Understanding the layers of crypto market cap
Where we explore the limits of crypto indices and take apart token supply into various shades of capital
In a previous publication I have explored the un-deterministic or complex nature of crypto markets. One recommendation I made was for people to invest their money in a crypto index fund.
Original traditional index funds were built on the insight that in aggregate active investors see lower returns than passive investors. Two key drivers for passive investing adoption were exceptionally low fees and high tax efficiency.
Traditional indices have evolved since the early Vanguard days and now come in all shapes and colors. A couple of “big ideas” remain though. The first one being that an index fund is a way to “buy the market” and the second is that it provides “diversification”.
We have since looked into what the crypto market had to offer in terms of investable crypto index (crypto indices hereafter). Products like the Coinbase Index fund, Iconomi’s flagship Blockchain Index, Bitwise’s Hold10 Index and Crypto20.
We have come to the conclusion that current crypto indices can not possibly serve a similar purpose as traditional index funds. They do not come in cheap, they are built on questionable representations of the market and they offer next to null diversification.
Price:
This point can be made with a quick chart comparing crypto indices fees with regular indices:
Prices to invest in a crypto index are around 7x superior to what you would be charged in a regular Vanguard index fund with a similar strategy. Token custody cost can not possibly justify such a high premium. Neither does illiquidity — partly addressed with gated redemption mechanisms.
Buying the market:
The usual strategy here is to use market cap as a weighting mechanism to build a portfolio. Let’s make it clear right from the beginning. Market cap when it comes to crypto markets is a deeply flawed metric.
There is a lack of understanding around what digital tokens stand for and what they entitle their various holders to. Traditional equity shares are claims over a company’s cash flows. Hence market cap in traditional markets represent the sum of expected cash flows. But what exactly are digital tokens? Truth be told a digital token is a single form that can have two different substances within a same blockchain. Utility or capital.
As a utility, a digital token represents an access right to the blockchain. As capital, it is to be assimilated with various forms of traditional financing. Together, both substances form a blockchain’s total token supply.
There are three layers that make a blockhain’s total token supply: circulating tokens (1), issued tokens (2) and total tokens (3). We shall see that circulating tokens (1) is made of utility and convertible tokens. Issued tokens (2) includes circulating and restricted tokens. Total tokens (3) encompasses all issued and eventual tokens. See below on the left for a visual representation.
Which one of these elements should be included by an index to reflect the market? Needless to say, depending on what method you employ you get some widely different results. See below on the right for a visual representation.
Fig 1: Different levels of supply and the impact of including them on portfolio weighting
Each crypto index that we have looked at uses its own method to calculate market cap. Below, we should look at various approaches. We will assess the representativeness as a mean to “buy the market” for each case.
- Including convertible — non operating — supply:
All crypto indices and in fact most crypto funds calculate market cap by starting with: circulating token supply x token price. Circulating tokens are all the tokens that have already been issued and that are tradable.
But in many cases these tokens have been released prior to the network being operational. Hence they have no present utility and are equivalent for now to a convertible form of capital. One that will be converted eventually into a utility by investor turned users.
However, contrary to convertible bonds and preferred shares convertible tokens offer no yield, no dividends and have a 1:1 conversion rate and highly. More importantly, the claim’s enforceability is highly hypothetical since circulating tokens are never presented as such. Not a very good deal overall. One that should be reflected in their price.
In traditional markets, convertible securities are not included in calculating market cap. Even if non operating tokens are not straight up convertibles, they should not be confused with proper utility tokens. Including them to a network’s market cap would be providing an investor with exposure to some measure of completion risk not utility itself.
Unfortunately, every crypto indices that we have looked at seem to overlook that fact.
- Including restricted supply:
Crypto indices like Crypto20 go even beyond circulating supply and use total issued market cap glossing over the fact that some issued tokens — usually pre-mined assets released by ICO teams, are not available for purchase.
These tokens that are not available for purchase are similar in substance and form to Restricted Stock Units (RSU). First, they reduce agency cost by aligning ICO teams incentives with the rest of the community. Second, they are consistent with early stage economic value creation. The conditions under which these restricted tokens can be sold are formally established, either cryptographically locked, reserved or pledged.
Fig 2: The difference between circulating and restricted supply in crypto and traditional markets
Restricted tokens exist for the same purpose as RSUs. They are a great tool to sort and compensate the best individuals to build a blockchain.
However, like RSUs restricted tokens are costly to users. If only because those who hold them are risk averse, lowly diversified and consequently do not value them as much as cash. Make no mistake, the utility that accrues to a user through a restricted token is suboptimal compared with that accrues through cash.
Overall, restricted tokens benefits are reflected in a token price at launch while their cost will be reflected through dilution once the restriction is lifted. That is how things work in traditional equity markets. That is among the reasons why no one would ever think to include RSUs in a regular market cap calculation.
Yet some crypto indices include restricted tokens to calculate respective asset weights in their portfolio. In fact, not only most crypto indices but also some crypto funds.
This assumes that crypto markets have not priced the benefits of restricted tokens in full already. It also implies that restricted tokens cause value expansion proportional to the number of units issued.
As we have explained above both timing and expectation of the effect are wrong. Once restriction is lifted, the only way is dilution.
There is one case though where including restricted tokens to the calculation could potentially cause some form of value expansion. That is when the inflated market cap is used as a marketing tool. Some teams such as Ripple are very good at playing that game. Though no matter how self fulfilling that practice might be, we question the sustainability of the effect.
It results from all this that investors in crypto indices like Crypto20 are buying a very distorted representation of the market. One that is heavily skewed towards teams that are more focused on marketing and hype.
- Including eventual supply:
Some indices like Hold 10 by Bitwise stick with circulating supply but are also adding token inflation into the mix. How about this one?
Protocols use inflation tokens as a mean to pay for the computing and work resources necessary to maintain them. In most cases these computing and work ressources have structured themselves as real life companies — mining companies or similar.
The relation protocols have with mining companies is reminiscent to the relation Holding Companies (HoldCos) have with Operating Companies (OpCos). It is that of an Operating lease. As of such it should be treated as an off balance sheet form of capital and approached with a capital allocation lense.
In traditional equities capital allocation goal is to generate growth. But growth can come in two forms. It can create or destroy value. When incremental capital generates incremental returns that is above the cost of capital then growth creates value. When incremental capital allocated generates incremental returns that is below the cost of capital then growth destroys value.
Like for Restricted Stock Units, the net effects of any capital allocation strategy are already reflected in the asset price — read here the token price.
Any index or fund that adds it to its market cap calculation assumes that the inflation tokens effect hasn’t been fully priced by the market yet. It also implies a linear net positive relation between inflation tokens and value.
Fig 3: The relation with inflation and market cap is not 1:1
As we have seen above not only can these net effects be positive or negative but also they are very likely to have already been priced by the market.
Once again an investor in such crypto indices would get a very distorted exposure to the market. One that is strongly skewed towards coins with aggressive issuance or inflation policies.
Buying diversification:
Some crypto indices like the Coinbase Index are built around a very limited number of digital tokens. The Coinbase Index focus on 4 of them. Two of which have been demonstrated to move almost in lockstep with a correlation of daily returns over a trailing 360 period ranging between 0.8 and 0.5. in There is not much to get in terms of diversification here.
But there is not much diversification to get from the broader market either.
This point can be made as quickly as price with a quick time series plot (left) and a 90 days correlation table (right).
Fig 4: Increasing correlation across the board
Some teams have done a great job at exploring emerging performance clusters among digital tokens. Recently, Radicle was able to identify 3 distinct clusters in the crypto market using an Affinity Propagation algorithm. A promising sign for future potential diversification yet not something that can be used as of now.
Parting thoughts and practical conclusions:
We have seen other elements in crypto indices that amounted to various forms of factoring. The Blockchain Index on Iconomi for instance is adjusting for liquidity. A laudable effort in such a small and prone to volatility market.
However we see a couple of limitations to this. Liquidity across the whole market is hard to assess. This is due to the fragmented nature of exchanges and to the malicious behaviours of some participants. But even controlling for opacity does not completely solve the problem. There is no empirical evidence that factoring inflation generates smart beta.
Another recurring form of factoring was to adjust for size. By caping maximum allocation to 10% or by taking a log value of the market cap some crypto indices are in fact tearing a page from the small cap investment strategy. But once again, like for inflation, there is no empirical evidence to back that decision. In fact, we can see as many pros than cons for it.
Overall we have demonstrated that existing crypto indices fail in at least one if not all points. They do not come cheap. They are built on flawed metrics and make questionable adjustments. They offer little diversification.
Why would such smart people bother launching them in the first place then? First because there is a big demand for it. At least there was back in December when the crypto market was spiralling upwards. Second because it is a really smart PR move. If the thing picks up and becomes a reference can you imagine the fallout? Being quoted everywhere in the press the same way the S&P 500 is? “Now in the news, the Gauthier40 Index.” That is a genius PR move.
Now in the light of all this we would like to make some recommendations:
If you want to buy the market: build a portfolio that only accounts for operating tokens. In practice you would end up holding mostly store of value tokens (BTC, XMR, ZCH, ETH etc.).
Interestingly the latest launched quality projects such as Ocean, Blockstack or Keep are made of 100% of restricted tokens until network launch. This means that if you only take into account their circulating tokens there is not any more work required to separate operating and non operating — or convertible — tokens. In fact the market cap of such projects will start much smaller and will build up slowly over time. So will your exposure to them.
If you want to buy diversification: while you can not diversify today across currencies you can diversify across strategies. The best way to do so is to invest in a fund with a near obsessive focus on risk management, in a fund of fund or in a portfolio of various funds.
And on a side note: beware of any funds parading performance over some questionable benchmark index.
I hope that you’ve enjoyed the reading. And welcome all feedbacks!
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Of course, I’d also be happy with a small donation
BTC: 3GpM8G2L4WaYKiTNwmM1QMBYt8AmEocBDj
ETH: 0xFF8Ff84905A324CB2F8047540E06845A9a25B416
XMR: 4GdoN7NCTi8a5gZug7PrwZNKjvHFmKeV11L6pNJPgj5QNEHsN6eeX3DaAQFwZ1ufD4LYCZKArktt113W7QjWvQ7CW8RLGbq2HXP6KSm5Ch
Disclaimer:
This document is intended for informational purposes only. The views expressed in this document are not, and should not be construed as, investment advice or recommendations.
