About This Content
Floating Point Group’s research team endeavors to bring quantitative insights to our institutional audience in short, easily communicable pieces of written content. Questions you’d like examined or questions about this article and its associated data can be sent to firstname.lastname@example.org
Published in video form on December 31st, 2021 for the Crypto 2021 Summit adapted for written form by Natalia Gadjieva and Kevin March, January 19th, 2021.
2020 was an unprecedented year with a volatile election, Tiger King rising to fame, Tesla 10x’ing, a booming stock market yet an ailing economy, and a pandemic that changed how we will live for years. Covid taught us that predicting even the next day can be challenging, but we want to give it a shot nonetheless. We anticipate that three things will mark 2021 in crypto:
- Mergers & Acquisitions — as players scramble to go faster, buying and scaling wins over building internally.
- DeFi — The captivating DeFi community will face an ultimatum, to comply with U.S. AML/CFT regulation and do business in the U.S. or abandon the world’s leading crypto market, forking the movement.
- Clearing & Settlement — Market demand from institutional investors coping with capital inefficiency will propel settlement solutions to become viable and see substantial adoption in 2021.
Crypto is growing at lightspeed, rapidly approaching a trillion dollar market cap (edit: did reach a trillion dollar market cap!) Existing financial institutions eying the space have a decision to make. Commit to a lengthy exploratory and building process that may take as many as 5 years to bring a technologically sound product to market, or acquire an existing player with a product and the expertise to take advantage of the land-grab year that 2021 will be. There are three pieces of evidence that you can look towards: Blockchain consolidation, addressable market growth, and last year’s M&A activity.
The first, blockchain market cap, is indicated by bitcoin at its highest dominance since 2016. The top 5 coins now represent 85% of the market cap (Figure 1), and this number is growing, indicating that the consolidation we see on the horizon is happening even at a fundamental level. This is happening in DeFi as well, with dominant player Uniswap capturing about 40% of all DeFi trading at the time of writing.
The second piece of evidence is the addressable market. By our modeling, custody, trading, lending, and settlement each represent a substantially lucrative billion-dollar market. Given the powerful, sticky position that custodians, brokers, and exchanges hold when they take custody of customer assets, we expect to see further broadening of those player’s business lines in 2021. Great examples of this can be seen in Coinbase, BitGo, and Anchorage who have aggressively expanded their product lines and target customers. While we’ll avoid describing our opinion on most of Bakkt’s eye-popping IPO financial projections included in their recent SEC filing, their $3T crypto market prediction by 2025 seems on target.
The last piece is M&A; 2020 saw a couple of larger groups and reasonably sized deals in the space, with CoinMarketCap, Tagomi, Blockfolio, and B2C2 accounting for 98% of the nearly $1B spent on acquisitions (Figure 2).
2021 will knock this out of water.
Already we see this horizontal expansion as a focus as companies scramble to incorporate more services and grow faster to meet the demands from the market in what will become a land-grab year. With a handful of notable crypto IPOs potentially coming from Bakkt, Coinbase, Blockfi, Gemini, and others, the injections of fresh capital and more focus on crypto will catapult M&A deal-making forward. While the institutional interest in crypto is mostly quiet, it’s massive. If would-be entrants from other assets classes haven’t been building for more than two years already, they’re not going to get to market in 2021 meaning the only move is via acquisition. Compounding that with new capital from raises, IPOs, and investor growth means that the M&A market is poised to pop in 2021.
2020 was the year DeFi peeked its head, but 2021 will be the year that DeFi faces an ultimatum: become compliant or have limited reach. We believe that it will hit the mainstream as providers find ways to offer the technology in a compliant manner (see Alkemi + others). This offering will inevitably lead to a divorce from the regulatory issues DeFi is plagued by. Before 2020, DeFi was an interesting topic to hypothesize about during a single panel on the back-up stage at crypto conferences, but it took a sharp turn last year that’s put it squarely and likely permanently in the spotlight (Figure 3). Innovative technologies enabled automated market makers to grow, the advent of yield farming, algorithmic stablecoins, and ultimately brought in substantial user growth for smart-contract based products.
With all the growth and innovation comes a central question: how does DeFi reconcile itself with regulation? In 2021, some DeFi’ers will run from the issue while others will tackle it head-on through releasing products with gatekeeping mechanisms that ensure all users in the closed system have passed KYC checks and submit to the requirements of a compliant financial service.
Clearing and Settlement
Capital efficiency remains one of the most considerable unsolved problems in crypto. A restructuring that focuses more on streamlining clearing & settlement is coming to the crypto markets in 2021.
Imagine a simple scenario to give a perspective on that: you’re an institutional investor wanting to buy $1M of BTC. You could go to the most liquid exchanges and place a market buy for $1M. The issue is that you will immediately lose about 30 bips to slippage before accounting for exchange fees. Suddenly your $1M in BTC costs thousands of dollars in fees. We can extrapolate this line of thinking to larger numbers with even more significant slippage, which is why it’s essential to trade across multiple venues.
The issue is that exchanges do their own clearing and settlement. They each require pre-funding to put in trades, meaning that trading on numerous venues results in a mess of fragmented liquidity and settlement workflows that are primarily solved by scaling the manual, human side of the equation. The capital inefficiency is quantifiable.
If you only trade on six exchanges, you only need to worry about balancing your funds across those exchanges, and on average, you’ll only have 1/6 of the buying power on each of the exchanges (black arrows in Figure 4). If you carry this out with n = number of exchanges you trade on, you only ever have 1/n buying power per exchange.
This dilution underpins one of the major problems with crypto that we think will get solved in 2021.
Fragmented liquidity is not the only problem; the second issue we see is a lack of a cohesive solution for clearing & settlement. A recent survey conducted by FPG shows that nearly 40% of personnel at trading firms are dedicated to back-office ‘trading operations’, which in this case simply means moving the assets between exchanges and custodians, settling bilaterally with OTC desks, and spreadsheet tracking of all those movements. Furthermore, if the firm doesn’t have sufficient trading staff to meet their operational intensive teams, they will assign software engineers or their traders to help in the process. At worst, the partners of the firm take this task on themselves with a significant portion of their day.
Lastly, 68% reported that inefficient funding and settlement workflows were the primary problems scaling their business.
What needs to happen is the advent of a better mechanism for the trade settlement. While there doesn’t seem to be agreement in methodology, there are a few firms working on restructuring and introducing an efficient workflow, such as Curv, Anchorage, Qredo, and Etana Custody. The ability to deposit assets into a single location and get seamless access to deep liquidity across the ecosystem will be a crucial point of maturation that we will see in 2021.
2020 was an unpredictable year, and the preview of 2021 showed us that this year might be even wilder. We expect that M&A will explode as the rapidly growing space becomes a clash of traditional titans and new cash will propel buying solutions rather than attempts to build them in-house. DeFi will come to terms with U.S. regulators. Lastly, clearing & settlement solutions will rapidly proliferate as investors demand better capital efficiency and financial controls.
If you have questions you’d like to suggest we explore, please send them to email@example.com