It’s a Small Cap Life

The so-called small-cap effect, whereby small companies tend to outperform large ones over time is well documented. The basic theory states that there is a premium to be achieved by investing in smaller companies. However, the challenge arises from the fact that the aforementioned small cap assets are usually a lot less liquid and are also a lot more volatile. In turn, transaction costs are higher and there is a greater risk of information leakage, impact on the underlying price as positions are slowly built up by active money managers. Another key factor to consider when trying to harness the effect is re-correlation risk. In other words, small caps will tend to outperform large caps, but when markets fall, small caps underperform large caps and depending on the severity of the overall market weakness, the risk of re-correlation to the broader market increases accordingly – i.e. ability to outperform large cap peers is reduced substantially. There are other biases to consider, but the basic outline of the theory is as above.

While the above notions are commonly accepted in traditional markets, following the dramatic collapse of the Initial Coin Offering (ICO) market, investing in smaller cap assets has become even more of an opportunistic playground, as opposed to a means to outperform the core. For most part, the market is overly fixated on Bitcoin and its slowly dwindling supply, while market commentators are often seen commentating on its deflationary appeal and a hedge against inflation. Ethereum has also gained more interest from the crowd this year and that has been for several reasons. For one, the amount of Tether issued on Ethereum has grown exponentially this year and two, developers at Ethereum have made great strides in their efforts to accelerate the transition away from Proof of Work (PoW) to Proof of Stake (PoS).

What is more interesting is that heading into 2020, expectations were that block reward halving by Bitcoin that took place earlier in the year would be the dominant story but instead, it appears that this has been overshadowed by the fast-developing narrative of alt coins outperforming. On that note, when looking at year-to-date performance by the MVIS 100 small cap index relative to the large cap counterpart, small cap index has outperformed its large cap peer by over 10%. Specifically, small cap index is up 42%, while large cap is up 28%.

In traditional markets, such a dynamic would be most welcomed by the bulls, largely because it shows growing risk appetite, given that as alluded to earlier, small cap assets tend to be m­ore volatile and less liquid. As such, capital flow into such assets are seen as a sign of market confidence. In crypto markets, the sentiment is somewhat more mixed, largely due to Bitcoin’s recent inability to break past various key technical levels. However, while Bitcoin may have ended the previous bull run at around $20,000, it is often overlooked that at the peak of the bull run, small caps outperformed large caps significantly. When looking at the 5 year time horizon (June 2015 as the starting point), at the market peak in early January 2018, the small cap index was up almost 40,000%, while large cap was up around 11,000%. Both numbers are nothing short of being astronomical but fast forward to present day and large cap index is up 3,400%, while small cap index is up 1,900%.

Index composition and respective market capitalisation is an incredibly important factor when it comes to evaluating relative index performance, especially if, as is the case in the digital assets ecosystem, Bitcoin commands a significant market share. Specifically, Bitcoin makes up 70% of the MVIS 100 large cap index, followed by Ethereum at 10%, XRP at 3.64% and Bitcoin Cash, as well as Bitcoin SV at 1.7% and 1.3% respectively. The distribution across the small cap index is much more even, with Kyber Networks making up 4.4% of the index, followed by VestChain, MimbleWimbleCoin, Augur, Hedera Hashgraph and Zilliqa, each making up at least 3.5% of the overall index. However, looking at the composition of the tech-based NASDAQ 100 index, the top spot is commanded by Apple with 11.8%, followed by Microsoft with 11.4%, followed by Amazon with 10.3%. Going back to crypto indices and the outlined composition makes relative comparison incredibly biased to one asset, Bitcoin. As pointed out earlier, heading into block reward halving that took place in mid-May, there were two opposing theses in play. Crypto maximalists were positioning for another bull run, while crypto sceptics were pointing out that the apparent lack of transactional demand will see Bitcoin miners flee en masse given the reduction in mining subsidy. However, the aftermath was somewhat unexpected and instead the price action has been largely sideways since.

As alluded to in recent market commentary publications, much has been said recently about the ongoing surge in demand for crypto options but there is also a growing discontent, especially amongst the crypto natives about the lacklustre price action in the spot market. The end of June option expiry hit a record open interest (OI) of 110k BTC (circa UD 1.05bln), with the front-end of the skew creeping higher for much of the month, while the back-end has traded more or less steady. Looking at the front-end alone would imply cautious market positioning and yet, the spot has been resilient, albeit flat and the perp curve remained in contango territory (price bullish). One possible theory to explain this apparent bipolar view on the market is the growing interest in utilising options market by crypto lending desks to earn yield, but also to hedge their exposure.

The futures curve being in contango is less than appealing to the lenders and options market offers plenty of opportunities to capture yield, but this also comes at a cost – higher credit risk for participating firms. However, if the risk is adequately managed and capital position is not compromised, then entering markets such as options and even DeFi will not necessarily lead to losses imposed on users, likely retail. To that note, as per etherscan based transaction, NexoFinance has sent almost $25mln to Compound (COMP), a platform that has recently witnessed a huge growth after Compound Finance introduced its native governance token – COMP. One could even argue that participation in DeFi by CeFi based lenders will prove to be net positive for the respective tokens.

While the notion of DeFi might seem somewhat foreign to many, it has long been an area of fast growth and even some argue that only a mere $1 billion is locked in the entire credit ecosystem, it is $1 billion of capital that was allocated away from competing CeFi market or even other digital assets. Also, the entire market capitalisation of Compound is only $700 million, while over $500 million has been locked on the platform, similarly for Maker which is valued at $500 million and $450 million has been locked in the ecosystem. These metrics, together with the fact that arbitrageurs are increasingly turning to DeFi to capture price inefficiencies points to further growth in the market and in turn, higher valuations for projects involved.

At the same time, there is a risk that some digital assets that have either fallen behind their aspirations to join the DeFi race, offer fewer incentives and show evidence of lacklustre decentralisation practices may see capital outflow into higher yielding assets. There is no such thing as a free lunch, but in such a nascent and fast-growing industry, investors need to get compensated accordingly. Eventually, market consolidation and competition will level the playing field and the rate of growth will decline.

As per defirate, with the launch of COMP liquidity mining, yield farming has become a hot topic in DeFi. Users can start earning high yields across an increasingly wider range of Defi protocols in native tokens via by providing liquidity (or any value-added service) to the network. COMP will be distributed across ETH, DAI, USDC, USDT, BAT, REP, WBTC and ZRX markets. While yield farming is a newer concept to the DeFi community, we’re now seeing the ultimate yield hacking strategies emerge. Ren Protocol, Synthetix, and Curve have teamed up to launch a new incentivized liquidity pool on Curve for tokenized BTC.

On the one hand, the latest development in the already booming DeFi ecosystem has put a bit of a dent into Ethereum’s upside run up ahead of the widely anticipated updates relating to the transition away from Proof of Work (PoW). Even so, Ethereum is up 75% year-to-date, while Bitcoin is up 29%. However, while yield farming may be the term in vogue at the moment due to excessive returns, the aforementioned returns will eventually stabilise and it is also easy to forget that DeFi is built on Ethereum.  As such, DeFi’s success is ultimately Ethereum’s success.

All the while, Tether continued to wreak havoc on Ethereum network, causing the network to swell and gas usage to creep to record highs, while also pushing capacity to its limits. To note, Ethereum’s transaction count recently hit a 27-month high, while earlier this month saw an average of 9,500 unique Ethereum addresses transferring USDT each hour (as per glassnode it was a new all-time high and an increase of more than 820% since its low in January this year). As a reminder, almost $6 billion of USDT’s total supply is now on Ethereum, up from $1.5 billion in the beginning of 2020. It is not just USDT that has been causing the network to swell and Ethereum-based Decentralized Exchanges (DEXs) such as Kyber, Uniswap and IDEX have all experienced solid growth in transaction volumes this year. Kyber Network registered a transaction volume of $609 million in the first five months of this year. That’s 1.5 times more than the volume of $388 million seen in 2019, according to the official blog.

The reason why the above matters when trying to ascertain the reason for the outperformance of small cap assets relative to large cap peers, goes back to its illiquid nature and once provisions are made to support the flow of capital, these liquidity constraints are unblocked, even if temporarily. The conduit for the aforementioned flow of capital to some extent has been Tether, even if it came at the price in the form of a clogged-up network. Irrespective whether it is yield farming, staking or collateralizing, in order to achieve desired results, there needs to be liquidity. This liquidity can be achieved via flow of new capital and that is exactly what resulted in bubble like price surge in 2017/18, or it can be achieved by incentivizing the more liquid assets to “share” the liquidity by creating products that would allow to channel this liquidity and capital.

If it sounds a bit like structuring an exotic product that allows capital to be unlocked that otherwise would have been “stuck” underutilised, that is because it is exactly that. While such practice may be described as nothing short of hot money moving from one project to another, it is often the case that business enterprises undergoing fast growth rates, especially in the early stages are often funded by money that investors are more than prepared to lose in its entirety. Said otherwise, the digital assets ecosystem is no stranger to hot and speculative money.

One of the factors that contributed to the success of Kyber Network is that it provides on-chain token swaps and provides liquidity for a variety of wallets and other decentralized applications in the cryptocurrency industry. In addition to this, Kyber will be introducing staking of KNC tokens, as well as KyberDAO, as a component of the Katalyst update. Similar to Compound’s COMP token holders, KNC token holders will receive Ethereum (ETH) rewards from transaction fees collected from the Kyber Network. There are also token burns, thereby inflation is actually negative. The ethos of success is real and specifically, actionable liquidity. However, it is not just the growth of Ethereum based DeFi market that has been driving the sentiment towards alt coins, but also the progress that has been made when it comes to blockchain interoperability and thus unlocking the true liquidity potential.

As alluded to earlier, Bitcoin is the most liquid digital asset and while a number of projects that focused on unlocking this liquidity, tried to address interoperability issues, others looked at alternative solutions. Specifically, it was reported earlier in the year that Tezos Foundation and various partners involved in the initiative announced that they will issue the first tokenized version of bitcoin on the Tezos blockchain, tzBTC. The asset will also be the first vehicle for Tezos-based decentralized finance (DeFi), according to a press release from the association. Each tzBTC represents one bitcoin on the Bitcoin blockchain and is minted under the new FA1.2 Tezos token standard.

Elsewhere, the team at Ethereum Classic introduced a raft of updates that focused on making it interoperable with Ethereum, albeit with a slight caveat that while Ethereum will be moving ahead with its transition to PoS, Ethereum Classic will be looking to unlock the value using PoW. Following the latest update, dubbed Phoenix, blockchains reached protocol parity. For Ethereum Classic, the real value unlocking proposition is a stable network, as opposed to the upcoming state that Ethereum will turn to as it gradually transitions from PoW to PoS. More importantly, the beacon chain will feature the PoS consensus mechanism and it will also run alongside the current PoW blockchain to prevent a break in the continuity of the chains. This is where there is a lot of room for things to go wrong. In addition to that, the team at ETC Labs suggested that it is looking for stablecoin projects to support or establish a partnership with. It remains unclear whether that is Tether or other stablecoins, but the aim is just like with Ethereum based Tether, to facilitate flow of capital. Yet again, it is the stability of the network and subsequent status quo stance with regards to PoW that is part of the playbook, that’s as some fear that Ethereum’s move to PoS will turn into a direct competitor for DeFi based platforms.

Elsewhere, one of the projects that attracted fair share of attention is Kava Labs which has built the first cross-blockchain and multi-asset collateralized debt position (CDP) product, wherein users can collateralize a multitude of crypto assets (including BTC, XRP, BNB and ATOM to name a few) in exchange for a loan in the form of Kava’s stablecoin USDX. Interestingly, Ripple’s venture initiative Xpring has also invested in Kava.

However, it is the project that is Polkadot and Web3 Foundation that has been the driving force when it comes to interoperability. Earlier this year, Polkadot launched a stand-alone blockchain today, although the network is not considered the project’s mainnet yet. In this phase of Polkadot’s mainnet rollout, the Web3 Foundation still maintains control over the network, with plans to gradually hand over the control to the community in the coming months.

For those not familiar with Polkadot, it was founded by Gavin Wood, who wrote Ethereum’s technical paper in 2014, created Polkadot with the intention of allowing users to send transactions across blockchains such as Bitcoin and Ethereum in what is commonly referred to as making them interoperable. Polkadot has focused on integrations with other networks such as Chainlink and Polymath. The network will launch under a Proof-of-Authority (PoA) consensus algorithm. The PoA structure is not dissimilar to the NEAR protocol, another Ethereum competitor that announced the launch of its mainnet earlier this week. NEAR is likewise rolling out in a heavily restricted form.

Most recently, it was reported by CoinDesk that while Polkadot is running but not usable yet, but a company called Interlay has designed a model under a Web3 Foundation grant for locking BTC on the Bitcoin blockchain and minting what it’s calling PolkaBTC on Polkadot. The model deployed has similarities to the model Keep used in launching its tBTC system. A smart contract on Polkadot controls a key to a wallet on the Bitcoin blockchain and verifies its contents using simplified payment verification (SPV). That wallet is collateralized with Polkadot’s native token, DOT, which the initial design sets at 200%, though this could change. Once it verifies that the BTC is present in the wallet it controls, it issues PolkaBTC equivalent to the amount deposited.

Ultimately, further growth of staking platforms is unlikely to prove sustainable without hedging mechanisms and as it stands, the only deep enough derivative based asset that would allow for this is Bitcoin and, in some cases, Ethereum. However, if the aforementioned yield farming practices, staking and collateralization is underpinned by Ethereum, it is more likely that Bitcoin will play its part as a potential hedge. The hypothetical capital outflow from Bitcoin will then prove price supportive for smaller coins. However, this contrarian view does not presume that Bitcoin will fade away into the abyss and while the gap to Ethereum will be narrowed, and the likes of BitcoinSV may also benefit from this capital flow, this will then be followed by a much more balanced capital flow into digital asset ecosystem, as opposed to the current model that largely focuses on Bitcoin.

Denis Vinokourov  is head of research at Bequant, a London-based digital assets prime broker.

The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine, Markets Media Group or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community.