A quick look at market structure in crypto
Photo by Alain Pham on Unsplash
We’ve always been of the view that an understanding of market structure, especially of the participants in a specific market, is critical to mapping out as best we can the possible outcomes that may materialise.
In the world of equities, we have sought understanding of how the confluence of passive flows (primarily from the dominance of ETFs in receiving and deploying inflows), increased options activity, dealer hedging partly as a function of regulatory restrictions on warehousing risk and a burgeoning retail investor cohort has upended the long-held view of fundamentals being the primary driver of price action.
Understanding that it is very much a case of the tail wagging the dog is a critical eye-opener, giving context to market price action that would otherwise be simply labelled as “market irrationality”. It turns out that there is never “irrationality” – every decision that a market participant takes is rational to his/her own mind. As a whole, the aggregate outcome is strongly influenced by whichever form of “rationality” is dominant.
To the external observer, ignorance of this fluid definition of rationality leads to exasperation when trying to fit empirical observations into the framework of a flawed theory. Ultimately, the old adage, oft-forgotten, that one should be playing the players, not necessarily the game, holds true – and especially so in markets where emotions of fear and greed tend to run amok.
As we delved ever more deeply into the world of crypto, this same question about the nature of market structure inadvertently came up: is crypto just another asset class, in the same market as everything else? Or is it a completely different realm in itself?
The answer, not surprisingly, was the same: it was once again a matter of working out who the participants were.
If the participants were the same as in traditional finance, then crypto would be just another asset class to be rotated in and out of. But if the participants were distinctly different, with starkly different views and perspectives, then we’re looking at a completely separate market.
As it stands, we’re somewhere in between.
Institutional overlap? Not really.
When we think about “institutions” in finance, the stereotype on which our mental models are usually constructed is that of a gargantuan asset manager of global repute, with armies of analysts supporting a portfolio of hundreds of investment funds and billions of dollars in assets under management entrusted to them by customers all around the world. These customers may be other institutions, including pension funds and endowments, but ultimately, we’re talking about huge, well-established organisations with a reputation for stability, reliability and (allegedly) low risk.
Reasonable returns? Maybe. But reputationally, the risks are low. Their selling point is credibility built over decades or even centuries, as organisations, and in many cases, the mentality is one of “if it ain’t broken, don’t fix it.”
So just think for a moment – does this sound like the average crypto institution?
To be completely honest, this sounds like the exact antithesis of the ideology that crypto proclaims. Not only is the world of crypto a highly motivated profit-seeking machine whose primary aim is to make as much money as possible, it is also fundamentally anti-establishment. Its motto, very much like the early incarnations of today’s tech giants, is much more likely to be “If it ain’t broken, break it.”
This is not to say that there are no “institutions” in crypto. By the broadest definitions of what an “institution” is, for example a hedge fund or a VC fund, there are a good number of crypto institutions. But these institutions bear very little overlap with the “institutions” we are used to seeing in the traditional world. Crypto fund managers, VC or hedge fund alike, often bear little resemblance to their traditional finance (aka “tradfi”) counterparts.
As we previously wrote, most “crypto institutions” were started by individuals who created their wealth within the world of crypto itself, whether by building and launching their own projects, by backing the right projects that won over time or by good trading. As opposed to the “asset gathering” model that a tradfi institution would use (salespeople, distribution, advertising, gathering etc), the typical crypto fund is fronted by principals whose own capital make up the bulk of their fund assets.
No surprise then that this capital follows a very different modus operandi. This isn’t capital that needs to tick boxes and stay in the safe zone. On the contrary, this is capital that is as risk-seeking as a VC but as nimble as a hedge fund, a stark difference from the stereotypical private bank or mutual fund.
It is pretty clear then that the label of being “institutional” in crypto is very different to what a tradfi “institution” would be. As far as we can see (for now), the only overlapping area is BTC and ETH, which are behaving much more like a high-beta stock (much like growth tech or commodities) and displaying more frequent bouts of correlation to traditional markets, than other crypto names.
Different players, different eyes, different view
As a result, while macro issues like inflation and rates may have discernible effects on BTC and, to a smaller extent, ETH, those effects largely wear off when it comes to the rest of the crypto space. Of course, policies like central bank QE do impact market participant behaviour through the availability of credit, but for a native crypto investor, it has a much smaller bearing in active decision making.
However, it does have an impact on tradfi asset allocation decisions, since lower rates directly impact the performance of a textbook tradfi 60/40 bonds/equities portfolio, and effectively impact all segments of a traditional asset allocation decision palette. Furthermore, having missed out on the explosive performance in the crypto space over the past few years, tradfi funds – including top level asset allocators – want a piece of the crypto action.
The problem? A lack of expertise from the tradfi side of things, and an unwillingness to rock the boat, especially when it comes to working creatively to accommodate the self-custodial, decentralised and permissionless nature of crypto assets.
The solution? Hand it to those who know how to do it, and allocate capital to crypto-native funds on a long-term structural basis. We’re talking real money here, rather than “hot money” that comes and goes on a whim.
The result? Structural inflows into crypto VCs and hedge funds coming from traditional allocators like pension funds and endowments, deployed into the market in a manner that is more consistent with the opportunistic, actively managed ethos of a “crypto OG” than the comparatively bureaucratic, systematic approach of traditional allocators.
Furthermore, the structural growth narrative within crypto can even be said to be dominant to the point of overpowering some of the broader macro linkages that we expect to usually apply. While the average Wall Street denizen would watch, for example, inflation numbers and central bank commentary like the utterings of the almighty, the average crypto institution would likely be more focused on identifying potential hundred-bagger projects to deploy capital to.
To this point, again contrary to the narrative often peddled about crypto being an enormous casino, the fact that a crypto fund looks straight through to projects’ growth prospects – it’s fundamentals – rather than worrying about matching benchmarks and minimising tracking error vs MSCI indices makes the case that if anything, crypto is MORE driven by fundamentals than the multi-faceted markets for stocks, bonds, FX and other traditional instruments which find themselves driven by decision making unrelated to any fundamentals at all (e.g. exposure hedging because a risk policy says so).
Ultimately, we can call it differences in growth stage, or a difference in mentality, perspective or priorities. Whatever reasoning we invoke, the result is that even though there are “institutions” in the crypto space in the absolute sense of the word, they are very different from what we’re used to in traditional assets. They respond to different triggers, look out for different criteria and operate generally on a different frequency.
Free for all
In our view, therefore, it is largely safe to say that the crypto markets generally operate on a different plane from traditional markets. Yes, there are occasional bouts of correlation, especially when it comes to the general market mood shifting to risk-off mode.
At the institutional level, the overlap of mentalities and moods is arguably confined to the likes of “mainstream” crypto assets like BTC and ETH. There are multiple exchange-traded products that track BTC and ETH, as well as derivatives traded on both tradfi exchanges like the CME and crypto-native exchanges like Deribit, FTX and Binance.
Over time, we would expect BTC and ETH, as the flagbearers for the crypto space, to become ever more correlated with the rest of the traditional markets. The challenge eventually becomes to continue to find new high-quality, crypto-native assets that allow us to express the structural view on crypto’s potential.
In terms of headcount, too, many traders have moved over from the trading floors of Wall Street (especially from FX desks) to trade BTC, ETH and other major crypto pairs as if they were an FX instrument.
No surprise then that there’s an overlap in mentality and thinking on that front.
But even more so than the minor institutional overlap is the retail overlap.
Crypto, for better or for worse, is an asset class that started out as more accessible to retail and individual traders than to institutions. As we’ve written before, crypto was built for the individual: permissionless access to early-stage projects with huge trading liquidity.
Where “retail” was often used in a derogatory sense in the past, to believe that remains the case now is a dangerous fallacy. Retail participants have demonstrated that they can hold sway over huge swathes of even traditional stock markets where the institutional players traditionally held court: Tesla, Gamestop and other “meme stonks” are more than enough evidence that “Retail” is not to be trifled with.
This same cohort, unconstrained by investment mandates and risk limits, also enjoy the freedom of moving between the equities markets (including the options markets) and crypto. Add to this the inevitable excitement that sexy growth narratives offer of sending prices “to the moon”, and one can hardly be surprised that changes in the mood within certain segments of the equities space, for example, do flow over into crypto.
Correlated, but not completely
For the sake of completeness, it is probably worth mentioning that a lot of the “automatic stabilisers” that exist in the equity markets, like a standing passive bid on index names and the monthly vanna/charm hedge unwinds on gargantuan S&P index hedges (and their accompanying gamma effects) are much less pronounced in the world of crypto.
There are huge inflows, but these inflows are going to actively managed crypto funds, not tracker ETFs; and while there’s a huge options market in play, there isn’t a comparable dynamic of constantly renewed hedges (long puts, short calls) which power the vanna/charm effects that come and go monthly, which for the most part stabilise volatility in markets through their gamma effects. The options world in crypto is much more similar to the options market for midcap growth stocks than that of index megacaps – no surprise then at the nature of price action.
Ultimately, no asset exists in a vacuum, especially not one that is as geared to growth as crypto is. Certainly not in a world as interlinked as it is now.
But as we’ve written time and again, it is only through looking at the structure of markets and understanding the nature of its participants that we can get a better idea of how to weight the relative importance of different drivers: fundamental, macro, positioning, asset flows etc.
It isn’t a case of suggesting any of these are invalid – they are extremely important when conducting research on any prospective opportunity. But without the context of market structure and its constantly evolving state, we won’t be able to understand how important each of these factors are relative to each other on a forward-looking basis.
Focusing on the wrong thing is arguably the fastest way to be right, and yet lose money.