Crypto Investors: Why You Need to Understand Layer 1 Protocols

As we discussed last week, the first quarter was a great time for cryptocurrency prices, but a terrible time for sentiment about the industry. I’d like to expound on the latter point, given that crypto is clearly in the crosshairs of regulators and politicians – including some who seem to not want this sector to exist at all.

Sen. Elizabeth Warren’s (D-Mass.) tweet about building an “anti-crypto army” is one of the more pronounced indications of that sentiment. CoinDesk has actually seen fit to recently post two editorials regarding the federal government’s crackdown on crypto and the Biden administration’s politicizing of it. I’ve voiced my own belief that bad actors, not the asset, should be the target.

But instead of critiquing the critics, I’d rather talk about what drew me into crypto, which is illustrative. My initial interest in 2018 was based on speculative interest, which may be dirty words to many. Why is speculation spoken of in the pejorative? I don’t know anyone who deploys capital with the expectation that it will decrease in value. If you are that person, feel free to just pass your asset on to me and I can hold onto it for you.

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Here are the questions I asked myself when crypto got on my radar:

• “What is this new thing that I’m hearing about?”
• “What does it do?”
• “How can I learn more about it?”

Intellectual curiosity, the desire to generate wealth and a goal to increase my knowledge of a nascent technology led me to bitcoin (BTC). In hindsight, though, it wasn’t just bitcoin. It was the concept of layer 1 blockchains, because ultimately that’s what we are accessing: space on a blockchain.

The value of a layer 1, or L1, network comes from people conducting peer-to-peer transactions with that blockchain. The native token of any given blockchain – BTC in the case of Bitcoin – acts as an incentive mechanism to get people to ensure that the data stored on the blockchain is secure and accurate.

The value is especially relevant in areas of the world where central bankers have caused local currencies to hyperinflate. One of the mistakes being made by U.S. lawmakers and regulators is looking at cryptocurrencies from a U.S.-centric perspective only.

It appears regulators don’t care about the functionality or reliability of blockchains, especially as some of the loudest opponents of crypto are in favor of central bank digital currencies – a type of digital currency issued by a central bank. The animosity feels more related to the decentralized nature of crypto – the ability to take fiat currency and exchange it for another asset of value, without the need for a central body (central banks, regulators, politicians, conventional banks, etc.).

Here are some of the larger layer 1 protocols and their recent performance:

The performance runs the gamut from impressive to anything but, which is how it probably should be. On a technical level, BTC is correlated most to ether (ETH), the second-largest cryptocurrency after bitcoin, with its lowest correlation being to crypto exchange Binance’s BNB token.

What I find intriguing about layer 1s is the nuance that exists between them. As one L1 comes into existence, another attempts to improve upon it on the basis of speed, scalability, etc. For instance, I am admittedly anchored to Bitcoin. Its foundation as a peer-to-peer network gives it a first-mover advantage and the largest market share.

The ability to develop smart contracts on top of the Ethereum blockchain, where predetermined conditions are met and executed via code, is another facet that I find value in.

In many ways, crypto forces someone focused on assets and prices to level up on technology, while the tech-focused person is incentivized to get up to speed on market dynamics. The discipline of tech and the discipline of assets are pulled together, much in the way that code links tasks within a smart contract.

In my own experience, doing so caused me to uncover differences between blockchains. For example, Avalanche uses a “heterogeneous network of blockchains.” Rather than all applications occurring in one blockchain, Avalanche uses an Exchange (“X”) Chain, Platform (“P”) Chain and Contract (“C”) Chain. In doing so, the goal is to increase scalability and reduce fees, things the Ethereum blockchain has struggled with.

Asset ownership is important. It makes little to no sense to ignore a burgeoning technology, unless you want to be completely left behind. If people can engage in peer-to-peer transactions while having complete confidence in their accuracy, and not having to compensate a third party, they will do so.

L1s are at the base of the crypto economy and should be understood and be used as a base network for applications. And, yes, sometimes even used to generate a profit, as well.

Takeaways

From CoinDesk’s Nick Baker, here’s some recent news worth reading:

• THAT DOG: Sometimes crypto is about high-minded principles like breaking down barriers that keep many out of traditional banking or replacing obviously needlessly complex processes with more efficient smart contracts. And sometimes it’s about Elon Musk doing whatever he’s doing with dogecoin? That includes this week! Musk swapped out Twitter’s iconic bird logo for DOGE’s dog mascot, and DOGE’s price soared to a many-month high. This is not the kind of attention many in crypto want …
• BITCOIN VIX: The VIX is well-known in traditional finance (TradFi) circles as a measure of the degree of fear in markets. In reality, it’s not exactly that; it simply reports what the implied volatility is for S&P 500 options. It doesn’t have to rise when worry is plentiful, though that is often what it does. There’s something resembling it in crypto: Deribit’s DVOL, which measures bitcoin’s implied volatility. It has soared this year while bitcoin has, too. Fear is not plentiful with BTC, and yet DVOL is up, flipping what’s expected of “fear gauges.” CoinDesk’s Omkar Godbole spoke with experts who think that’s made bitcoin call options more attractive than ever.
• GETTING RICH: If you haven’t been paying attention to crypto prices but have been paying attention to what U.S. regulators are doing to the industry, you’d be forgiven for suspecting the prices of bitcoin and the rest of digital assets have been shooting straight toward zero. And yet they have not. Bitcoin has zoomed higher to start 2023, and the industry’s market capitalization has just hit a new high: $1.19 trillion, a level last seen in June. Markets can be weird.
• AN EDITORIAL: CoinDesk generally doesn’t take a position on issues, preferring to cover the news straight and let readers decide what to think. We just made an exception, in an editorial written by Editor-in-Chief Kevin Reynolds. The U.S., he argues, is giving off vibes of being completely against crypto, which Reynolds argues risks sending a vital industry overseas without actually protecting investors.

To hear more analysis, click here for CoinDesk’s “Markets Daily Crypto Roundup” podcast.