November 8, 2023

Insights and analysis for the professional investor

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Welcome to Crypto Long & Short!

This week, Andy Baehr, managing director at CoinDesk Indices, explains how understanding and measuring Ethereum's integrated staking rate is key to driving innovation and acceptance of ETH-based financial products.

Then, Jordan Tonani from The Index Coop shares how the next bull-run will see more liquidity going into on-chain structured products.

As always, get the latest crypto news and data from CoinDeskMarkets.com.

– Ben Schiller

From the Analyst

Why an Ether Staking Rate Will Increase Crypto Adoption

Ethereum's conversion to proof-of-stake not only created the foundation for the liquid staking ecosystem, it delivered a native crypto rate to finance that can serve as a critical piece of market structure. The staking rate – measuring the total income that stakers receive for validating Ethereum transactions – has immediate applicability in DeFi, centralized digital asset finance and traditional finance. This has fueled market demand for an ether staking rate for benchmarking, research and risk transfer.

Benchmarking

Mass adoption and integration of digital assets in investment portfolios is critically important to the future of the digital assets industry. While many investors will make their first allocation in Bitcoin, the investment case for Ethereum is likely to attract interest as a next step. Not only does ETH have history and scale; it now has an integrated yield.

As staking becomes better understood, investors will demand that yield rate be more predictable. Moreover, they will pit providers – LSTs, funds, ETPs, CEXes, futures contracts – against each other to hunt for the best return. Benchmarking these returns provides a yardstick for investors, and allows providers to show the alpha they are able to deliver.

Research

What is ETH's staking rate exactly?

It is a floating rate comprising two parts: rewards for consensus layer duties and priority transaction fees. The former is determined by Ethereum's simple "monetary policy" which adjusts rewards based on the aggregate amount of ETH that is staked – a single-objective, security-based policy. The latter is determined by demand for the Ethereum network, which tends to rise when new information or opportunities enter the system.

How does this compare to rates in traditional finance? Consensus rewards are paid to help secure – but not finance – the network. They are determined by a stated policy, like a central bank rate, but not subject to political influence or economic interpretation. They are crystal clear and reasonably predictable.

Priority transaction fees – those paid to validators after base fees are burned – are less predictable and subject to spikes when network demand rises. This demand-spread widens when demand for Ethereum causes users to pay extra gas to get transactions on the blockchain faster.

Should we (and if so, how) compare this rate to U.S. Treasuries or SOFR? They are clearly not direct analogues, given the different profiles of their funding bases. However, there are similar opportunity-cost dynamics. For instance, we've seen a shrinking of the validator queue as the staking rate has declined relative to available fiat rates. Should demand for the rate be adjusted by ether's forward-looking inflation/deflation status? Should it be implied in ether futures contracts or the OTC forward market?

The calculation of a standardized and independently-calculated rate, along with access to its components, can provide analysts with information to help understand Ethereum better, both internally and in comparison to other money markets. (Note: CESR™, the composite ether staking rate, which is administered by CoinFund and calculated and published by CoinDesk Indices does just that.)

Risk transfer

Ethereum validators stake 32 ETH, and get a variable stream of rewards. Future rewards can be hard to predict. This yield volatility is not optimal when evaluating a validator's financial performance with measures like its Sharpe ratio.

What if the validator could swap its future staking yield for a fixed rate, and what rate would it accept to enter that transaction?

This is the genesis of a fixed vs floating swap market, and the birth of a forward curve for the ETH staking rate. Speculators may also want to gain exposure to the future rate, expressing views on network demand, volatility or macro events. OTC dealers and DeFi protocols can create such marketplaces, whose contracts must settle into an independently calculated, well understood value.

This embryonic but scalable market is an important addition to the idea set for crypto derivatives markets because it goes beyond serving investors and lenders and addresses a new use case: corporate finance.

Conclusion

Expanding the users and use cases for Ethereum's staking rate will help improve network security, invite new investment interest in ether, and create new bridges from digital assets to traditional finance. This fueled the inspiration to create CESR™, the composite ether staking rate. CESR and other Ethereum-focused LSTfi Protocols can be found in the newly launched report, The Ultimate Q4 2023 Market Overview.

– Andy Baehr, Managing Director, CoinDesk Indices

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Institutional Outlook

DeFi's Next Frontier: The Untapped Potential of On-chain Structured Products

Globally, asset management is a huge industry, with a large percentage of assets in each nation being held in ETFs, index funds and other passive vehicles. In Europe, €28.4 trillion of assets are managed by the industry, of which 20% are held in passive strategies, about half in exchange traded products and half in index funds. All told, passively-held assets under management have doubled since 2015, with around one fifth of European retail investors holding such products. Analysts predict that by 2027 ETFs will account for 24% of total assets in Europe, up from 12% in 2022.

In the world of decentralized finance and digital assets, some commentators see the on-chain structured product market as analogous, but this sector has yet to capture much market share. on-chain structured products make up 0.07% of the crypto market overall currently, with a combined TVL of $2.46 billion across protocols. In comparison, the DeFi market is $48.29 billion and the total crypto market is $1.18 trillion.

Nevertheless, over the last several years, on-chain structured products — that is, index tokens and strategy tokens — have shown the kind of promise that led to these types of products' dominance in traditional markets. In 2020, the on-chain structured product market saw 20 projects launching (including nine projects that launched during what would come to be known as DeFi Summer). Yearn, Compound and the Index Coop all started offering such products during this period. At the height of the 2021 bull market, Index Coop's on-chain structured products captured over $550 million in TVL.

In total, 47 projects have launched in the on-chain structured product space since 2016, with the majority of projects offering index or yield-earning products. Of those, 37 are still operational.

At the Index Coop, we're bullish on the long term promise of on-chain structured products because of their advantages in transparency, security, accessibility, automation and liquidity. Regrettably, the sector has been hampered by regulatory ambiguity, as well as nascent technology and market infrastructure. That said, some encouraging signs have emerged recently. If, as seems likely, BlackRock's spot Bitcoin ETF and Grayscale's spot Ethereum ETFs are approved in the U.S. that would represent a major step forward for the on-chain structured product sector.

As digital asset markets mature, we expect to see more growth on the on-chain structured product market, especially as correlations reduce across digital assets. Currently high correlation across digital assets means that different assets move together, reducing the value of a diversification strategy. As digital assets become less correlated, diversification will become more attractive proposition. Additionally improvements in UX and cross chain infrastructure could contribute to growth in our space. Long-term, we expect on-chain products to prevail because of their unique advantages, enabling underlying tokens to reach wider audiences.

You can learn more about the on-chain structured product space in our annual report on the state of the industry.

- Jordan Tonani, Head of Institutions, Index Coop

Takeaways

From CoinDesk Deputy Editor-in-Chief Nick Baker, here is some news worth reading:

FTX 2.0: Sam Bankman-Fried was just found guilty (remarkably, on Nov. 2, exactly a year after the CoinDesk scoop that undid him). Crypto traders are ready to move on. But are they ready for SBF's exchange to come back from the dead? The bankruptcy estate is trying to sell the exchange. CoinDesk just reported that Proof Group, which was part of the consortium that won the bidding for another bankrupt crypto firm, Celsius, is one of the three parties trying to buy FTX and relaunch it. FTX was a big part of the professional trading landscape before it expired last year, so its reemergence could make a splash. That said, as we discussed last week, traditional finance giant CME has made its way nearly to the top of the list of crypto derivatives exchanges along with Binance. Success is not guaranteed.
SOLANA: The Solana blockchain has been pitched toward the professional trading community as a platform capable of processing transactions at the pace they're accustomed to in conventional markets – unlike plain vanilla Bitcoin and Ethereum, which are comparatively sluggish. Reality, however, hasn't matched the hype and Solana is not, so far, home to a big, crypto-powered Nasdaq or whatever. And its future felt in doubt after Bankman-Fried's downfall since he was an early backer and investor in Solana. Its SOL token tanked. But it's come roaring back, recovering all its post-FTX crash losses. And that's left the FTX bankruptcy estate in a surprising place: within striking distance of making customers whole. You know, the people whose money was taken by Bankman-Fried so he could spend it on all kinds of stuff via Alameda Research.
SAFETY IN BITCOIN: The classic response to the question, "What's a safe place to stash my money?" is something like Treasuries or gold. So it is unexpected to hear famous veteran finance pros talking about bitcoin (BTC) in that same category. Yet, they are! "You have people talking about bitcoins, about equity, being the 'safe asset' because they've lost confidence in government bonds being the safe asset because of the nature of the interest rate risk," Allianz's Mohamed El-Erian recently told CNBC. With BlackRock and peers gearing up for bitcoin ETFs, it's clear traditional finance sees a large opportunity ahead. Not exactly what Satoshi Nakamoto had in mind!