Translation: Blockchain in Vernacular
If you have traded or invested in the crypto markets over the past 12 months, you will notice a common theme: divergence in altcoin performance. In other words, the market has become more mature, the number of altcoins has surged, while the total amount of capital purchasing these altcoins has remained roughly the same or slightly decreased. These factors combined make altcoin selection a critical factor in success in the crypto markets.
We recently highlighted that crypto markets favor active strategies, and that pure “buy and hold” often does not lead to significant excess returns. With Bitcoin or Ethereum, anyone can now easily acquire it. If you are not going to compete with Citadel and Jane Street, your advantage should be focused on on-chain altcoins, choosing those areas that are easiest for market participants to enter.
A side note: Ethereum ETFs have been lackluster so far. We believe that the inherent reflexivity of crypto markets is not lost with the existence of ETFs. Broad market demand for risk assets (like crypto) will positively impact ETF inflows, while a sharp sell-off in Bitcoin will negatively impact ETF inflows. In simple terms: you will see a surge in inflows at market highs, just as interest in crypto increases as prices rise. There may be some continued institutional buying at value prices (especially Bitcoin), but retail inflows will react to reflexive price increases, as they have in past cycles.
In today’s article, we want to provide DeFi readers with some framework for analyzing and investing/trading altcoins. Note that for today’s article only, when we talk about altcoins, we exclude “MemeCoin” because MemeCoin has a completely different framework/approach that we will not discuss here.
1. Understanding the altcoin market
Altcoins are tokens that are part of an underlying protocol, application, or other crypto project. Typically, these tokens are transferable and tradable. On-chain tokens utilize liquidity pools to enable trading, and a portion of these tokens are listed on exchanges, usually due to size/volume or to pay exchange listing fees.
1) Altcoin life cycle
Understanding the creation process and owners of the token is key to understanding altcoins. Are there venture capitalists and angel investors holding large profits and entering the market in a weak market, waiting for a small exit opportunity? This may mean either abandoning the token or looking for a short-term opportunity.
An early investor base is critical to a token’s success. The valuation of a token at launch (i.e. what price you can get the token for) will be significantly affected by the market in which the token is issued.
Tokens usually come from the private market (venture capital, angel investment, private pre-sale, etc.) or are directly launched on the public market (on-chain private issuance, public pre-sale, ICO, farm, etc.).
Private market deals involving venture capitalists and angel investors are often executed in the form of SAFE + token subscription rights, or SAFTs, which provide investors with a pro-rata token allocation at a future (usually undetermined) date. Like traditional startups, investors provide funds to crypto projects at a defined valuation to receive a stake. Then at a later date, the project distributes the token supply to various stakeholders and launches to the public. This is the on-chain version of a "IPO."
The following is the token distribution using the Ethereum L2 zkSync token as an example:
Source: ZK Nation
Tokens held by teams and investors almost always come with a vesting period, especially in legitimate projects. In the case of zkSync, both team and investor tokens had a one-year lockup period (during which they could not be sold), followed by a three-year linear vesting period (0.82% unlocked per month). zkSync was founded in 2019, which means it took up to nine years from the launch of the project until the tokens were fully unlocked. In contrast, airdrop recipients get their tokens immediately, and in the case of zkSync, it was a fairly generous airdrop considering the size of the project.
So why is this information important? All the investors who invested venture capital and the team members who worked so hard for the company will eventually need to sell these tokens to realize the value of their equity. Understanding these "unlock schedules" and their impact on token prices is critical for long-term trading.
Once a token moves from private markets to public markets, it becomes widely accessible to every type of investor and trader.
2) Dumpy’s Law
Without a strong narrative and frenzied buyers on the other side, tokens tend to decline over long time horizons as teams and private investors sell tokens and public market demand wanes. Even in the best of cases, altcoins tend to perform similarly to majors, doing well on a USD basis but not necessarily outperforming Bitcoin over multi-year time horizons. Therefore, it is critical to enter token markets at the right valuation and ride on periods of outperformance (which can sometimes be quite extreme).
Teams often sell equity through the secondary market before tokens are issued, and may also sell locked tokens "over-the-counter" at a discount. This means that these team tokens may be sold on the market by non-team participants.
The most conservative approach is to follow what we call “Dumpy’s Law”.
Dumpy’s Law states that any token that can be dumped will eventually be dumped. If you follow Dumpy’s Law, you can get an idea of the supply the market needs to absorb. The price (or expected price) of the token and the supply unlock schedule will tell you how many new tokens are likely to be sold and over what time period. The overall context of the market (i.e. uptrend vs. downtrend, trading volume, narrative sentiment, etc.) can help you assess whether the market is ready to absorb that supply.
2. Public Markets (i.e. “Liquid Tokens”)
This is the area of the crypto market that retail participants have the most access to. It is also where all other participants look for “exit liquidity,” making it an extremely competitive market with huge potential for profit and loss.
Liquid fungible tokens can be traded by anyone on decentralized exchanges (DEX). Altcoins trade based on a combination of narrative, fundamental catalysts, and technical/market drivers.
1) Narrative
Narratives are developed by bullish price action in specific coins. For example, memecoins have outperformed all other categories over the past 6 months or so. The growth of coins like PEPE and WIF from small market caps to multi-billion dollar, coupled with the past success of mega-coins like DOGE and SHIB, solidifies the memecoin narrative.
During this time, tokens in the DeFi, Infrastructure, and other technology categories have underperformed (we believe these tokens have bottomed now). As technology tokens like Aave and Sui have outperformed over the past month or so, the dominant narrative and focus among traders has shifted. Whether or not this performance is organic is immaterial. What we do know is that market participants typically focus on tokens that are rising with liquidity and volume. The price performance of a token strongly influences not only its own demand, but also the demand for tokens in its category and adjacent categories.
In other words, AAVE is outperforming UNI, CRV, and other DeFi tokens, and vice versa. SUI's outperformance (if sustained) is good for other alt-L1 tokens and SUI ecosystem tokens. PEPE and WIF's outperformance is good for memecoins. This trend encourages venture capital firms, liquidity funds, market makers, and other well-funded market participants to invest heavily in a certain category of tokens to benefit from it. Crypto venture capital firms can't just explain to investors that the crypto future they are selling is memecoins. This is one of the fundamental reasons why altcoins may outperform again. Otherwise, it will be a serious blow to the crypto investment management business!
2) Management of information asymmetry
In crypto markets, attention and information flows drive decisions, and sometimes a single tweet is enough to change the perception of a certain coin/narrative. New investors may be confused by unexpected reactions of certain coins (e.g., after a coin has been rising for several days, some bullish news is announced and it is sold off). Managing and exploiting information asymmetry in altcoins is a risk, but also an opportunity that can be turned into an advantage.
Below is a graphic we created to help you visualize the challenges you face. This is part of our framework for altcoins and should be helpful whether your strategy is trading, investing, narratives and catalysts, etc.
Illustration Description:
Imagine a piece of information that is developing, such as a partnership for a project or a new product launch. This piece of information flows from the inner circle to the outer circle.
Core Team: These are the people responsible for building the project. It goes without saying that the core team of a project is often the source of news and data, as they are the “root cause” of change. It’s unlikely that you know the market better than the core team, but it’s helpful to understand their incentives and track record.
Venture Capitalists, Angel Investors, Other Employees, and Third-Party Vendors: This information is passed on to private investors and others who work with the core team, such as marketers and influencers. In the course of business, the core team will often share important product updates and events with this group. “Dumpy’s Law” often applies here.
Inner Circle of Friends and Acquaintances: Once information enters this layer, it may attract market attention. Participants outside the insider circle are less likely to have free tokens to sell and will position around good news. Market activity at this layer can provide useful information, although it is not always easy to find. In more competitive market conditions, even the market reaction at this layer may be weak and become exit liquidity.
Informed Participants: This is the layer that turns information into large-scale buying and selling. Informed participants look for arbitrage opportunities, bid on tokens, shape the market narrative, and profit in the process. They know enough about the inner workings of the crypto industry to gain an advantage even if they are not the first to know something.
Uninformed Participants: This is where everyone starts, but (hopefully) doesn’t stay for too long. If you’re new to crypto, you’re in this group, even if you don’t consider yourself so. These people wait for “Twitter influencers” to tell them when to buy and sell, while lacking independent critical thinking.
Note that this flowchart is dynamic - you may flow between different tiers depending on your situation. This is why we recommend that new entrants focus on a specific area of crypto (such as DeFi) and then gradually expand. While you are still an unknown participant, it is almost always better not to invest or trade, but to reduce your active risk and work towards becoming an informed participant.
If you understand where you are on the information flow spectrum, you will have a clearer idea of the risk you are willing to take. Hard information that can move the market often leaves you very little time, so if you are close enough to this information, you can make more money. For example, the announcement of the ETH ETF is a good example, and ETH rose nearly 20% in a few minutes. Even after such a big announcement, you only have about 5 minutes to make a layout! Although this is not a long time, it is still much slower than traditional financial markets.
You can also analyze around each layer's objectives (buy/sell/hold), time frames, and use this information to guide your decision making.
3. Don’t fight Bitcoin
The crypto equivalent of “don’t fight the Fed” is “don’t fight Bitcoin.” While altcoins can selectively outperform in times of market distress, their performance will eventually exhaust themselves as market participants de-risk or lose capital. Despite the maturity of the crypto market, the altcoin market remains highly correlated to Bitcoin. In fact, in the current market environment, you could probably earn the returns of altcoins simply by trading Bitcoin at 2-3x leverage (we don’t recommend leveraged trading - just for reference).
However, in 2024, there have been multiple instances where huge excess returns can be obtained by buying on-chain coins (mainly memecoins). This is why it is still important to keep an eye on altcoins. When altcoins rise, they are able to bring returns of more than 100% in a short period of time.
Scalability considerations
For investors with larger capital (such as our paid subscribers), scalability is a key consideration. It is very difficult to move $50K+ in and out of small or medium-cap memecoins, mainly due to slippage and the impact on holder sentiment. If you operate with larger funds, you will want to focus on coins with much higher liquidity than the average. This is one of the reasons why we think the altcoin market will continue to thrive - large funds and funds also need a place to operate.
