Relative Value (RV) trading is one of the bedrock techniques for traditional stock market analytics. By comparing the fundamental drivers of a company’s growth against its peers, an investor can define comparative success for a company, rather than viewing it in a vacuum.
At the most basic level, this technique can facilitate a number of different investment strategies:
- Value Investing, or finding companies that produced outsized returns on key metrics, relative to normalized cost.
- Factor Investing, or finding companies that have higher exposure to certain desirable factors (e.g. momentum, growth), relative to other companies in the space.
- Long / Short Investing, or buying the companies within a sector that outperform across key metrics, and selling those that are set up to underperform. This hedges out some amount of sector & market risk, and consolidates long investment exposure to only the differentiated elements of the company.
Bringing these fundamental strategies to crypto is important for future uptake and efficient pricing in the market. We have done a lot of different work looking at what moves the price of cryptocurrencies. Currently, uptake for the majority of tokens is driven largely by momentum and social media.
Even when responding to significant news, action often occurs with a meaningful lag, highlighting the inefficiency of current company information distribution. Two major factors are primarily responsible for this:
Market Immaturity creates a variety of difficulties. Only recently, through the expansion of on-chain analytics for DeFi, has crypto discovered any true company fundamentals. On top of this, sectors are frequently new and have hard-to-judge smart contract risk, leading to problems with multiple analysis. This has heavily skewed the culture of crypto toward trading & speculating, rather than investing.
Regulatory Uncertainty causes uncertainty for institutional investors and token issuers. This prevents sticky capital from entering the space, and creates headwinds around creation of best practices for issuers.
While these factors remain true, and will be discussed in more detail later, careful analysis of on-chain information and tokenomic structure can reveal valuable information on company success in crypto. Let’s dive into some examples of how this works.
Crypto Fundamental Investing
At its core, the theoretical strategy behind fundamental analysis in crypto is largely the same as in traditional finance:
- Identify the core drivers for successes within the company’s business sector.
- Decide on which metrics most effectively capture the desired result.
- Track metrics on a sector-wide level to view relative performance over time.
- Invest in businesses that have both intangible (team, idea, network, moat) and tangible (metric-based) upside.
Practically, instantiating this theory is significantly more difficult than it is in traditional markets. Not only do companies trade less efficiently, but the actual method through which value is accrued to tokens is extremely inconsistent. There is a clearly defined set of rights guaranteeing privileges as a result of owning stock; this is not so the case for tokens, which are both inconsistent in function and in a state of regulatory flux.
This means that two companies with functionally identical tangible and intangible qualities could trade out of lockstep with one another. While currently difficult, adjusting for this is possible through tokenomic analysis.
In crypto, companies are identified through a combination of their ecosystem and their sector. Ecosystem refers to the blockchain that the project operates on. Due to different codebases, applications built on different ‘families’ or ecosystems of blockchains aren’t interchangeable.
This means that, while elements of the underlying technology are similar, projects on different chains aren’t necessarily competing for the same real estate. Rather, they’re taking a two pronged bet- partially on the success of their ecosystem, and partially on the success of their project.
Practically, this ends up looking a lot like geographical relative advantages. A blockchain like Solana has a strong NFT culture and market, so you may want to launch an NFT project there to maximize demand. On the other hand, Avalanche or Ethereum might be a better fit for Decentralized Finance, or Polygon for a Web2 project looking to make the move on-chain. Each chain creates different infrastructure to support companies, and tries to make the most compelling value proposition for project builders.
Token Economics, or Tokenomics, are the biggest upgrade between legacy and digital financial markets. At their core, tokenomics are direct methods for companies to align incentives between investors and issuers. Crypto’s uncertain regulatory environment, and casual blurring of the lines between social and financial, has created a variety of different token use cases.
The simplest tokens are referred to as ‘governance tokens’, which refers to their sole use case voting on protocol decisions. While these votes are sometimes worth a lot of money, more often than not these tokens are communally considered to be proxies for ‘stock’, despite carrying few of the rights granted to shareholders.
Lack of clearly defined best-practice creates a Catch-22 for established companies. Many of the largest, blue-chip projects (Aave, Uniswap, etc…) weren’t founded with token economics in mind. This puts them at a disadvantage relative to newer projects, which have created more thoughtful token synergies and value accrual. However, the lack of regulatory clarity, exploit risk from new tokenomic models, and greater visibility of these firms keeps them trapped in the status quo.
More recently, there have been two major movements in tokenomics bringing value to holders. The first, known as ‘real yield’, is focused on converting organic on-chain activity into sustainable yield for holders. A great example of this in work is GMX, which converts decentralized crypto trading activity on the platform into ETH rewards.
The second movement is focused on creating utility and demand for the token through integrating it into platform operations (and therefore growth). Another decentralized trading protocol, dYdX, has recently launched an upgrade to accomplish this. Their token, DYDX, must be staked to validate their Cosmos blockchain. Stakers will also be able to run an off-chain order book, allowing them to extract arbitrage opportunities in the blocks they submit. This creates a fundamental baseline value for DYDX, based on the volume of arbitrage available in each block for market makers. Similar designs include FRAX, which burns its governance token, FXS, as new stablecoins are minted.
At the very least, it is quickly apparent that even among companies with almost identical aims, completely different value accrual methods cause inconsistency around modeling. A great example of this are dYdX and GMX, mentioned above, which are both focused on decentralized perp trading, but utilize completely different strategies for driving investor value.
This creates a few different sector-based relative value trading opportunities:
- The first is to compare projects on the same blockchain, allowing investors to arbitrage differences on the protocol or sector level, but avoid exposure to any differences in blockchain technology that could affect performance.
- The second method compares projects in the same sector across blockchains. There are two different potential goals here. One may be to compare similar projects across blockchains, based on a belief that one chain has a relative advantage over the other in that sector. That would cause an outperformance of the protocol relative to the other, despite similar fundamentals. Alternatively, due to the open source nature of crypto, projects are often ‘forked’, leading to identical codebase projects with completely different teams. This creates an opportunity to arbitrage mispricing that ignores large moats surrounding project teams, upgradability, or other idiosyncratic factors.
- The final method compares blockchains fundamentally, based on beliefs around throughput, scalability, or user/company uptake. Comparisons based on blockchains typically have different factors, so I’d recommend some supplemental reading on validation, security, and staking for PoS.
As regulation, institutional uptake, market maturity, and macro all normalize, projects will likely begin to trade closer to fundamentals. As such, understanding the drivers of sectors, tokenomics, and blockchains will grow increasingly important.
This report is for informational purposes only and is not investment or trading advice. The views and opinions expressed in this report are exclusively those of the author, and do not necessarily reflect the views or positions of The TIE Inc. The Author may be holding the cryptocurrencies or using the strategies mentioned in this report. You are fully responsible for any decisions you make; the TIE Inc. is not liable for any loss or damage caused by reliance on information provided. For investment advice, please consult a registered investment advisor.