $55 million. The collateralization rate for SNX minting sUSD is 400%, and the liquidation threshold is 160%. Capital utilization is inefficient because of this relatively high collateralization rate. Additionally, due to SNX being the governance token of the protocol, its price fluctuations are significant. To address serious market risks and maintain stability, a higher collateralization rate is needed.

sUSD maintains its price peg through arbitrage mechanisms. If the market price of sUSD is higher than the mint price, arbitrageurs may mint new sUSD increasing market supply, then sell it at the market price thus lowering its price. When the market price is lower than the mint price, arbitrageurs can buy back sUSD from the market, then burn it, to reduce debt.

The application of sUSD is based on the “debt pool” formed by SNX collateral. The debt pool is a unique mechanism of Synthetix. All users who stake SNX to mint sUSD share a debt pool. When a user mints sUSD, the proportion of the minted sUSD to the total sUSD in the debt pool is the user’s share, and all minted sUSD is the total debt of the entire system. If a user’s investment strategy achieves asset appreciation (such as purchasing sETH with sUSD and the price of sETH rises), it will increase the debt of other users.

The debt pool can provide liquidity with zero slippage and can act as a counterparty for various protocols to provide liquidity services, with good composability.

On the basis of this debt pool, SNX has built its ecosystem. Synthetix does not directly provide any frontend, but serves as the backend liquidity provider for some DeFi protocols. The current ecosystem includes Curve, the contract exchange Kwenta, the options exchange Lyra, etc. sUSD has a relatively stable usage scenario. Recently, the trading data and revenue data of Kwenta have increased significantly.

During the USDC de-peg panic, although the underlying assets of sUSD did not include $USDC, the price was still affected to some extent, dropping to around $0.96 at its lowest point. However, it was quickly balanced by arbitrageurs. The related panic selling was mainly dominated by emotional factors as the Synthetix system does not have direct exposure to the risk, and the drop in the prices of non-sUSD synthetic assets during the same period actually reduces the debt (liquidation risk) of sUSD minters. Therefore, compared to stablecoin projects with a large amount of USDC on their balance sheets, the certainty of returning to peg for sUSD is higher.

Chart: Comparison of sUSD and USDC prices

Source: Trend Research, CMC

In addition, there are theoretically still arbitrage opportunities within the protocol at this time, such as purchasing sUSD at a price of $0.95 in the secondary market, exchanging sUSD for other synthetic assets such as sETH in the Synthetix system at a ratio of 1:1, and selling sETH in the secondary market at a price above $0.95 to obtain arbitrage profits, provided the friction costs are low enough.

Synthetix is currently undergoing modifications for version 3.0. In V3, there will be new types of staking assets, in addition to SNX, other cryptocurrencies such as ETH can also be staked to generate sUSD. Previously, the size of sUSD was limited by the market capitalization of SNX, but after the implementation of V3, it will no longer be limited by this, and the scalability of sUSD will be enhanced. It is anticipated that Optimism will develop a more diverse ecosystem and gain a greater market share as funding flows into it.

MakerDAO

MakerDAO is a smart contract application built on Ethereum in 2014, which issues a decentralized stablecoin called DAI that pegs to the US dollar in a 1:1 ratio through a DAO model. The protocol uses various types of crypto assets as collateral and issues stablecoin DAI based on a certain collateralization ratio, essentially creating a trustless over-collateralized loan. When the value of the collateral falls below the minimum collateralization ratio (150%), the user’s collateral may be liquidated (forcibly sold to repay the DAI), ensuring that Maker does not experience a debt shortfall.

DAI’s goal is to minimize cryptocurrency volatility, but market behavior often causes DAI to deviate from the original price of $1. Therefore, Maker’s primary goal is to maintain the stability of the DAI price..

One of Maker’s tools for regulating the DAI price is adjusting its stability fee. Because the stability fee represents the interest rate users have to pay for borrowing DAI, it can influence their borrowing behavior by increasing or decreasing the borrowing rate. However, the adjustment of the stability fee is decided by MKR holders through voting, and the governance cycle is relatively long, resulting in a longer period of price control. Moreover, the actual market scenario for DAI is that demand for DAI decreases as ETH increases while demand for DAI rises as ETH declines, but the market supply rules are the opposite.

To address these two issues, Maker has designed the Peg Stabilization Module (PSM). PSM’s first implementation was the USDC PSM, which allows customers to deposit USDC and withdraw DAI with only 0.1% transaction fee at a 1:1 exchange rate. The module is a currency exchange protocol based on the fixed price of DAI, similar to a rigid redemption with a certain amount of funding, providing bilateral buffer protection for the DAI price.

PSM largely addresses DAI’s price stability problem and allows Maker to maintain control over borrowing costs without constantly changing their borrowing rates. PSM’s funding scale has expanded rapidly, making USDC the largest source of collateral for DAI. While a smooth exchange mechanism, this was exactly what caused USDC to be quickly dumped into the PSM during the most recent panic event. Currently, the debt ceiling for DAI issuance through USDC PSM has been set, and other more volatile assets (such as MATIC) have been largely redeemed, which has resulted in USDC PSM’s share of DAI issuance rising from 40% to 62%.

Image: Percentage of MakerDAO locked assets and resulting DAI debt.

Source: Trend Research, Daistas.com

There are two main types of market crises that DAI has gone through:

When most collateral falls in price due to stablecoin panic:

On March 12, 2020, the price of Ethereum plummeted 43% in one day, which resulted in significant deficits for many users who created DAI using Ethereum and other cryptocurrencies as collateral. These deficient Vaults were forcibly liquidated, and their collateral was auctioned off to repay debts and fines. Nevertheless, several auctions resulted in no bids due to market panic, network congestion, and system problems, resulting in a user winning a significant amount of collateral for 0 DAI. Due to this, there were 5.4 million DAI lost to MakerDAO, and the supply of DAI decreased significantly.

Since DAI demand far exceeded supply, the peg was broken, and DAI experienced a premium of up to 10%. There was a high risk-to-reward ratio for shorting DAI and waiting for its price to rise or fall even further at this time.

When only USDC continues to trade at a discount:

This was the first crisis in history where USDC had come off its peg. As half of the DAI was generated with USDC as collateral, this posed a significant risk to the DAI system. The price of DAI will fluctuate or become unredeemable if USDC loses its peg. As a precaution, the MakerDAO community approved a number of urgent measures to reduce the debt ceiling of several liquidity pools to zero DAI, meaning that they cannot continue to issue new tokens. In addition, the daily issuance limit of the portion exposed to USDC risk in the so-called “stability module” (PSM) was reduced from 950 million DAI to only 250 million DAI, and the fee was increased from 0 to 1%.

Liquidation is not feasible because USDC is not overly collateralized when creating DAI. Users who generate DAI using USDC as collateral will run out if the price of USDC drops below $1, thus they will have to pay more DAI to redeem their USDC. This puts them at risk of losses or being unable to exit, and the entire system may be paralyzed. Therefore, there may be another auction of MKR to make up for the shortfall, which is why the price of MKR plummeted by more than 30% during this crisis period. However, after the USDC crisis was resolved, the price of MKR quickly recovered to its pre-crisis level.

Image: Price changes of USDC and MKR during the de-pegging crisis.

Source: Trend Research, Tradingview

In addition to the trading opportunity to recover the value of MKR, there is also a trading opportunity for DAI. DAI is a strengthened version of USDC as the overall collateralization ratio behind DAI is primarily above 150%. Due to this, the price of DAI should rise even faster when the price is below USDC and once the risk surrounding USDC has been eliminated. According to the chart below, the DAI price was always slightly higher than the USDC price as the crisis on the 11th was slowly resolved by the market.

It is also important to note that the stablecoin minting module PSM saw a huge inflow of 950 million USD during this crisis, while the safe GUSD deposits also flowed out significantly. Other collateral pools also had more or less outflows, showing the effect of “bad drives out good”. How to deal with similar structural risks is worthy of more attention and discussion.

Liquity

Liquity was launched in April 2021 as a decentralized stablecoin lending platform built on Ethereum. Users can only generate the stablecoin LUSD, which is pegged to the US dollar, by collateralizing ETH. Liquity charges a one-time minting and redemption fee to support long-term LUSD holdings rather than interest on loans. Liquity is managed by smart contracts that cannot be modified after deployment and do not handle front-end operations, so user interaction requires third-party frontends, making it highly decentralized and censorship-resistant.

Currently, the circulating supply of LUSD is around 243 million, with a TVL of $572 million and 388k ETH collateralized, resulting in a total collateral ratio of 235.1%.

The minimum collateral ratio on Liquity is 110%, and the system enters recovery mode when it falls below 150%, with liquidation triggered below 110%. In recovery mode, vaults with a collateral ratio below 150% may also be liquidated, and the system prohibits further reduction of the overall collateral ratio. The goal of the recovery mode is to rapidly increase the overall collateral ratio to above 150% to reduce system risk.

Liquity employs a graded liquidation mechanism to maintain system stability. The stability pool incentivizes users to store LUSD through liquidity mining, and during liquidation, it destroys the debt and receives ETH. When the stability pool is exhausted, the system will reallocate the debt, distributing the remaining debt to ETH proportionally to other vault owners.

Stability pool providers and frontend operators can earn governance token LQTY rewards. LQTY represents the right to claim protocol revenue (minting and redemption fees) and governance rights (voting power).

When the price of LUSD falls below $1, users can buy LUSD at a lower price from the market and then redeem ETH for a profit. When the price of LUSD exceeds $1 (e.g., $1.1), users can collateralize ETH to mint LUSD, and then sell LUSD at a higher price on the market for a profit. This way, the price of LUSD fluctuates between (1-redemption fee and 1.1) and tends towards $1, creating a stable peg mechanism for LUSD. Also, since users can mint and redeem LUSD at any time for $1, they form a Schelling point and believe that 1 LUSD = 1 USD.

Image: LUSD peg mechanism

On May 19, 2021, the price of ETH rapidly dropped from $3400 to $1800, and over 300 addresses were liquidated. Liquity initiated two recovery modes, but the data was not captured by Dune because the recovery was too fast (the collateral ratio quickly returned after falling below 150%). During this period, a total of 93.5 million LUSD debts were liquidated, and 48,668 ETH were allocated to the depositors of the stability pool. All the liquidation was completed by the stability pool, and the participants in the stability pool were able to purchase ETH at a discount. This stress test proved the robustness of Liquity’s model.

Image: Liquity System Collateral Ratio Changes, TCR = Total Collateral Ratio.

Source: Trend Research，Dune

During the USDC panic, LUSD also experienced fluctuations, with a minimum of 0.96 and a maximum of 1.03. Arbitrageurs quickly brought the price back to normal. Specifically, users can purchase LUSD on the secondary market for $0.96, repay their LUSD loan in the Liquity system to redeem their collateral ETH. Since the price of LUSD in the Liquity system remains at $1, the value of the ETH asset that users can redeem is greater than the value of LUSD they purchased on the secondary market, resulting in arbitrage opportunities.

Source: Trend Research，Dune

During the market crisis, the reason for the rise of LUSD was that some users needed to repay LUSD to avoid liquidation, and some users had the motivation to deposit LUSD into the stability pool in hopes of obtaining discounted ETH in liquidation. Both factors contributed to the demand for LUSD. In addition, USDC holders who rushed out of the LUSD-USDC liquidity pool also helped passively boost the LUSD price.

Price fluctuations on the day of the USDC panic resulted in arbitrage opportunities, which resulted in a significant increase in mint and LUSD burn. There were 11.22 million burned LUSD and 21.98 million newly minted LUSD. The net increase in LUSD supply was about 10 million, accounting for about 4% of the total LUSD supply on that day. As a result, the protocol’s revenue on March 11th increased significantly, with 377,000 LUSD earned in the minting process and 97.4 ETH earned in the redemption process. This revenue is fully attributed to LQTY stakers, resulting in a short-term increase in LQTY yield. At the same time, the USDC panic increased the market’s attention to the decentralized stablecoin LUSD, and the supply and trove numbers of LUSD showed an upward trend. The overall supply of LUSD increased by roughly 12% from March 11 to March 16.

Chart：LUSD mint and burn, protocol insurance income, and redemption income.

Source: Trend Research，Dune

Reflexer

Reflexer is an overcollateralized decentralized stablecoin platform where users can generate RAI by staking ETH, a stablecoin not pegged to any fiat currency or asset. The redemption price of RAI is automatically adjusted by a market supply and demand-based algorithm using a PID controller to achieve low volatility. Users can mint RAI by over-collateralizing ETH, pay 2% annual interest, and redeem ETH by repaying RAI. The liquidation threshold is 145%, but currently, over-collateralization rates are between 300%-400%. Reflexer has a triple liquidation mechanism to ensure system security and charges a 2% stability fee as a surplus buffer. FLX is Reflexer’s governance token and also the final lender in the system.

When the market supply and demand are imbalanced, Reflexer proactively adjusts the RAI redemption price by incentivizing users to arbitrage and guide the market price back to the redemption price. The RAI system uses a PID control mechanism based on a series of parameters to adjust the control process mentioned above.

When the value of a user’s collateral is lower than a certain threshold relative to the borrowed amount, liquidation is triggered. The liquidator acquires the liquidated user’s ETH collateral through a fixed discount auction and repays the RAI debt on behalf of the liquidated user. When the surplus buffer is not enough to handle bad debts, the protocol enters the “debt auction” process, and the system issues more FLX to exchange RAI to complete debt processing on the market. Reflexer’s 2% stability fee is allocated to the following purposes: Stability Fee Treasury smart contract, FLX stakers, for buyback and burn.

Use cases for RAI include currency markets, stacked funding rates, yield aggregators-leverage positive/negative redemption rates, and sophisticated arbitrage tools.

Overall Reflexer has the advantages of being completely decentralized, ultimately moving towards no governance, and having a collateral mechanism that does not peg to any Fiat currencies, with positive comments from Vitalik and support from the Ethereum community. However, it lacks passive demand and use cases, and the over-collateralization rate is currently 300%-400% (357%), with low capital efficiency and token value capture, and insufficient tokens for incentives (the FLX reserved for promoting use cases may not be sufficient).

In terms of capital efficiency, Liquity is better than Reflexer (Liquity 260% collateralization rate vs. Reflexer 357%).In terms of borrowing volume, Liquity’s records is several times of Reflexer, and in terms of P/S valuation, FLX is undervalued compared to LQTY.

In this crisis, Vitalik minted RAI purchasing power for USDC and USDT, which seems to be a recognition of an entirely decentralized (non-pegged to fiat currencies) stablecoin backed by ETH. However, as RAI does not have a fixed peg price and is inherently unstable, it is still challenging for Reflexer to attract mainstream users.

Additionally, in January of this year, Vitalik suggested improvements to Reflexer’s collateral mechanism. He believes that ETH holders need more incentives to over-collateralize ETH and borrow RAI on the Reflexer platform because by staking ETH users can earn a risk-free 5% reward, and the arbitrage floating return on the redemption rate obtained on Reflexer is not very attractive when it does not exceed 5%. However, the community has rejected the proposal to use ETH as collateral due to additional contract risk considerations.

Celo

Celo is a mobile-focused open-source payment network. Its mainnet was launched in April 2020. The network combines a PoS mechanism with EVM compatibility, providing users with various DeFi services. These include using stablecoins for remittance and cross-border payments, supporting multiple token payments for gas fees, and mapping phone numbers to wallet addresses to simplify transfer operations. Celo has also introduced its stablecoins CUSD, CEUR, and CREAL on-chain.

The stablecoin mechanism of Celo works as follows: users can send 1 dollar worth of Celo to the official Mento pool and receive 1 dollar worth of stablecoins such as cUSD. Conversely, they can also send 1 dollar worth of cUSD to Mento and receive 1 dollar worth of Celo. Under this mechanism, when the market price of cUSD is lower than 1 dollar, someone will buy cUSD at a low price to exchange it for 1 dollar worth of Celo. Similarly, when the price of cUSD is higher than 1 dollar, someone will mint cUSD using Celo and sell it, and the existence of arbitrageurs will ensure that cUSD does not deviate too far from its peg price. Currently, the reserve pool behind stablecoins is CELO (81.9 million USD), ETH (48.89 million USD), and BTC (7.91 million USD).

Source: Trend Research，Defillama

The difference between the Celo mechanism and the LUNA/UST mechanism is that the funding for CUSD, cEUR, and cREAL is backed not only by CELO but also by ETH and BTC. Therefore, as long as the asset size of ETH and BTC in the reserve pool is greater than the circulating market value of the stablecoins, even if the price of CELO tokens fluctuates greatly, the stablecoins will still be over-collateralized, and there will be no risk of de-peg. The market value of ETH and BTC in the reserve pool may not be sufficient to cover the circulating market value of stablecoins if CELO’s market value declines quickly, which might result in stablecoins becoming unpegged.

Consequently, as long as CELO’s price does not decline by more than 50%, the risk of stablecoin de-peg is fairly low. It will increase the possibility of depegging, though, if the size of stablecoins keeps growing in the future and the size of BTC and ETH in the reserve pool does not rise as a result.

Looking at the historical volatility of CUSD, except for the market panic caused by the FTX incident last year, the overall price has remained above $1 for most of the time.

Source: Trend Research，CMC

Generally speaking, there aren’t many external factors that can affect Celo’s stablecoin mechanism, and the primary factor is the asset size of ETH and BTC in the reserve pool. In addition to the fact that CUSD is mostly circulated on the Celo chain and is not directly connected to USDC, the recent USDC de-peg has no direct impact on it.

Frax Finance

A core component of the FRAX stablecoin system, the Algorithmic Market Operations (AMO) controller, was introduced in December 2020 and is currently in version 2.

Although the FRAX token was originally intended to have 100% USDC as collateral, it was later transformed into a mixture of USDC and FXS, gradually reducing the proportion of USDC collateral. As of February 2023, the community voted to permanently increase the collateral rate to 100%, suspending FXS buybacks until sufficient revenue is generated by the agreement. The protocol’s collateral rate is currently 92%. A lending market called Fraxlend was also introduced by Frax Finance in September 2022, allowing users to borrow FRAX against their assets, similar to the MakerDAO protocol. The difference is that FRAX holders can deposit FRAX into the lending pool and earn interest on their loans.

Without lowering the collateral rate or altering the FRAX price, the AMO is designed to create FRAX monetary policy and invest in reserve assets, improving capital efficiency and capturing more value for FXS holders. Following the activation of the mechanism, the scale expansion of the stablecoin is largely under the control of the AMO. Currently, Liquidity AMO (multi-chain DEX providing liquidity), Lending AMO (lending pool), Investor AMO (investment), and Curve AMO are the core AMO pools (Curve ecosystem). About 800 million FRAX tokens are under the control of the protocol.

The recent USDC event had a significant impact on the FRAX price, which dropped to a low of $0.87. The main reasons were that 1) Since USDC+FXS has 92% of the actual value of the FRAX algorithmic stablecoin, and after the community voted to raise the collateral rate to 100%, only 100% USDC is utilized as collateral. 2) The FRAX amount in the Curve AMO LP pool is 270 million, and the core pools are FRAX/USDC and FRAXBP (FRAX/USDC/USDT/Dai).

In spite of the fact that Frax Finance did not make any public announcements of any remedial measures during this event, the team informed the public that the long-term plan is to address such risk concerns by establishing Frax Market Assurance (FMA).

Due to the fact that the collateral is a stablecoin and the collateral rate will eventually rise to 100%, it is not possible to increase the efficiency of user capital. There are few other FRAX use cases on the market right now, and Curve and Convex are FRAX’s main ecosystem collaborations. Overall, there is a low demand for FRAX in the market.

Since FRAX tokens are not commonly used on other dApps, most arbitrage activity takes place on Fraxlend, where users who have borrowed FRAX tokens can purchase them at a discount in the market to pay off their loans.

Image: Changes in the prices of FRAX and USDC before and after the de-pegging crisis.

Source: Trend Research，CMC

Despite this, its governance token also experienced a sell-off with a decline of more than 20% during the crisis due to the uncertainty brought on as a result. Like MKR token, the reason for the selloff might be due to potential risks of system imbalance and token inflation. However, after the USDC crisis was resolved, FXS prices rebounded rapidly by more than 40%, similar to MKR.

Chart: Changes in the prices of governance tokens FXS and USDC before and after the de-pegging crisis.

Source: Trend Research，CMC

In addition, ETH 2.0 liquidity staking is a feature of the Frax system. In the midst of the market turbulence, node revenue increased more than five times around March 10 due to the rise in front-running transactions.

Chart: frxETH node income. Blue is the basic reward, and green is the fee “tip” income.

For example, on March 10th, a USDC user who exchanged 2 million USDC for USDT on-chain, and a MEV bot unexpectedly made a profit of $2.045 million after the user paid $45 in gas fees and a $39,000 MEV bribe because the user did not set a slippage limit. Unfortunately, the user traded 2.08 million USDC but received only 0.05 USDT.

Source: Trend Research, facts.frax.finance/frxeth

GHO

The Aave lending protocol supports any kind of lending and borrowing among various cryptocurrencies. The team announced its intention to introduce stablecoin GHO in July 2022. Based on over-collateralized lending, the overall mechanism for creating GHO is similar to DAI, which is maintained at a 1:1 peg to the US dollar. Essentially, the underlying logic is that users deposit supported collateral types into the vault and receive GHO stablecoins based on a certain collateralization ratio. In the event that these stablecoins are repaid or liquidated, they will be burned.

In order to generate more revenue, Aave first started its stablecoin business because stablecoin minting fees are typically higher than interest income from general lending and borrowing, which can generate extra profits for Aave. The money will also go straight to the vault.

Aave’s current lending and borrowing business is relatively mature, and compared to the difficulty of promoting stablecoins for other newer protocols, Aave has some market credit endorsements. Secondly, Aave’s current protocol version has been iterated to V3, and the V3 upgrade plan has not yet been fully deployed. V3 will also provide significant support for stablecoins.

One of the unfinished plans is the efficient lending market (e-Mode), which allows borrowing against the same type of collateral with a higher LTV. Firstly, borrowing between ETH assets (WETH, wstETH) can achieve a 90% LTV, meaning that originally collateralized $2,000 WETH can now borrow up to $1,800 wstETH, improving the efficiency of capital utilization. The next step is to implement e-Mode lending between stablecoin assets (L2 has been deployed, but Ethereum mainnet has not), with an LTV of up to 93%. This implementation will greatly improve the efficiency of using stablecoin assets. In the future, after the launch of GHO, it will have a positive effect on the stable price of GHO and its adoption. However, it faces the same problem as MakerDAO PSM, which is the regulatory issue for centralized stablecoins within the module.

The second unfinished plan is cross-chain deployment. Although Aave has already been deployed on multiple chains and maintains its advantage as a top DeFi lending protocol, it has not yet achieved true cross-chain liquidity. After the implementation of Aave V3’s cross-chain deployment, there will be some advantages for the expansion of GHO. Aave V3’s “gateway” feature allows assets to flow seamlessly between V3 markets on different networks, meaning that “aTokens” can be minted on the target chain through a whitelisted cross-chain bridge protocol, and then burnt on the source chain, to achieve the goal of liquidity transfer from the source chain to the target chain.

Image: Top Protocols on various chains

Source: Trend Research，defillama.com

Now, the V3 cross-chain gateway whitelist proposal has been voted through. Aave will use the cross-chain interoperability protocol Wormhole for general message passing between the source and target chains, and use Hashflow’s cross-chain DEX to obtain quotes from market makers with zero slippage and MEV protection to execute transactions.

CRVUSD

In October 2022, Curve published its white paper for the stablecoin protocol, Curve.Fi USD Stablecoin, also known as crvUSD. In order to provide continuous liquidation and purchase collateral, Curve designed the LLAMMA model. Users can over-collateralize to mint crvUSD in LLAMMA and avoid the risk of their assets being liquidated all at once. The relationship between crvUSD’s supply and demand in the market is stabilized by Pegkeepers’ automatic issuance and destruction mechanisms.

The official launch of crvUSD has not yet taken place. However, if a major stablecoin such as USDC were to de-peg in the future, based on the design mechanisms Curve has disclosed, the following situations could occur (assuming USDC de-pegs once more):

1.In theory, crvUSD is over-collateralized with mainstream assets such as ETH and BTC, so if a major stablecoin de-pegs and the collateralized asset prices remain unaffected, crvUSD should not experience direct price fluctuations.

2.Although crvUSD is minted through over-collateralization, its price stability still depends on the liquidity depth of the market pool. As the official stablecoin of Curve, crvUSD may enter the 3pool in the future. Curve’s team holds a large amount of veCRV and can provide significant liquidity incentives for crvUSD early on. Hence, a comparatively smooth start should be made. If crvUSD, USDC, and USDT are all in the 3pool as USDC de-pegs, users may panic and convert large amounts of USDC to USDT and crvCRV, causing crvUSD’s price to temporarily exceed $1. To maintain the stability of crvUSD, Pegkeeper will issue a large number of crvUSD to the market pool, which will restore the price. Therefore, compared to other stablecoins, the mechanism of crvUSD may not be suitable for slippage arbitrage because Pegkeeper’s automatic issuance function will quickly reduce the arbitrage opportunities.

3.If a major stablecoin de-pegs, causing significant market panic and leading to massive liquidation in the cryptocurrency market, including LLAMMA, which converts user collateral into crvUSD, crvUSD may also experience a price de-peg due to panic. However, if users believe that Pegkeeper has funds in the market to buy crvUSD and burn them, thereby restoring the price when crvUSD falls below $1, there may be potential arbitrage opportunities.

4.Since LLAMMA is still an AMM-based mechanism, LPs consisting of stablecoins and collateral may exist in the liquidation pool. When prices fluctuate, on the one hand, the frictional cost of collateralized assets due to continuous liquidation and purchase can cause wear and tear, which is difficult to avoid for collateral providers. On the other hand, LPs may receive a certain amount of transaction fee subsidies from the continuous liquidation process, especially when there is a significant liquidation on the chain, the trading volume of LLAMMA may increase in the short term, and 50% of these fees may be given to LPs.

All of the above four points are based on the current Curve mechanism disclosed and require further testing in the market after the official launch of crvUSD.

Impact and opportunities of borrowing and trading agreements

Image: Price changes of the four largest stablecoins and TUSD after USDC de-peg

The largest stablecoin on the market, USDT, remained the top choice for capital outflows despite the USDC de-peg crisis and had the strongest price performance, with a growth rate of one point even exceeding 1%. As approximately 50% of DAI’s collateral is in USDC, the continued decline of the USDC market price caused DAI to experience severe de-pegging as well, although to a lesser extent than USDC.

Despite recent additions to Binance’s stablecoin trading pairs, the price performance of BUSD and TUSD has remained relatively stable without experiencing price fluctuations exceeding 1%.

Measures taken by different protocols

In this USDC de-pegging crisis, besides a large number of people “running for the exits” to reduce their losses, there is also a group of arbitrageurs who have a deep understanding of mainstream DeFi project mechanisms. The core idea is to use protocol mechanisms for USDC by linking the value of USDC to $1, seeking to exchange USDC when its price is lower than $1 for other stablecoins or cryptocurrencies with a value greater than $1, successfully booking a profit. This event will also bring about reflection on current and future projects, whether the price of all trading targets can be replaced by a fixed value instead of the actual market value. The following are several cases for reference.

PSM (Peg Stability Module) of MakerDAO

The PSM is a mechanism designed to help maintain the stability of the DAI price. It allows users to exchange other tokens for DAI at a fixed rate, without having to go through an auction. USDP is a stablecoin issued by PAXOS and was not affected by the recent crisis. When USDC and DAI experience a discount, the PSM price mechanism is applied to take advantage of the arbitrage opportunity: 1 USDC = 1 USDP.

Arbitrage path: Use assets to borrow USDC on AAVE, then exchange USDC 1:1 for USDP on the PSM. When the price of USDC drops further, exchange USDP back to USDC, repay the USDC loan, and keep the remaining USDC as profit. As shown in the figure below, during the USDC de-peg crisis, USDC experienced a significant inflow while GUSD and USDP quickly experienced outflows, causing a shortage of USDP supply.

Image: Changes in the three different stablecoin collateral in the Maker system during the USDC de-peg period.

Curve

The Curve price formula is designed for stablecoin trading, with lower slippage for exchanging large amounts of stablecoins. When using the algorithm for non-stablecoins, this model provides greater trading depth than UNI at the current order book mechanism, resulting in price differences with other markets, with Curve’s USDC/USDT price > UNI’s USDC/USDT price. Similar to traditional arbitrage, one can buy USDC on UNI and sell it on Curve to earn the price difference, but there is a risk of rapid USDC price drops in between.

AAVE

In the case of AAVE’s long ‘leverage looping’ of USDC, the buyer makes the assumption that the USDC price will eventually re-peg and is willing to take on the risk of further USDC price drops. The specific process involves borrowing USDC using asset lending (borrowing USDT and then trading for USDC through a DEX), collateralizing USDC to borrow USDT, using USDT to purchase USDC, and then using USDC to borrow USDT again in a loop.

Centralized exchange arbitrage

Binance supports USDC deposits, and USDC can be exchanged 1:1 for BUSD, completing the exchange of low-value USDC for high-value BUSD. Coinbase users can withdraw USDC 1:1 as USD into their bank accounts to complete the arbitrage process. However, both exchanges react quickly and the arbitrage process lasts for a short period of time.

Depending on USDC’s collateral issues and USDC’s de-peg price, several types of DeFi applications may be subject to the following risks:

Risks faced by lending protocol

Aave and Compound are the two largest on-chain lending protocols, allowing users to borrow and lend various cryptocurrencies and earn interest income or pay interest fees. USDC is one of the commonly used assets on these platforms. If a user uses USDC as collateral for borrowing, they may face the risk of being unable to repay or being liquidated. Aave uses Chainlink as the oracle for USDC value calculation, and Uniswap as the backup oracle. For users who borrow USDC by depositing ETH, they can take advantage of the opportunity to buy back USDC with less capital to redeem their original collateral. Compound, on the other hand, uses a fixed value of $1, which may lead to risks.

Specifically, when the USDC price de-pegs, lending protocols may have some risks associated with lending protocols:

The loan-to-value ratio (LTV) of borrowers who collateralize USDC may exceed the liquidation threshold, resulting in their collateral being liquidated.

Liquidators may not be able to obtain sufficient profits to compensate for their trading costs and risks.

Aave’s Safety Module (SM) may be unable to bear potential bad debts, resulting in a decline in the value of Aave tokens (AAVE). (Note: AAVE token holders can collateralize AAVE in the safety module to obtain stkAAVE tokens and receive AAVE rewards. If the Aave protocol experiences fund losses, the safety module can be activated to deduct up to 30% of funds from stkAAVE holders to offset losses.)

More valuable stablecoins such as USDT on lending platforms may be fully borrowed, resulting in depositors being unable to recover their full USDT amount.

Compound may not be able to adjust the fixed price of USDC in a timely manner, resulting in market imbalances and arbitrage opportunities.

These risks can be mitigated through the following measures:

Suspending the USDC market or setting the LTV ratio to zero to prevent further borrowing activity.

Increasing the liquidation reward for USDC or using a dynamic pricing mechanism to incentivize liquidators to participate in the market.

Using ecosystem reserves or other assets to increase the capital adequacy and shock resistance of the safety fund.

Regularly monitoring and updating the price parameters of USDC to reflect market conditions and expectations.

For trading protocols: If USDC is a trading pair or for a liquidity provider, they may face the risk of loss. For example, on the Uniswap platform, users can trade between any two cryptocurrencies or provide liquidity to earn fees. If users use USDC as a trading pair or one of the currencies in the liquidity pool, they may lose money due to the deterioration of the exchange rate or inability to exit when the USDC price falls. In addition, there are some default USDC applications in derivative trading applications that bring arbitrage opportunities.

Taking the derivative protocol GMX as an example

GMX is a decentralized perpetual exchange built on Arbitrum. In the trading mechanism of GMX, users take long positions and receive the underlying assets, rather than the margin itself, which is priced in USD. Arbitrageurs use discounted USDC to open positions and are paid according to the standard USD price.

After this incident, the protocols of GMX and similar mechanisms may optimize the stablecoin price curve, calculating the actual value of the stablecoin used as margin by users when placing orders.

In GMX’s Swap, the price of USDC/ETH is based on the price of ETH/USD, creating arbitrage opportunities in the Swap market as well.

Moreover, such leveraged trading platforms received 2–3 times as much fee income as usual as a result of the market turbulence.

Image: Revenue of the four major on-chain trading platform

Prediction applications: If users use USDC as a betting or reward currency on prediction platforms such as Augur, they may face the risk of reduced payouts or profits if the USDC price drops. For example, users can create and participate in various market prediction events on the Augur platform and win rewards based on the results. If users use USDC as a betting or reward currency, they may lose money if the payout amount decreases or their profits shrink due to a drop in the USDC price.

Summary

During the USDC de-peg crisis, the discount of USDC brought about significant uncertainty to the DeFi ecosystem, but it was eventually resolved by government and regulatory intervention. In this process, there were both one-way bets on the price re-pegging (ie. a wallet receiving 215 million USDT from Binance to purchase USDC and DAI stablecoins, earning about 16.5 million US dollars in profits); low-risk arbitrage exploiting mechanism loopholes (such as the Maker PSM arbitrage mentioned in the article); panic selling of various assets at discount prices (such as BUSD and USDP mentioned in the article); in addition, the passive income increase brought to leveraged trading and LSD applications due to the significant market fluctuations cannot be ignored (such as Frax and crvUSD can capture relevant income). These applications themselves have small USDC risk exposures and instead become passive beneficiaries.

website: ldcap.com

medium：ld-capital.medium.com

Summary

MakerDAO, one of the most long-standing and successful crypto projects in decentralized governance, development, and operations, has entered the “Endgame Plan” phase. It aims to reduce Maker’s operating costs and isolate risks by establishing several SubDAOs, stripping new features and products based on the Maker system, and to self-govern, self-profit, and loss, including potential new coin offerings. This move is expected to make Maker into an ecosystem similar to that of Layer 1s, allowing “all things to grow” and enhancing the sustainability of its increasingly complex system.

A new SubDAO composed of former MakerDAO members, including core developers and its Chief Growth Officer, will release the Spark lending protocol based on Aave V3 code in April this year. Spark is expected to unlock more value for the over $8 billion collateral in Maker’s treasury, theoretically combining with the low-cost D3M lending module and PSM minting pool within the Maker system to form powerful synergistic effects, providing the most competitive and relatively stable interest rates for $DAI.

The “matrixing” of DeFi has become a trend, with some old-school DeFi applications developing more native nested products based on user assets or liquidity advantages. For example, Curve has announced crvUSD, Aave plan to launch $GHO, and Frax has launched its Lend pool. However, compared with the difficulty of Aave/Curve in growing its market share of its GHO/crvUSD stablecoins, it is much easier for Maker to expand its lending business.

The launch of Spark represents the beginning of a major transformation for the Maker ecosystem. One of the most significant marginal improvements is the $MKR token, and the valuation model needs to shift from being viewed as a single project token to an ecosystem token similar to that of a permissionless blockchain. The $MKR token, which originally granted only governance rights, now has a scenario for staking the token which may provide $MKR stakers 12–37% APY, while ecosystem applications will effectively expand Maker’s balance sheet. Under bear and base-case scenarios, it could bring an additional $2.75–12 million in annual revenue to Maker, which in turn increases the amount of $MKR burned by 1–3 times.

Spark Protocol

On February 9, 2023, part of MakerDAO’s core team❶ created Phoenix Labs, which is dedicated to developing new decentralized financial products geared towards expanding the Maker ecosystem. The creation of Phoenix Labs came after MakerDAO’s founder proposed the “Endgame Plan” last June, stating that the project needed to continue expanding while maintaining maximum flexibility.

Spark Protocol is the first protocol developed by Phoenix Labs. It is a money markets protocol that facilitates borrowing using the $DAI stablecoin and other mainstream crypto assets as collateral. As the first protocol to illuminate Maker’s new DeFi matrix, the name “Spark” coincidentally conveys the Chinese proverb “a single spark can start a prairie fire.”

The protocol is built on Aave V3 code, whose lending business has been battle-tested by the market over a long period. Users can use highly liquid assets such as ETH, WBTC, and stETH as collateral to borrow corresponding assets based on its interest rate model. In theory, it will combine with Maker’s low-cost D3M lending module and the PSM casting pool, which is nearly 100% capital-efficient for stablecoins, to form a strong synergistic effect, providing the most competitive and relatively stable interest rates for $DAI across the entire market.

Figure 1: Spark Beta Webpage

Source：Spark， Trend Research

The Spark team has stated that 10% of the profits earned from its $DAI market will be distributed to Aave over the next two years only once the $DAI lending market reaches $100 million. A proposal for this has already been initiated on the Aave forum.

Product Advantages of Spark Protocol:

Proven Codebase

As the codebase is based on the mature codebase of Aave, its code has been battle-tested and is highly secure. Additionally, like aTokens, depositors can also receive tokenized versions of their positions (spTokens). spTokens can be moved and traded like any other crypto asset on Ethereum, thus improving capital efficiency.

Low-Interest Stable Rate Lending

Spark Lend can directly utilize Maker’s credit line, known as the Dai Direct Deposit Module (D3M)❷, allowing users to theoretically borrow any amount of Dai at a slightly higher❸ interest rate than the Dai Savings Rate (DSR), currently at 1% (with an initial debt ceiling of 200 million $DAI).

High Capital Utilization Efficiency of ETH Assets

Spark Lend also introduces Aave V3’s e-Mode module, allowing ETH assets to be borrowed with LTV ratios of up to 98%. For example, pledging wstETH can allow for borrowing up to 98% of ETH, increasing capital utilization efficiency.

Double Oracle Price Feed for Increased Manipulation Resistance

Spark may use both ChronicleLabs (formerly Maker Oracles) and Chainlink as data sources to provide on-chain prices. These two data sources will be checked through three steps: TWAPs (time-weighted average prices), signed price sources, and circuit breakers, to ensure prices cannot be manipulated.

Fair Launch

Protocol token distribution is entirely through liquidity mining, with no pre-allocation❹, providing a fair distribution mechanism that can attract more people to join the community and increase consensus and value. The project also believes that Spark Protocol needs to compete in a fair environment to win support from SubDAO and to be fully accepted as a product.

100% Backed by MakerDAO

Spark is not a typical “third-party” protocol. Though it is being developed by Phoenix Labs, it is fully owned by Maker Governance (including all smart contracts, trademarks, IP, etc). This means that in the event the protocol encounters any insurmountable difficulties, Maker will likely step in to provide support.

Three initiatives to help DAI become a better “world currency”:

Maker’s mission is to create a “fair world currency”. But so far, compared to the $70+ billion market cap of USDT, DAI’s market cap of $5+ billion is relatively small. So how can DAI expand and ultimately surpass centralized stablecoins?

The launch of the Spark Protocol indicates three directions for the future development of Maker’s products, all aimed at increasing the minting volume of DAI and reducing its usage costs:

Integration of Internal D3M and PSM Features

Spark Lend has integrated Maker’s internal D3M❺ and PSM❻ modules to provide liquidity for the stablecoin DAI. The most significant advantage of D3M is that it allows the secondary market to directly mint DAI, eliminating the need for primary minters to first mint DAI in Maker and then deposit it into secondary market applications. This merges the two layers of excess collateral into one layer, improving the capital efficiency of DAI.

The initial plan is to provide $300 million of D3M liquidity to Spark Lend, with $200 million as a hard cap in the first phase and $100 million as buffer funds. This scale limit will be adjusted based on the actual market lending rate performance.

In addition, the Spark Lend front-end will support MakerDAO’s PSM and DSR. This promotes the use of DAI from the demand side as USDC holders can directly convert USDC in the PSM into DAI through Spark Protocol’s website and earn deposit interest through DSR.

For example, under normal circumstances, lending out 1 DAI in Aave’s lending market requires two layers of collateral: about $1.5 of Aave collateral❼ and $1.5 of collateral in the Maker vault. Without considering circular borrowing and lending, this common scenario actually requires $3 of asset collateral. However, after integrating D3M and PSM, lending out 1 DAI on Spark only requires $1.5 of collateral (or $1 of whitelisted stablecoins such as USDC), greatly improving capital efficiency.

2. Entering the LSD Market through EtherDAI

Spark Protocol will bootstrap the use of EtherDAI, a liquid staking derivative based on ETH (ie. Lido’s stETH). Users can wrap stETH as ETHD and use it as collateral to borrow DAI.

Maker governance will have backdoor access to the ETHD collateral and may incentivize liquidity by setting up short-term liquidity mining programs for ETHD/DAI on Uniswap. On the other hand, the stability fee for the EtherDAI Vault may be set to zero to encourage demand for the EtherDAI Vault.

Furthermore, with the Ethereum Shanghai upgrade, which will provide over 4% base yield for ETH assets, a large-scale migration of ETH assets is inevitable. Spark’s support for liquid staking derivatives (LSD) wrapped tokens will prevent TVL from shrinking and may even attract more funds into the protocol through income stacking, potentially reducing its reliance on USDC.

More importantly, TVL represents the locked value of funds in the protocol. As TVL increases, so does liquidity, availability, and potential revenue for the protocol, primarily from the interest rate spread between lenders and borrowers.

3. Maker + Spark = The market’s lowest and predictable interest rate

The introduction of Spark Protocol will enable Maker to better control DAI supply based on market demand, interacting directly with its secondary market to provide better rates for its users and increase DAI supply.

Specifically, during DeFi booms, lending rates often skyrocket. This causes users to pay higher-than-expected borrowing rates and negatively impacts the supply-demand market for DAI. D3M will influence the main DAI lending market (Spark) by stabilizing DAI interest rates. When there is high market demand for DAI, Maker can increase Spark’s hard cap for DAI minting and its supply to lower its interest rate. Conversely, if demand is weak, DAI liquidity will be removed from Spark to increase its interest rate.

Overall, maintaining the cheapest and predictably fluctuating borrowing rate for DAI in the stablecoin “battlefield” is a key competitive advantage in increasing its usage. The D3M funding pool can achieve relative stability in DAI borrowing rates and offer the most competitive rates across the market.

Current Revenue and Expense Analysis of the MakerDAO Protocol

MakerDAO’s current expenses exceed $40 million per year. Without aggressive investment in RWAs, the protocol would face a net loss of $30–40 million. Therefore the founder’s proposal for an “Endgame Plan” is centered on increasing revenue and reducing expenditures.

Revenue

MakerDAO’s current sources of revenue mainly come from four areas:

Stability fee income from over-collateralized Vaults, i.e. interest on minting/borrowing DAI;

Liquidation revenue from under-collateralized asset liquidations;

Stablecoin trading fees from PSM; Returns on RWA (real-world asset) Vaults.

The stability fee charged on crypto asset Vaults used to be the protocol’s most significant source of revenue, but currently income from RWAs has become its largest revenue source.

Expenses

Protocol expenses mainly include employee salaries, growth/marketing expenses, with the largest proportion being engineer salaries to maintain the protocol’s core.

Data released by MakerDAO co-founder Rune Christensen in June 2022 showed that MakerDAO’s annual stability fee revenue was about $51.4 million, but the cost to maintain the protocol was $60.9 million, including $43.6 million in cash flow and $17.3 million in $MKR priced in $DAI. Its cost has exceeded the protocol’s revenue, resulting in a net annual loss of approximately $9.4 million.

Figure 2：MakerDAO Profitability Breakdown

Source：Spark， Trend Research

One major reason for the protocol’s significant losses is: 1) the bear market environment has led to a sharp decrease in protocol revenue; 2) team expenditures are generous; 3) governance redundancy. The existing governance process is complex, requires extensive personnel participation, and has a long governance cycle. All of which constrain the development speed of new product features.

Therefore, Rune Christensen proposed the concept of the Endgame Plan, which we will detail in the following text. The plan includes a solution to the current protocol’s revenue shortfall, which is to increase the growth of RWA (real-world assets).

Figure 3：MakerDAO Revenue Breakdown

Source：Spark， Trend Research

From the above chart, we can see that: 1) ETH Vault was a significant source of revenue for MakerDAO before November 2022; 2) After November 2022, RWA (real-world assets) Vaults became the largest source of revenue for the MakerDAO protocol.

The RWA Vault refers to investments in off-chain financial markets, mainly bonds and mortgages. Because RWA collateral can bring higher stable fee income to MakerDAO, it has indeed brought higher income to the MakerDAO protocol as expected. Based on its current investment of $696 million, it is expected to generate over $26 million in interest income, accounting for more than 40% of Maker’s total revenue.

However, on the other hand, there is a relatively large risk for RWAs to be confiscated by regulators. Therefore, the ‘Endgame Plan’ proposes a series of strategies to mitigate RWA regulatory risks: under mild regulatory conditions, Maker will prioritize maintaining a 1:1 anchoring strategy with the US dollar and will not restrict RWA exposure to generate as much revenue as possible. The founder assumes that future regulatory policies will become increasingly strict, so Maker’s exposure to RWA will not exceed 25% and may de-peg from the US dollar when necessary. The ultimate stance is to maintain maximum flexibility and survivability of DAI, to no longer allow easily seizable RWAs as collateral, and to not have a major currency act as a price reference.

Relying on RWA income is not a viable long-term solution. To maximize the sustainability of the Maker protocol, it is necessary to expand Maker’s sources of revenue as much as possible, optimize its system’s organizational structure, and aim for increased revenues & reduced cost expenditures.

The Endgame Plan, Everything Grows.

In order to better understand the upcoming major changes in the Maker ecosystem and the improvement of the supply-demand relationship of the $MKR token, it is necessary to first understand the “Endgame Plan”. Although the plan involves many discussions regarding regulation and politics, it essentially aims to make Maker into a Layer 1-like ecosystem that allows for the “growth of all things”.

The Endgame Plan was first proposed by Rune in June 2022 and has undergone at least three versions of full-scale discussions on the governance forum. It is a structural reorganization plan for MakerDAO that aims to make it a decentralized, self-governing DAO (decentralized autonomous organization) to better meet the needs of its stablecoin DAI users. The plan includes four main components:

● Establishing complete decentralization for MakerDAO

● Improving DAI liquidity and stabilizing its interest rate

● Enhancing protocol sustainability and reducing system risks

● Improving decentralized governance and DAO operations

To simplify the complexity of governance, Maker will create a series of self-sustaining DAOs called MetaDAOs❽. Rune compared Maker Core to L1 Ethereum, which is secure but slow and costly to operate. MetaDAO is an L2 solution that can operate quickly and flexibly while also obtaining security from the L1. Through implementation of MetaDAOs, MakerDAO can focus more on its primary goal of issuing and stabilizing its stablecoin DAI. Additionally, MetaDAOs can provide governance support for other projects in the MakerDAO ecosystem.

The so-called MetaDAOs will modularize the Maker protocol, with each MetaDAO being a small community that can have its own tokens and treasury. The core value proposition of MetaDAOs is isolation, risk reduction, and parallelization of Maker’s highly complex governance processes.

Figure 4：The role of MetaDAOs in the Maker Ecosystem

Source： MakerDAO Forum， Trend Research

MetaDAOs will be classified into three types:

Figure 5：Types of MetaDAOs

Source： MakerDAO Forum， Trend Research

Maker Core retains all the essential and irremovable components of the Maker protocol to fully function and achieve its goal of generating and maintaining DAI. Each type of MetaDAO around the Core has its own function, which determines its interaction with Maker Core:

Governor (also known as Facilitator) is responsible for organizing decentralized staff management, on-chain governance, engineering, protocol management, and brand management of Maker Core;

The creator focuses on the growth of the Maker ecosystem and the development of new features, such as the Spark team;

Protector will manage RWA Vaults, focusing on real-world assets and protecting Maker from physical and legal threats against its real-world collateral.

Similarly, MetaDAO has a governance process similar to Maker Core, using the deployment of new ERC-20 tokens for governance, which can overcome the current single-threaded problem in Maker’s governance process and allow MetaDAO to execute in parallel, speeding up the governance process.

However, MetaDAO runs its governance process on top of Maker Core’s governance infrastructure, meaning that MetaDAO voters pass governance signals that are bundled and executed in Maker’s Executive Vote. This means that MKR holders can act as an “appellate court” and have actual control over the protocol of MetaDAO through MKR voting.

The Endgame Plan is divided into four stages, with the Pregame stage expected to be launched within 2023, including the construction of ETHD, the launch of MetaDAO, and the initiation of liquidity mining, among others.

Figure 6：Endgame Plan Roadmap

Source： MakerDAO Forum， Trend Research

Spark Protocol will be the first MetaDAO, which is expected to launch in April 2023. It is currently undergoing mainnet deployment and a series of branding initiatives. In the second half of this year, Spark plans to integrate with Element Finance and Sense Finance to offer fixed-rate borrowing and more diversified yield strategies.

In the initial phase of the Endgame plan, Maker will launch six MetaDAOs, each of which will issue Sub Tokens. Although Spark Protocol does not explicitly introduce its tokenomics in the documentation, according to the plan and description by Spark’s founder, the protocol should have its own token.

At the same time, each Sub Token will form a core liquidity pool with $MKR. The Maker team plans to incentivize LPs by issuing 45,000 MKR to the pool annually. This means that during the Endgame period, each MetaDAO will accumulate 7,500 MKR. Of course, liquidity pools related to ETHD, DAI, and MKR will also receive a small token reward.

Figure 7: Spark Roadmap

Source： MakerDAO Forum， Trend Research

As the first application in the Endgame plan: Spark is expected to bring Maker over $10 million in annual revenue growth, while also marking the first time that the $MKR token has a liquidity mining scenario. We will further analyze this in the following sections.

Industry Trend: The Matrix-ization of DeFi Applications

The Spark Protocol’s lending platform will directly compete with established lending protocols such as Aave and Compound. Although Aave and Compound have integrated with D3M❾in the past, Maker’s limited D3M resources❿ in the future will inevitably be prioritized for Spark. This is because Ethereum’s mainstream DeFi protocols seem to have started a “matrix” competition.

Various DeFi applications are developing more native nested products based on the advantages of user assets or liquidity, leading to a trend of “matrixing”. For example:

Curve, originally a DEX, has been actively promoting its “stablecoin” $3CRV, trying to tilt as much incentive as possible to the $3CRV currency pair rather than individual stablecoin pairs. It has also announced a new overcollateralized stablecoin crvUSD in the middle of last year;

Aave, the leading lending protocol in TVL, also announced plans to launch its over collateral stablecoin $GHO last summer;

And FRAX, which has always shown flexibility in its thinking, launched Frax Lend in September last year, allowing users to borrow/mint FRAX from the official contract by paying the market rate instead of via the conventional minting mechanism, which is similar to MakerDAO’s D3M mechanism.

Among these protocols, MakerDAO has long held the top spot in terms of TVL. As of February 25, 2023, its collateral vaults hold $8.2 billion worth of collateral, which theoretically can be released as new lending funds. If achieved, MakerDAO could surpass Aave as the market’s largest lending protocol, and its strategy of entering the DeFi matrix could open up new possibilities for its ecosystem expansion.

Currently, GHO and crvUSD have not officially launched yet. However, we believe that compared to the difficulty Aave/Curve face in growing their GHO/crvUSD stablecoins, Maker’s difficulty in growing its lending business is much smaller. This is because:

For a new stablecoin, selling pressure is certain (primary minters can only choose between pledging or selling), while buying pressure is uncertain and highly dependent on whether Aave/Curve can create enough use cases within their own & partner ecosystems. Looking at the performance of the second-ranked decentralized stablecoin Frax, which has been around for two years, its market capitalization is almost less than a quarter of DAI’s, despite controlling a significant portion of voting power in the ‘Curve War’. This shows that even with subsidies that help create usage scenarios, it is evident that there is a ceiling for Frax’s expansion.

Figure 8：Stablecoin Market Share on Ethereum

Source： The Block， Trend Research

Stablecoin governance is difficult and requires governance representatives with high levels of expertise to participate in its maintenance. MakerDAO is one of the earliest (founded in 2015) and most mature DAOs for governance, attracting a group of professional DeFi and monetary banking researchers who have led DAI through several leveraged and deleveraged spirals, effectively accumulating stablecoin governance experience. It must be acknowledged that Aave/Curve’s governance forums are also very active, but unlike lending, governance failure for stablecoins can easily lead to a “death spiral” that can cause the protocol to collapse. In this respect, Aave/Curve still has a long way to go.

The threshold for establishing liquidity is high, and the window of opportunity is limited. For a new stablecoin to be adopted by users, in addition to high rewards for staking in certain locations, it is even more important to have good depth and low slippage when performing its primary function as a “trading medium”. This means that the issuer of a new stablecoin may need to heavily subsidize and incentivize users to deposit their stablecoins for liquidity to other tokens in the early stages and cultivate enough user stickiness before subsidies decline to a point where they lose their attractiveness. Otherwise, LPs will begin to withdraw, transaction experience will decline, and de-pegging will occur frequently, marking the moment when the stablecoin enters the death spiral.

MKR Use Case Transformation: Staking+Liquidity Mining + Doubling of Burning Quantity

The launch of Spark represents not only a product update, but also the beginning of a major transformation of the Maker ecosystem. Most evident is the marginal improvement of the $MKR, and the valuation system will need to evolve from a single-project token to an ecosystem token similar to that of public chains. This is because the $MKR token, which previously only had governance rights, will now have single token staking + liquidity mining scenarios that we estimate staking $MKR alone may get an APY of 12–37%. At the same time, the expansion of ecosystem applications will effectively expand Maker’s balance sheet, bringing in an additional $10–20 million in annual revenue for Maker under the baseline scenario, which will result in a 1–3 times increase in the amount of $MKR burned.

General collateral lending has opened up asset inter-borrowing types, increasing protocol revenue streams.

As a leading DeFi protocol, MakerDAO has significant network effects, and Spark’s potential TVL is expected to be on par with Aave. Among the various asset types in the Aave ecosystem, ETH and stablecoins gold have the largest market share. As an example, Aave V2’s market size reached $5.44 billion, with an annual revenue of $16.3 million. The market size of the top five assets, including USDC, DAI, ETH, WBTC, and stETH, is about $1 billion, accounting for one-fifth of its total market.

The collateral value locked in the MakerDAO protocol is now worth $8.2 billion, and the value of single-currency assets (excluding LP tokens and RWA assets) is $6.6 billion. The total supply of DAI is 5.2 billion, of which 4 billion is generated by pledging USDC. Based on this number, even releasing only 1/4 of the USDC from PSM can achieve Aave’s current TVL.

Figure 9：Distribution of Collateral Types in MakerDAO Vault

Source： The Block， Trend Research

Using Aave protocol’s annual revenue as a reference, we can project Spark protocol’s revenue performance under different scenarios where 20%/35%/60% of MakerDAO’s existing liquidity (with a non-LP token and non-RWA asset size of $6.6 billion) migrates to Spark as a result of liquidity mining incentives. The projected revenue performance is as follows:

The Spark official team also assumed three scenarios: base, bear, and bull, for the protocol’s revenue performance. Readers can compare and refer to it. In the Bull Case, the expected revenue is higher than ours, which means that they have an optimistic estimate and may have 5 billion+ TVL. However, we believe that the expectations for neutral and pessimistic scenarios are relatively reasonable.

Source：forum.makerdao.com， Trend Research

2.MakerDAO will transform from the current dual-token (MKR/DAI) model to a multi-token model, with MKR opening up liquidity mining scenarios.

It is expected that when the new MetaDAO is launched, 2.6 billion MetaDAO (MDAO) tokens will be deployed, of which 2 billion will be released through liquidity mining, with 1 billion released in the first two years and then halved every two years. 400 million will be allocated to MetaDAO contributors and 200 million to the MetaDAO Treasury.

Figure 10：Distribution of Liquidity Mining Rewards

Source：forum.makerdao.com， Trend Research

The liquidity mining allocation plan is as follows: 20% is used to incentivize the demand for DAI, 40% is allocated to ETHD Vault holders, and 40% is allocated to $MKR stakers.

For $MKR, staking represents a significant change in its economic model, as the supply and demand relationship of $MKR will thus be re-adjusted. Prior to this, $MKR had limited capture of protocol value as a governance token, resulting in insufficient market demand. In addition, in the event of debt shortfall, there is a possibility of inflation⓫ due to the need to increase the issuance of tokens to make up for it.

Although protocol surplus can repurchase and burn $MKR to make it deflationary, it seems to be insignificant. In the five years since $MKR was launched, only 22,000 tokens have been burned out of a total of 1 million tokens, resulting in an average annual deflation rate of 0.4%.

Figure 11：MKR Issuance and Burn History

Source：Makerburn，Trend Research

Because the expansion of Spark’s lending business will bring additional TVL and generate additional fee income for MakerDAO, Spark has also provided simulated income as a reference for MakerDAO.

Source: Spark, Trend Research

If we calculate the expected Maker new TVL and MKR annual deflation rate based on the average stability fee of 1.5% and the current MKR price of $764⓬ under the three scenarios, the base-case scenario may bring Maker an additional TVL of $800 million, annual revenue of $12 million, and an annual deflation rate of 1.6%, which is four times the current rate. However, in the bear-case scenario, it may only bring less than $200 million TVL growth and $2.75 million annual revenue, but even so, this will correspond to an annual 0.37% MKR burn rate.

The above is based on the assumption of linear burning. In reality, MakerDAO will trigger the buyback mechanism only when protocol surplus reaches $250 million. Current surplus is only $74 million, which has not yet reached the buyback and burn standard⓭.

With the improvement of Maker’s revenue structure, the burning rate of $MKR should accelerate. At the same time, the opening of staking is expected to significantly improve the supply and demand relationship of circulating $MKR and will consequently be reflected in the price performance.

3. MakerDAO is shifting its focus from being a standalone protocol to building a DeFi ecosystem around stablecoins.

The goal of stablecoins is to expand their acceptance and usage as much as possible. MakerDAO has been working to collaborate with top DeFi protocols such as Aave and Compound. With the establishment of the MetaDAO model, Maker will build its own DeFi ecosystem around stablecoins as the core, and recycle the value of stablecoins back into the Maker ecosystem to enhance the overall valuation of $MKR.

Using the current price of $764 for $MKR and Spark tokens staked for mining as an example, simulations and predictions were made assuming that the value of Spark tokens could reach 35%/20%/60% of the value of Aave tokens in base, bear, and bull scenarios. The expected APR for 20% of $MKR participating in staking ranges from 12% to 37%.

It should be noted that this is a very preliminary and static assumption. Clarity on actual APR will have to wait as more details on Spark tokenomics are yet to be released. APR will also depend on the change in the price of $MKR.

4. MKR Expenditure Slowing Down

By outsourcing financial functions to new teams, MKR expenditures in the treasury will also slow down. As a result, the token supply-demand relationship will enter a natural state of market equilibrium. For example, from February 2022 to now, the treasury has spent nearly 13,000 MKR, bringing millions of dollars in selling pressure to the market.

Figure 12：Treasury

Source：Makerburn，Trend Research

Conclusion

The essence of the Spark Lend, the first application of the ‘Endgame Plan’, is to bring the capital-efficient D3M module, which was previously limited authorized for use by very few third parties, in-house. This eliminates security and governance risks that external protocols may cause, and the addition of the PSM module allows $DAI to maintain its cost advantage in the stablecoin war. Compared to variable rate competitors such as Aave or Compound, $DAI also offers more certainty in the interest rates charged, and users do not have to constantly check their borrowing costs.

Following Spark, there will be a series of subDAO projects whose tokens can be reward for $MKR staking. This greatly increases the revenue scenarios for $MKR while isolating risks. This marks the first time that $MKR has had an exogenous source of income through the staking mining scenario. In addition, Maker’s ecosystem may further incentivize trading liquidity LP for subDAO tokens with $MKR/$DAI, potentially changing the valuation framework of the token from a single project token to a token similar to Layer 1 ecosystems.

$DAI, as the most successful decentralized USD-pegged stablecoin, has been widely used in various DeFi applications, whether it is borrowing, trading, liquidity mining or other applications. However, the disadvantage is that the increase in the usage of $DAI seems to have not contributed enough to the sustainability of the Maker ecosystem. The project has entered a state where the bigger it gets, the more it loses. In addition to the technical and market operations required to maintain this complex system, high-quality governance talents and proposals must also be incentivized to make Maker sustainable. Given that the main incentive method is only through stablity fee revenue and $MKR tokens, the essence of the Endgame series product upgrade can be understood as:

Breaking down the original silos of collateral within Maker and allowing for inter-collateral borrowing which would enhance capital efficiency, increase revenue streams for the project..

Capturing the value of the $DAI use cases outside the Maker ecosystem into the internal ecosystem, similar to a bank’s diversified business expansion, providing end-to-end services to meet customer needs.

As a result, it is expected to achieve a simultaneous increase in the asset lock-in volume within the Maker ecosystem, DAI minting volume, and $MKR price.

Appendix

Risk Warning

The conservative setting of the D3M low-interest minting hard cap significantly limits Spark’s ability to help Maker “expand its balance sheet” and has some constraints on the overall size of assets in the Maker ecosystem..(Of course, the debt ceiling of D3M is not the higher the better. It should be considered in conjunction with the market demand for $DAI and price stability.)

Maker has invested more than 700 million RWA assets and plans further exposure, but there are regulatory risks: 1) there is a potential risk of freezing the RWA collateral itself; 2) the risk of partner institutions going bankrupt, such as Centrifuge, which has met a 6 million loan defualt; and the planned asset manager for Maker, Coinshares, has admitted that if there are regulatory questions, it will have to cooperate with regulatory scrutiny of fund sources, which means that temporary freezes/seizures may occur.

The marketing ability of the Spark project is still unknown: first, founder Sam MacPherson holds multiple positions and is currently the CTO and co-founder of game company Bellwood Studios. It is crucial whether he has sufficient energy and time to devote to the future development of Spark. Second, the Spark Operations Director is @na d8802, the current Chief Growth Officer of MakerDAO. Based on past performance, his approach to marketing may be relatively laid-back.

There is a possibility that DAI may abandon its anchoring with USD, resulting in a large number of users leaving in the short term. Although this may be beneficial for $DAI to become the ultimate decentralized currency with stable purchasing power (rather than via the USD exchange rate), the community has not reached a consensus, and it is only the unilateral idea of founder Rune, which is planned to be the focus of discussion around 2025. Vitalik Buterin has expressed his concerns about this.

There is a risk of changes to the $MKR feedback mechanism. Currently, there are discussions in the governance forum about how protocol revenue can repurchase MKR or even reduce repurchase, and the reward of subDAO tokens to MKR in Endgame may also change as governance discussions deepen. Overall, the core members of the Maker community are relatively conservative and not eager for quick money.

Decentralization under regulation may conflict with the true spirit of decentralization. The reason is that Oasis, the front-end provider for MakerDAO, recently helped a third-party authorized by the court, Jump Crypto, to recover 120,000 ETH stolen by attackers from the cross-chain bridge Wormhole in February last year. Because the attacker deposited the funds in Oasis, Jump Crypto used the upgradable agent mode in the Oasis protocol to change the contract logic automatically, transferring the collateral and debt from the attacker’s treasury. Although Oasis made this decision under legal intervention and the MakerDAO protocol itself does not control any front-end provider or product that allows end-users to access Maker Vault, it ultimately violates Maker’s mission to make DAI a fair world currency. Of course, this also demonstrates the necessity and importance of Rune’s early planning of regulatory defense strategies.

Potential security risks in smart contracts. Even after strict audits, no code can be said to be 100% secure, and its maturity and reliability need to be tested by the market. Users must remain vigilant against this kind of risk.

The Basic Mechanism of MakerDAO

MakerDAO is a decentralized stablecoin lending protocol based on Ethereum, which is backed by over-collateralized assets and lends out stablecoin DAI that is pegged to the US dollar at a 1:1 ratio. By adjusting the stability fee through governance, the market can stabilize the price of DAI through arbitrage. When the value of collateralized assets is insufficient, the system forces the sale of collateral to liquidators to ensure debt repayment.

Overview of Maker System Data

Top 25 Holder Addresses: Token distribution is relatively diversified

Source：etherscan.io，Trend Research

MakerDAO Vault Collateral Value & Types

Source：makerburn.com，Trend Research

Changes in the distribution of ETH/stETH within mainstream lending protocols: MakerDAO has the largest share.

Source：Dune Analytics，Trend Research

Annual revenue overview of MakerDAO protocol.

Source：Dune Analytics，Trend Research

RWA debt distribution: the largest debt is generated by Monetalis Clydesdale.

Source：Dune Analytics，Trend Research

DEX Distribution of DAI: The largest proportion is held in EOA accounts, followed by DEX.

Source：Dune Analytics，Trend Research

Distribution of MKR governance weight.

Source：Dune Analytics，Trend Research

Historical Events and Milestones of MakerDAO:

In 2013, Daniel Laimer, the founder of EOS, proposed the concept of a Decentralized Autonomous Corporation (DAC), which was one of the precursor concepts of DAO.

In March 2015, Rune Christensen founded MakerDAO and began planning a stablecoin pegged to the US dollar.

In December 2017, MakerDAO released the first version of the DAI stablecoin and launched the first version of its smart contract on the Ethereum network.

In 2018, MakerDAO made its first adjustment to the DAI stability fee, lowering the borrowing interest rate from 1.5% to 0.5%.

In September 2018, venture capital firm Andreessen Horowitz invested $15 million in MakerDAO by purchasing 6% of the total $MKR token supply.

In February 2019, MakerDAO launched the Multi-Collateral DAI (MCD) system, which allowed users to generate DAI using various types of collateral.

In November 2019, Maker released MCD, which supported borrowing DAI with multiple types of collateral assets.

In January 2020, the total supply of DAI surpassed 100 million.

In March 2020, a market crash caused Ethereum prices to plummet, resulting in a debt shortfall of $5.3 million, which was covered by auctioning off MKR tokens.

In April 2020, the Maker Foundation announced that it would transfer control of the MakerDAO protocol to a decentralized community governance system.

In May 2020, MakerDAO launched a decentralized governance system based on on-chain voting.

In November 2020, the total supply of DAI surpassed 1 billion.

In 2021, MakerDAO introduced the D3M mechanism, which provided a more flexible and low-cost way for collaborating lending platforms to mint DAI.

In April 2021, Maker’s Liquidation Mechanism 2.0 went live, and the Wyoming state legislature officially approved the DAO bill, allowing DAOs to be registered as limited liability companies in the state.

In May 2021, the Maker Foundation returned the 84,000 MKR assets held by the Dev Fund to the DAO.

In February 2022, the supply of DAI exceeded 10 billion for the first time, and Maker announced a multi-chain deployment plan.

In August 2022, MakerDAO partnered with Huntingdon Valley Bank (HVB) of Philadelphia to link its native stablecoin DAI with regulated US financial institutions for the first time.

In October 2022, Maker proposed a community initiative to invest 1.6 billion USDC in Coinbase Prime for investment purposes.

In December 2022, MakerDAO announced a $220 million real-world asset fund in partnership with BlockTower Credit, with MakerDAO deploying four vaults providing a total of $150 million in the capital.

In February 2023, MakerDAO announced the creation of the Spark Protocol, a universal lending protocol.

Reference materials

endgame-docs-staging》https://makerdao-1.gitbook.io/endgame-docs-staging/tokenomics/subdao-tokenomics

《MIP116：D3M to Spark Lend》

https://forum.makerdao.com/t/mip116-d3m-to-spark-lend/19732

《Announcing Phoenix Labs and Spark Protocol》

https://forum.makerdao.com/t/announcing-phoenix-labs-and-spark-protocol/19731

《MakerDAO Valuation》

https://messari.io/report/makerdao-valuation

《Endgame Communications Strategy & Plan》

https://forum.makerdao.com/t/endgame-communications-strategy-plan-community-feedback/19818/2

《Endgame Plan v3 complete overview》

https://forum.makerdao.com/t/endgame-plan-v3-complete-overview/17427

《MakerDAO Governance Risk Framework》

MakerDAO Governance Risk Framework (Part 1)

Whether vilified as a protagonist of the robber barons, the architect of the 'money trust', or lauded as the savior of…

blog.makerdao.com

Footnote

❶The team, formerly known as Crimson Creator Cluster, consists of four core members. Founder Sam MacPherson (@Hexonaut on Twitter) joined MakerDAO in 2017 as a core engineer and is also the CTO and co-founder of game company Bellwood Studios.

❷D3M, the Dai Direct Deposit Module, was first introduced in November 2021.

❸According to PhoenixLabs’ description in February, the rate is “slightly above” 10%, which means if the DSR is 1%, the user’s borrowing rate would be 1.1%.

❹According to the founder of PhoenixLabs on Twitter, there was no pre-allocation, but there may be uncertainty here due to the Endgame discussion draft for the subDAO project, which reserves 400 million tokens (out of a total supply of 2.6 billion) for incentivizing subDAO employees.

❺When the D3M module was launched, its purpose was to allow Maker to execute the maximum variable borrowing rate on the DAI market of its partner lending protocols, such as Aave. It does so by calculating how much DAI supply is needed to bring the interest rate down to the desired level and then minting DAI against the returned aDAI from Aave.

D3M has a specific target borrowing rate, such as 4%. Whenever the variable borrowing rate of DAI in the lending market exceeds 4%, anyone can call the exec() function of the treasury to readjust the amount of DAI in the pool. In this case, it will calculate the amount of DAI that needs to be minted to achieve the target rate and put it into Aave’s lending pool. This will continue to increase DAI until it reaches the debt ceiling or reaches the target of 4%.

On the contrary, when the variable borrowing rate falls below 4% and users have previously added liquidity, the exec() function will calculate how much liquidity needs to be removed to bring the target rate back to 4%. It will continue to remove liquidity until all the debt in the treasury is paid off or the liquidity in the pool is exhausted.

❻PSM allows users to exchange whitelist stablecoins (USDC, USDP, GUSD) for DAI at a fixed exchange rate (may including a 0.1% fee) of 1:1. Its main purpose is to help maintain the peg between DAI and the US dollar.

❼Assuming that Maker and Aave both have a 150% collateralization ratio.

❽In the community, later it was renamed as subDAO, which directly reflects the meaning of “subordinate DAO”.

❾The D3M collaboration module of Aave was launched in April 2021 with an initial credit limit of 10 million DAI, which was gradually increased to a limit of 300 million DAI. However, due to the volatility of the cryptocurrency market, it was temporarily closed in June 2022. The Compound V2 D3M module began operating in December 2022, with a current credit limit of only 20 million USD as of the time of writing.

❿Because the D3M system bypasses Maker’s Stability Fee system and uses the relatively lower DSR interest rate as its cost, rapid increase in the issuance of Dai may lead to oversupply, which could in turn cause the price of Dai to depeg. Therefore, in theory, the early D3M limit should not be raised too quickly, and further observation of its impact on the stability of the Dai price is needed.

⓫In the 2020 March 12 liquidation event, the Maker protocol incurred a deficit of 5.3 million USD and compensated for it by issuing 20,980 MKR.

⓬Data is sourced from Coingecko as of February 27, 2023.

⓭Due to increased market uncertainty, Maker suspended MKR buybacks and burns in the second quarter of 2022, sending all protocol revenue to the DAI buffer. Normally, Maker would use DAI to buy MKR directly from the MKR-DAI liquidity pool of Uni V2 and then burn it. However, the community is also discussing using the repurchased MKR for new holding incentive plans, or investing the repurchased MKR instead of fully burning it.

website: ldcap.com

medium：ld-capital.medium.com