Dec 2022#MarketResearch

Market cap down 30%, user outflow, and a trust crisis: what Layer-1 & 2 executives are saying

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Authors

Marat Gizatullin

Marat Gizatullin

Analyst, R&D

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14 min

Context

The current stage of the bear market began in Q1 or Q2 2022. According to Grayscale, the downtrend was originally predicted to end between November and December 2022, but the market kept falling because of the FTX collapse. 
In a recently published study, the top executives of a large range crypto projects named infrastructural projects as the safest for investors having the biggest growth potential at the moment. 
The core of this group of projects are Layer-1 and Layer-2 chains, as well as bridges. They provide an infrastructure for the the developers of user-facing crypto apps, and the conditions in this niche will largely dictate the future size and dynamics of the crypto market as a whole. 
In order to understand the sentiment in the infrastructural niche, we conducted a series of interviews with their executives and analyzed the publicly available data on the subject. 

Market overview

As of December 2022, the crypto industry’s total market cap was down 20% compared to November 2022, before CoinDesk published its now-famous now-famous article on FTX. 
Analyzing project dynamics over the course of 6 months, we see a decrease in market caps and trading volumes in virtually every market niche.

The combined market cap of Bitcoin and Ethereum dropped by 12%. Interestingly, Layer-2s have experienced the smallest decline so far: only -5%. For the rest of Layer-1 chains (except for BTC and ETH), it amounts to 37%, while for bridges it’s a staggering 42%.

By the end of December, the overall market cap of these three niches was $47.3 billion. Out of these, L1 solutions accounted for 80%, while L2s and bridging solutions fell by 20%.


Current challenges and solutions


According to BDC’s respondents, the current negative sentiment and volatility are largely caused by the speculative actions by many market players. The events of November and December 2022 led to a chain reaction: a mass user outflow caused a lack of liquidity, which, in turn, can make users leave, and so on.

“There is less, less demand on the market and less new projects coming, less investment in projects. So you really need to search for them. It's not just like, yeah, okay, we have a great game. Yeah, we will raise 2 million and we can start developing it. ow, this process is a bit longer, it takes a bit more effort. So there are less projects coming up to build it.”
Gasper Stih, CMO at Ternoa (Layer 1)


The interviewees also named several reasons that lead to this situation.

Project-related reasons

  • Weak vlue proposition;
  • Limited use cases;
  • Trying to attract an audience without engagement and retention mechanics.
“The biggest lesson is we should always be building for real world use cases. If not, then we have to think about what a tech stack offers? What does blockchain allow you to do that you may not better do otherwise? Or what does it allow you to to sufficiently be able to do for a real world utility versus what you might be able to do with more centralized models such as  traditional finance.”
Nikhil Raghuveera, Head of Strategy and Innovation at the Celo Foundation (Layer 1)

 

"There is a lack of how crypto can be used. Crypto and blockchain in general is essentially a way to convey self-sovereignty/self-custodianship to certain assets. And by having self-custodianship users get the very powerful means to compose different kinds of assets together and to have or be exposed to the landscape of certain service providers. 
Tokenizing securities, such as equity in a specific business sector, allows for the reconciliation of traditional assets and crypto assets. For example, if you purchase a bond from the Marriott hotel and it is offered in a tokenized form, you are combining a traditional asset (the bond) with a crypto asset. The bond, which represents a financial interest in the Marriott hotel, is independent of the value of the crypto asset and will continue to generate yield through the operations of the hotel, even if the crypto asset experiences a decline in value or is subject to a hack. In this way, tokenization allows for the merging of these assets, enabling investors to potentially benefit from both the stability of traditional assets and the potential growth opportunities offered by crypto assets."
Emanuele Francioni, Founder, Director and Tech Lead at Dusk.Network (Layer 1)

 

“There is a crisis of ideas in the crypto market right now. Compared to DeFi-spring, when there were a lot of projects, a lot of experiments with different blockchains. There is no such thing now. It hurts because there is no new trend.”
Andriy Veliky, CEO at Allbridge (Bridge)

As a solution to these challengers, the speakers named business process optimization and a long-term strategy, which involves:

  • Implementing internal security audits
  • Strengthening partnerships with developers and investors
  • Building a new value proposition oriented on useful and actionable use cases.  

User behavior-related challenges

  • A low level of UX and of the Web3 integration into daily life. 
"How many people are using Web3 applications regularly and constantly? Until we solve this sort of user experience problem I think it will be really hard to onboard users. Our friends and parents are not currently using these tools if they are not confident using them. It's not enough that it just works. They have to actually feel confident. Because ultimately they are transacting potentially large sums of their assets. That is something people want to feel confident in. As much as they need to feel that that is secured."
Adam Simmons, CSO (a core developer behind the Radix Network) at RDX Works (Layer and Bridge solution)
  • Loss of user trust
“The project should be transparent, auditable, the user should always understand and be able to check what is happening with the operating capital of the company in general and with his personal liquidity in particular.”
Rostyslav Shvets, CEO at Stroom (Layer 2 and Bridge solution)

 

"I think one of the biggest challenges is the lack of regulatory clarity. In some ways what's happening with FTX will help improve that. Because there is the recognition that regulators either haven’t paid enough attention or haven't been prescriptive in terms of the guidance that they’ve given this industry. And so the industry has just moved forward and continued to build without detailed guidance."
Zenobia Godschalk, SVP at Swirlds Labs, focused on growing the Hedera ecosystem (Layer 1)

As a solution, the speakers suggested working on blockchain adoption in business and among the general public. Many of the speakers named an increase in user numbers as the result of their own work building user-friendly products and interfaces. 

Market-related reasons

  • New attack vectors, new scams, databases getting compromised, etc. 
"Many small PoS blockchains, including those that rented computing power, were attacked 51."
Andriy Veliky, CEO at Allbridge (Bridge)

 

"You have the user's wallet and smart-contract. The user sends a token and the token is sent back to the user's wallet. The user's wallet is a private key and has an associated balance . So basically messages signed with this private key gives the pool that you've interacting with permission to balance the token. The messages are sent between different smart contracts to update balances of the token. This is a relatively complex solution. You actually give blank permission to smart-contract to do whatever they want. When you're approving a transaction how do you know you're approving the right amount? You actually have to trust the UI. All of those things make it very difficult for developers to build intuitive and secure decentralized applications because of the amount of surface area and exploits and attacks possible."
Adam Simmons, CSO (a core developer behind the Radix Network) at RDX Works (Layer and Bridge solution)

 

"17% of top hacks are bridges. It has not been solved yet. Bridge hacks are especially important because if we use this current paradigm of bridges locking some assets on one side and minting on the other side. We all saw what happened with the hack on wrapped ETH on Solana. I think it was $130M. The whole wrapped ETH on Solana would be worthless and it would be a systemic risk. So every DeFi protocol that uses these wrapped assets will be in trouble. Another example is Nomad when it was hacked with a synthetic asset being worthless."
Georgios Gontikas, Product & Research at ChainSafe Systems (Layer 1)

Projects offering Bridge solutions have been frequently attacked over the past year. If you are building a cross-chain solution, this is a kind of red flag for investors, everyone sees huge risks in this, first of all, behind which it is not always possible to see the value of the project.
Rostyslav Shvets, CEO at Stroom (Layer 2 and Bridge solution)

  • Manipulating investor expectations, reckless asset management practices;
  • Absence of a clear and innovative crypto legislation.
“It is a challenge to make sure that the regulators do things efficiently but also thoughtfully. You don't want everybody to get painted with the same broad brush of what happened with FTX. You want to make sure that they are educated and that they understand the industry and they understand the potential implications of any kind of regulation. And so therefore they are able to be thoughtful about the kinds of regulation they will implement.”
Zenobia Godschalk, SVP at Swirlds Labs, focused on growing the Hedera ecosystem (Layer 1)

 

“I can say that regulatory change has been needed for some time, and this will, to some degree, influence the evolution of the cryptoasset and wider markets.”
Michael Charles Borrelli, COO at Convex Foundation (Layer 1)

 

"The biggest challenge for crypto is bad regulation, right? I want good regulation.
A good regulation will not use the laws that were created 100 years ago to regulate something so modern as crypto. A good regulation won't prevent innovation. A good regulation will preserve privacy and sovereignty and decentralization."
Greg Osuri, CEO at Akash.Network (Layer 1)

The respondents said that overcoming these challenges requires strengthening decentralization (both of projects and of the technology as a whole), as well as increasing projects’ transparency.

Plans and development strategies

Product features: development and expansion

All the interviewees mentioned that their highest priority is developing their respective products and adding new features. For some projects this mean expanding the core functionality, while for others it’s more about enhancing security and infrastructure. Development was described as a long-term process, the result of which is a product that ensures safe, private, and decentralized transactions. 

Partnerships

The second priority for the respondents was developing partnerships. Like development, it is seen as a long-term strategy. Projects wish to attract both B2C and B2B partners (the latter being more important). Developers and startups can use the provided infrastructure to expand on the underlying architecture. 

"We are typically targeting application developers. As a layer 1, we're targeting developers at both enterprises as well as at sort of startups and new projects and new architects."
Zenobia Godschalk, SVP at Swirlds Labs, focused on growing the Hedera ecosystem (Layer 1)

L1s and L2s working with B2B and B2C differently. B2B startups are interested in business models and performance metrics, while B2C teams prioritize transparency and a long-term roadmap.

“For B2B you need to be factual, data-oriented, and provide to partners what are the costs and opportunities. For B2C it is more important to provide a roadmap. The description of future endeavors and intent. Nobody is looking at what the platform is doing right now, but what the platform will be able to do in the medium or long term in the future.”
Georgios Gontikas, Product & Research at ChainSafe Systems (Layer 1)

The key partnership development tools are:

  • AMO sessions and community support;
  • Direct search for development partners;
  • Incubators, hackathons, grants;
  • Creating and maintaining a DAO. 

Product security

Security was a major topic for the interviewees. Projects’ mid-term strategies focus on maintaining internal security systems and introducing a practice of regular protocol audits. 

Future prospects

Speakers mostly share the opinion that the current market phase will last for at least six more months. However, even a general downturn doesn’t mean that the whole project development strategy has to be changed. Projects still look to hire team members, expand, and keep building. 

“There are many crypto teams that are still hiring.”
Georgios Gontikas, Product & Research at ChainSafe Systems (Layer 1)

 

"We are still hiring. And so I think there's an opportunity for us to recruit some of the best and brightest talent that's been on the market in years. So for us, it's actually pretty exciting."
Zenobia Godschalk, SVP at Swirlds Labs, focused on growing the Hedera ecosystem (Layer 1)

 

"There's no change in our roadmap if anything it's continuing about that. 
In terms of what happened, you know, like with FTX and the contagion effect of that as well as kind of the general market, the main thing we see for us on some of the blockchain specifically is just lowering the token price. We just see that generally. But I think generally across the ecosystem, I don't think it has really affected our roadmap because a lot of projects are about because so many people in our ecosystem are really just building for real world use cases."
Nikhil Raghuveera, Head of Strategy and Innovation at CELO (Layer 1

Promising regions

The respondents noted that the idea of the best GEO doesn’t fully apply to the crypto market with its quest for decentralization.
Almost any project that is building for the long term wishes to expand into and interact with users from multiple regions.
At the same time, there are a few key geographic criteria that projects take into account: 

  1. Legal status of cryptocurrencies: those projects that offer users to invest in various assets, this criteria is crucial (for instance, for EU-registered startups).
  2. Presence of a community for building mutually beneficial partnerships and fundraising: this is important for B2B-oriented projects, as well as for those in an active development stage (e.g. tech hubs in the US or Southeast Asia). 
  3. Financial system: this criteria determines a project’s role in a specific region — when an official financial system is lacking, crypto projects can take up some of the features of traditional finance institutions (North Africa, Central Asia).


Conclusions and insights

  • The average market cap decrease in the past 6 months was 30% for Layers 1 and 2 and bridges. The decrease was the smallest for Layer-2s (-5%).
  • Layer-1 projects account for 80% of the total market cap of L1, L2, and bridges. 
  • The key problem faced by projects is the outflow of users and the liquidity deficit that stems from it. 
  • The liquidity crunch and user outflow have many reasons:
    - Insufficient protocol security and new types of attacks;
    - Exhausting the original list of use cases;
    - No adequate legal base, a crisis of trust;
    - Low level of crypto integration and adaptation.
  • Project geography is contextual it depends on regulators, profressional environment in the region, and on how developed the regional financial system is. 

Tip: it’s preferable to prevent liquidity deficits and user outflows. 

If such a situation occurs, the project should identify all the reasons why users are leaving using feedback forms and direct communication with the community. 

A liquidity crunch can be offset by incentivizing users to join liquidity pools, as well as by onboarding external liquidity providers that already work with one’s partners. 

To prevent a user outfolow, a project needs to consider the tokenomic balance in order to make sure that they will benefit from staying with the project. 

Tip: security is a crucial element in a project’s success. To keep a protocol safe, you need to:

1. Regularly go over the protocol’s security tools and internal data;

2. Conduct penetration tests for possible new attacks and scrutinize the results;

3. Participate in external security audit conferences;

4. Use a bounty campaign to motivate users to look for and resolve vulnerabilities;

5. Educate the users.

Tip: for users to stay, they need to feel sure about the product they are using. To create this certainty, a project needs to:

  • Analyze all incoming feedback;
  • Conduct Q&A sessions;
  • Be very visible in social network: add links to the profiles of various team members;
  • Have a realistic mid-term and long-terms roadmap;
  • Make sure that the roadmap is being followed;
  • Maintain interest in the product and engage users in a dialogue.

 

 


 

 

 

 

 

 

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