Outlook for the third quarter of the encryption market: 9 major catalysts and key projects

Written by: THOR HARTVIGSEN

Compilation: Deep Tide TechFlow

The second quarter was indeed a volatile period for the cryptocurrency market. The market peaked around the middle of the quarter, but the ensuing month and a half was rocked by a string of bad news, including lawsuits against major exchanges and concerns about the decoupling of USDT and TUSD.

Before diving into the upcoming episodes, let's take stock of the protocols that have performed well over the past quarter.

In the DeFi space, several sectors continue to grow and attract organic demand. These include liquidity staking, on-chain perpetual transactions, and more.

Perpetual DEX

In the second quarter of this year, on-chain perpetual exchanges such as dYdX, GMX, and Gains generated a total of $117 million in transaction fees. These products have maintained high usage throughout the bear market. The ability to trade cryptocurrencies, foreign exchange, and other assets on-chain remains one of the most organically in-demand areas of the DeFi space.

The table below compares transaction volume on the largest perpetual agreements in Q1 and Q2.

Total transaction volume was down 8.2% compared to Q1, which isn’t that much of a drop considering the generally bearish environment we experienced in Q2. While dYdX still clearly leads in terms of transaction volume, the protocol has seen a significant drop in market share quarter-to-quarter. The same goes for other "OG" perpetual exchanges like GMX and Gains.

New protocols like Level and Kwenta have seen a lot of growth, and the main reason for this growth is undoubtedly the massive transaction rebates (i.e. native token issuance) offered to traders of the protocols. As these incentives diminish over time, it will be interesting to see whether users will remain on the protocol or jump to other exchanges.

Vertex opened their Arbitrum native exchange to the public in April and has recently seen a huge increase in trading volume. Vertex has yet to launch their native token, so this volume may be generated by airdrop speculators.

Ethereum Liquidity Staking

In the past six months, liquid pledges have grown from roughly $7 billion to over $18 billion. With the total value locked (TVL) in DeFi as a whole remaining at about $45 billion, an inflow of $11 billion is quite impressive.

After the Shanghai hard fork, de-staking was achieved and a large amount of liquidity was attracted in this area. The following is a comparison of some data about pledged assets in the first quarter and the second quarter:

From the first quarter to the second quarter, the projects that benefited the most were Lido, Rocket Pool and Frax Finance. Not only did Lido see inflows of 1.6 million ETH ($3 billion), but the protocol also gained significant market share despite the emergence of new competitors.

Both Rocket Pool and Frax have unique moats that attract new liquidity.

Rocket Pool launched their 8ETH mini pool and Frax Ether consistently offers the highest staking yield due to its dual token model.

Swell launched in the second quarter and also achieved significant TVL. They are currently running a campaign where early depositors can mine the upcoming release of $SWELL tokens. Therefore, some of this new liquidity may come from users wishing to participate in the airdrop.

chain

Below are the financial statements of the largest L1 and L2 blockchains by market capitalization in the cryptocurrency space. The values are interpreted as follows:

• Service fee = transaction fee paid by the user on the chain;
• Revenue = the remaining part of the transaction fee after the verification node obtains its share;
• Profit = Revenue minus Token Emissions.

Ethereum had its best quarter ever in terms of profitability, up more than 300% from the first quarter of the year.

As shown below, in the fourth quarter of 2021, Ethereum generated $4.3 billion in fees, but due to the large amount of ETH released before switching to proof-of-stake, this resulted in largely negative returns.

How would these fee amounts translate into profitability in today's environment?

If Ethereum reaches an average annual fee of $4 billion for the full year, and the profitability ratio is similar to that in the second quarter of 2023, then the annual profit will be about $24 billion, which makes the price-earnings ratio of Ethereum no more than 9.5, considering the current price for $1900.

Arbitrum also generated a significant increase in fees during this period and was one of the few chains with positive profitability. Currently, the profit margin of L2 is quite low, because most of the fees are paid to the validators of the main network.

With the launch of Proto-Danksharding later this year, profit margins are expected to increase as Rollup fees decrease.

Chains such as Solana, Polygon, and Optimism have seen large negative profitability due to massive token issuance to incentivize users and pay validators.

9 Catalysts and Narratives to Watch in Q3

Cryptocurrency is an attention economy. Protocols with product updates and narratives are more likely to attract attention and outperform in the short to medium term. Here are some of the top narratives to keep an eye on.

Bitcoin ETF

The second quarter was very positive for the cryptocurrency market due to the sudden institutional interest in Bitcoin. Companies such as BlackRock and Fidelity have applied for Bitcoin ETFs, and the market generally believes that they have a high probability of being approved. A few days ago, the SEC called the recent filings incomplete, and despite an initial sell-off in the market, prices quickly bounced back as the filings seemed to just require more clarity as to which exchange it plans to use to deliver this product. Many ETFs have been resubmitted, such as the Fidelity Bitcoin ETF that lists Coinbase as the exchange used.

**When is the ETF likely to be approved? **

The deadline for the BlackRock and Ark ETFs is Aug. 12, and while it may be delayed, experts predict the answer is likely to come out on that date.

The market appears to be anticipating approval in August, so a rejection or delay could adversely affect prices. The deadline for the Blackrock ETF is February 23 next year.

Importance of Bitcoin ETF

This is the most important driver of all to watch closely in the coming months. Not only did the Bitcoin ETF give large institutions access to the asset, but it kicked off a bullish period for the entire cryptocurrency market. Other altcoins cannot stage a rally without proper bitcoin price action.

DeFi cannot get new liquidity injections for the same reason. If the ETF is approved later this year, it's not just bitcoin that could benefit. With this in mind, the following catalysts could cause specific assets to outperform in a more optimistic environment:

EIP-4844

You probably already know that EIP-4844 will bring Proto-Danksharding to Ethereum in Q3/Q4. With this implementation, Rollup will be able to send batches of transactions (called blobs) to the Ethereum mainnet, reducing fees on these secondary chains by as much as 20x. Therefore, the main beneficiary will not be the Ethereum mainnet, where fees will not be reduced in the future until full Danksharding is launched, but Rollup chains like Arbitrum and Optimism. $ARB and $OP are trading at much lower prices than they were at the start of the year, and if history repeats itself, they could both bounce back ahead of this event.

Liquidity Staking and LSDfi

As mentioned earlier, liquid staking on Ethereum (ETH) was the fastest growing of the various DeFi sectors in Q2. Here are some deals to keep an eye on in the third quarter:

frxETH - Frax will launch frxETH V2 and the Frax chain later this year, which includes creating a native lending market for LSD, using frxETH as a native Gas token on the chain to increase the annualized rate of return on pledges, and more.

EigenLayer - Eigenlayer has already seen a lot of interest from investors, and with their official launch later this year, there is likely to be a significant injection of liquidity.

swETH - Swell is running a campaign where early users who mint their native LSD swETH can earn "pearls" which can be redeemed for native $SWELL token airdrops. As long as this activity continues, the protocol will likely continue to grow.

ETHx - Stader Labs will launch ETHx on mainnet on July 10th. Its main feature is that it only takes 4 $ETH to run an Ethereum node.

The tremendous growth that the LSD space achieved in the second quarter is unlikely to continue at the same pace in the third quarter. Higher staking ratios and less on-chain activity lead to a general decline in annualized returns. With lower returns, stakers are looking for ways to increase their yield, and this is where the LSDfi protocol comes in. The table below is data from last week's newsletter, showing the current stats for the top LSDfi projects.

Pendle has seen huge gains in liquidity, with its native token $PENDLE up over 100% in the past week, with the most recent high following the announcement of its Binance listing. The Pendle team likes to keep a low profile on new features on the protocol; however, I think it's safe to assume there are a lot of plans for the protocol in Q3. They recently applied for an OP-grant to drive liquidity on Optimism and hinted at a launch on the BNB chain. Cross-chain expansion seems to be close.

LSD-backed stablecoin protocols like Lyra and Raft have also seen significant growth recently. It's clear that there is a demand for this type of product, but it's even more obvious that much of the recent success is due to massive token incentive/airdrop mining. There are already 3+ protocols planning to launch very similar products in the coming weeks/months, so competition for liquidity will undoubtedly increase.

Base (a two-tier expansion solution provided by Coinbase)

Just last week, Coinbase announced that Base passed all security audits and has met 4/5 of the mainnet launch criteria. Base is built on top of the OP-stack, and Optimism's recent Bedrock upgrade has resulted in a significant reduction in transaction costs on both Optimism and OP chains like Base. Now only the condition of "testnet stability" is left, so the mainnet launch will likely happen in the third quarter. Coinbase has over 40 million registered users, many of whom may have never been exposed to DeFi. This is quite possibly one of the most important "Onboard" events of the year. Coinbase may only offer support for mass-tested mainstream protocols like Uniswap, Aave, etc., but having a large retail user base is great for the space as a whole.

Also, this might be a good narrative for $OP as Base will commit a portion of transaction fee revenue to the Optimism treasury.

Frax Chain

Frax Finance has developed various products including $FRAX stablecoin, $FPI price index, Fraxswap, FraxEther, FraxFerry (cross-chain bridge) and more. Frax also announced that they are building a second-layer blockchain based on Ethereum, which aims to unify all these products into a DeFi hub. This is a hybrid Rollup, which means it uses the Optimistic Rollup architecture and utilizes zero-knowledge proofs to achieve state consensus. Its purpose is to provide end users with high scalability, fast determinism, and strong security. The chain is scheduled to launch in Q3/Q4 of this year, but the most important part of the announcement is that frxETH will be the token for transaction fees. This could lead to a substantial increase in the supply of frxETH if there is a demand for new layer 2 solutions. However, more frxETH used to pay Gas fees will also lead to less frxETH being pledged as sfrxETH, which will increase the pledge yield. However, switching to another token to use the chain could be a burden for some users and, at worst, could slow adoption. I was a little skeptical, but generally excitedly anticipating this outcome.

Polygon 2.0

Polygon recently announced "Polygon 2.0," bringing together various innovations the team has built over the past few years. It not only includes Optimistic Rollup like Arbitrum and Optimism, but also combines a cross-chain security mechanism similar to Cosmos. Polygon 2.0 consists of four layers.

• **Staking Layer: **Validators stake MATIC tokens in a similar manner to PoS chains.
• **Interaction layer: ** Shared cross-chain bridges, allowing chains to mint and burn assets on Ethereum in an interoperable manner.
• **Execution layers: **Polygon 2.0 will run two different execution layers.

1. Supernet: Application-specific blockchains, similar to Avalanche's subnetworks or application chains on Cosmos.
2. Public chain: zkEVM will use Ethereum for data availability and is the most secure but also the most expensive Rollup solution. PoS-based zkEVM uses Polygon for data availability (secured by MATIC) and then simply publishes proofs on Ethereum for higher scalability.

$MATIC has been falling recently due to forced sell-offs as Celsius sold its holdings to buy BTC and ETH. Therefore, once Polygon 2.0 is launched in the second half of this year, prices may rebound.

dYdX V4

The goal of V4 is to decentralize dYdX by launching an exchange on a custom AppChain within the Cosmos ecosystem. The order book that was previously operated in a centralized off-chain manner will now be managed by Lisk validators through an in-memory order book. Validators for each block will submit transactions, ensuring that all transactions go through and that they have the same version of the order book/chain. The current test has reached a transaction volume of more than 500 per second. $DYDX has been criticized in the past due to high inflation and low token utility. With V4, the token is likely to gain a more significant use, possibly including a revenue-sharing aspect. The protocol mentions this in a previous post.

"Starting with dYdX V4, dYdX Trading Inc. will no longer operate any part of the protocol. As such, it will no longer earn revenue based on the protocol's transaction fee revenue. The same is true for all other centralized parties, unless the community otherwise Decide."

The unlocking plan of $DYDX is as follows:

• 30% unlocked on December 1, 2023;
• From January 1, 2024 to June 1, 2024, equal installments of 40% on the first day of each month;
• From July 1, 2024 to June 1, 2025, equal installments of 20% on the first day of each month;
• From July 1, 2025 to June 1, 2026, equal installments of 10% on the first day of each month.

A public testnet will be launched, suggesting that the mainnet launch is near. If there is an announcement about the $DYDX fee sharing mechanism, this could serve as a strong narrative for the token. However, it's important to keep in mind the massive unlock program starting this December.

GMX V2

With the public testnet going live a few weeks ago, GMX V2 seems closer than ever. This upgrade brings many new features, one of which is the adoption of Chainlink's custom low-latency price oracle for better trade execution. Another big change is the independent liquidity of each trading pair and the possibility to create synthetic trading pairs.

Each trading pair will have its own liquidity pool. For example, ETH/USDC will use ETH as long collateral and USDC as short collateral. The synthetic trading pair can also be SOL/USDC, and its liquidity pool has ETH as long collateral and USDC as short collateral. This model is designed to simplify the deployment of new liquidity pools, and the main benefit of independent liquidity is to reduce the risk of providing liquidity.

Synthetix V3

Synthetix is a DeFi liquidity hub that provides support for various derivative protocols on Optimism (such as Kwenta, Lyra, Thales, Polynomial, etc.). There has been a significant increase in trading volumes this year, with most of the volume coming from Kwenta traders.

Synthetix V3 is an upgrade made over the past two years to make the protocol the liquidity layer for all of DeFi. Currently, all synthetic assets are collateralized by the native governance token $SNX. V3 will introduce a variety of upgrades, including multi-staking staking, risk-isolated permission-free pools, cross-chain liquidity, and more. V3 is technically already on mainnet, but core innovations like Perps V3, Pools V3, Teleporters, and Cross-chain Synthesis are all in development.

other

Some other protocols in this space that might be worth watching:

• The Vertex protocol was recently launched, with strong growth in transaction volume;
• Level recently launched on Arbitrum, and ~50% of transaction volume now comes from the chain;
• Pear protocol is coming soon and will leverage existing infrastructure for liquidity on its trading platform.