By @bitbear

Bear Market Rally or Return to Fundamental?

Bear market rallies are not strange to crypto investors. There were five retests of the 6000 resistance level during the 2018 bear market, each followed by rallies that were increasingly weaker, which ultimately led to a final leg down to 3000 in November 2018.

Similarly, we saw a relief rally in this third quarter of 2022, not just in crypto, but across all risk asset classes. The correlation that had developed between Bitcoin and Nasdaq during previous two-year bull run had continued into this bear market.

However, as we approached the end of this rally, BTC had given up most of its gains, only to fall back to its June levels. Yet a few other tokens had demonstrated relative strength, the most stellar performances being LDO(263%), GMX(173%), CHZ(149%), OP(69%), AAVE(36%),UNI(34%), LINK(27%) , ETH(27%), APE(18%) and many others.

We rarely wrote about specific alt tokens, as we understand prices of smaller market cap (and even larger cap) tokens are subject to rapid changes in market conditions and high volatility. However, I do find this disparity in strength to be worth a second thought. Is the divergence caused by fundamentals? Or just market overreacting to narratives?

Looking for Fundamentals at the Peak of Inflated Expectations

Take OP for example. OP is the governance token of Optimism, a Layer 2 solution on Ethereum that aims to become a faster, cheaper smart contract execution layer, with the goal of reducing transaction throughput pressure on Ethereum mainnet.

Users pay a transaction fee to the OP network just like they do on Ethereum mainnet, but at a much lower rate. However, under its current design, only a small amount of this transaction fee go to Optimism’s network sequencer, while the rest amount go to validators on the Ethereum mainnet for data and security provision.

Below is Optimism’s transaction revenue and network activity for the past 180 days. Network activities have been growing, but transaction fees remain flat.

The OP foundation also plans to expand its revenue base by selling sequencer rights, which equates to selling licenses for high frequency trading, arbitrage or even front-running in the Optimism network.

Funding for the OP economy comes from ownership of the Optimism network and the value of its blockspace. Today, funding comes directly from the centralized sequencer, accruing to The Optimism Foundation for redistribution. In the future, funding can accrue directly to the protocol by selling the right to participate in Optimism’s decentralized sequencing network. Simply put: the right to blockspace is the sustainable source of revenue that drives OP’s economic model and grows with the network itself.

- Optimism Collective

With no substantial changes in the network’s strategy for expanding revenue sources, the recent 96% increase in OP’s price seems to be driven completely by inflated expectations: its current FDV of $4 Billion has to be supported by a network transaction volume (the “Network GDP”) of $144 Billion: suppose a 30x P/E ratio and a 10bps fee cut from the total traded volume and MEV licenses. (The 10bps rate is based on the estimated MEV profit as a percentage of total DEX volume on Ethereum in the past 360 days. )

Since Uniswap’s launch on Optimism in November 2021, its total transaction volume has reached $6.9B. The Optimism network needs to have at least twenty applications that can create the same amount of transaction volume as Uniswap per year to match the FDV it has today. Although this feat isn’t impossible in the future, today, Optimism’s valuation is, well, very optimistic, considering its current network activity.

We Can Only Find the Bottom if There is One

Another common problem in token valuation today is a token’s inability to capture value.

Asking token holders to hold a token without value accrual is basically selling hopes, or a ponzi scheme. Many crypto investors would argue “There is nothing wrong with ponzi !” There might be no legal problem with a Ponzi structure, however, how can we find the market bottom when there is no consensus to be found on the fundamental value?

Uniswap is a famous example of this - a project sitting at an annual fee of $1.2B (YTD) yet giving out all of these fees to Liquidity Providers. The UNI token is just a “useless” governance token with no value accrual mechanism, regardless of how much fees the protocol generates.

Today, there is discussion going on the Uniswap governance forum for a fee switch, which will allow the Uniswap protocol to retain a portion of the transaction fees collected and potentially reward UNI holders in some way. It still remains a question where Uniswap will choose this way to capture value from transaction fees (or it could launch its own chain and ask users to pay fees in UNI), and we expect the final vote will take some time to happen.

In comparison, Sushiswap is another decentralized AMM exchange that supports 22 chains and targets the same audience, albeit with a smaller audience. It’s governance token, SUSHI, is designed to enable token holder earn .05% on all trades for holding a staked version of SUSHI, its governance token.

Zooming out a bit more. Uniswap and Binance are both in the exchange business landscape, just with different technological frameworks to match liquidity consumers and liquidity providers. Binance’s BNB token captures profit from its many lines of businesses, and also functions as the gas token of Binance’s own public chain. It is the only token among these three that has a deflationary monetary policy, having a buyback and burn design that can capture value for its token holders.

BNB burning mechanism: in the initial version of Binance’s 2017 Whitepapaer, Binance promised to use 20% of its profits to buy back and burn BNB at market price until 50% of the total BNB supply is left. This has been revised allegedly, according to The Block, but here we will still use the 20% profit usage to get an estimate of Binance’s annual profit.

Since launch, 38.93 million BNB has been burned under this design, leaving 161.07 million BNB left. Based on the $626,356,129.62 worth of burned BNB fees during Q2 2022, we can get an estimate of its annual profit of $12.77 Billion.

Assuming Uniswap turns on a 10% fee switch that keeps 10% of the transaction fee to itself or its token holders, the P/E ratio of UNI, SUSHI, and BNB (before incentives) will be 53.02, 6.22 and 3.58, respectively.

Setting aside the question of whether Uniswap, Sushiswap and Binance have different business models or future growth trajectory (Unichain vs Binance Chain), the token that is essentially “unmeasurable” in value right now is most favored by the market among these three.

Nominal Fundamentals vs Real Fundamentals: Token Incentives Outweighing Revenue Generated

So who has the best fundamentals in crypto?

Figure 5 and 6 are the top blockchains and Dapps ranked by cumulative fees and gross profit(referred as ”revenue” on token terminal ) in the past 180 days. I used 180 days because this period can alleviate the “fake network activity” phenomenon during the previous bull market.

In order to make a transaction on chain, users must pay certain fees. These fees can be further categorized into:

• “Supply side fees” are fees that the protocol accuses in order to pay those who enable the actual protocol activity, such as liquidity providers in Uniswap and validators in Ethereum.

• Any fees, aside from the “supply side fees”, can be classified as “gross profit” for the protocol or application.

Gross Profit/Fees Ratio is one way to measure a protocol’s ability to capture value from transactions, similar to toll revenue/total traffic on the highway.

Another core feature of cryptoeconomics is using self-issued tokens to incentive early adoption. Just like Real Interest Rate= Nominal Interest Rate - Inflation, we consider Real Profit = Nominal Gross Profit - Token Incentives. (I didn’t use “net profit” because token incentive is not an expense.)

Network or Application Incentives are usually tokens a protocol prints of out of thin air to incentivize security provision or usage. For example, Bitcoin provides block reward to miners for maintaining the network. Fcoin, a centralized exchange that invented liquidity mining in 2018, rewards tokens to users based on one’s trading volume. A fatal error in its incentive mechanism design led to its demise after many users just washtraded to get the token and dump.

Printing tokens and giving them out is free, but not completely free in terms of opportunity cost. Giving out tokens today is basically giving up tokens that could be used tomorrow. Printing more tokens is also possible, but this will also make your Internet Money less valuable compared to other Internet Monies that have a “sounder” monetary policy.

Figures 7 and 8 are the real profit of top Dapps and Blockchains after subtracting out token incentives (past 180 days).

Of the top 20 Dapps, OpenSea, Metamask, ENS, 1inch, MakerDAO, Lido Finance, Tornado Cash, Yearn Finance, Decentral Game, and Sushiswap have a positive revenue stream, capturing more value than they pay out in incentives to users.

On the blockchain side, in order for a network to attract security providers (miners, validators, etc), they need to offer incentives. Because Arbitrum doesn’t have a token to offer as incentives yet, they are the only profitable network. However, when we switch to a 7-day timeframe (Figure 9), both Arbitrum and Ethereum have earned more in total fees compared to what they paid to security providers. In Ethereum’s case, their most recent upgrade, which occurred on September 14th, introduced a significant reduction in token incentives, making the network “gross profitable”.

Are these blockchains or applications worth more than the ones who are not yet profitable?

Escape Velocity: Generating Enough Organic Growth Before Incentives Run Out

Growing by incentivizing is not the problem. The key is to create enough organic traffic and real growth before the incentives run out. One has to reach the escape velocity, the minimum speed of growth, so that they don’t fall back due to gravitational force.

Take Ethereum for example. Since launch, Ethereum has given out $30.3 billion incentives to miners and validators in total for security provision and collected $14.8 billion fees from users. This deficit situation has only recently been reversed due to Ethereum’s switch to Proof of Stake and reduction in rewards: over past 7 days, Ethereum was able to collect $15.9 million fees while only giving out $14.9 million incentives to validators.This shows that ethereum is on course to become a global asset as adoption hits escape velocity, as the proof-of-stake transition transforms cash flows to real-income.

In addition, a previous upgrade on August 5, 2021 enabled Ethereum to keep most of transactions fees to itself through a burning mechanism, as all fees were sent to miners before the upgrade.

Today, security providers on Ethereum receive both token incentives(staking rewards) and a part of the transaction fees generated on the network, but on a much smaller scale than before. The Ethereum network is not running on massive deficit anymore, although the degree of surplus and deficit is still subject to changes in network usage.

While Ethereum is yet to be profitable for a sustained time (real profit can still be below token incentives sometimes), its network deficit has been drastically improved through several upgrades in the last two years. Fourteen years after the first cryptocurrency was born, we finally have a cryptocurrency that is earning more fees in value than printing.

Does this make our crypto world less “rat poison squared”?