Crypto assets (Bitcoin, Ethereum etc.) have appreciated in value faster than almost any other asset in the history of financial markets.
However, there’s one major difference. From what I’ve seen, it’s a phenomenon that is unique to crypto assets. I call it the magnification effect.
Here’s an example. Let’s say Ether (ETH) is trading at $500 (to make numbers easy). And 0x Project (ZRX) is trading at .001 Ether or .50 USD. Many of these smaller market cap coins trade on substantially smaller volume compared to the top coins such as Bitcoin and Ethereum. ZRX does not have a ZRX/USD trading pair on any exchange. ZRX trades on a ZRX/BTC or ZRX/ETH trading pair.
Now let’s say the price of ETH doubles to $1000 but the ZRX price in ether remains the same at .001 ETH (assume no trading volume to illustrate the example). The USD market cap of Ether will have doubled from ~$50B to ~$100B and interestingly, the ZRX market cap will double as well. ZRX at a price of .001 ETH has increased from .50 USD to $1.00 USD and from ~$250M in market cap to ~$500M. With no trading volume, the market cap of ZRX has doubled in USD terms. This is an interesting phenomenon because the USD value of the ZRX token has increased without any trading volume on the ZRX order books. The ZRX price appreciation come solely from the underlying trading pair ETH.
A similar effect happens in the equity markets but we don’t take notice or feel it. For example, if the dollar (USD) rises in value against the euro (EUR), all US companies are now worth more in terms of Euros even though their USD market caps remain constant.
This effect is exacerbated in the crypto markets because of the nature of crypto to crypto exchanges. For context, this would be like buying Snapchat stock with Apple stock on the ticker SNAP/APPL. There are no cross-trading pairs in the equity markets — all public stocks in the US trade against the dollar. If you own Apple stock and you want to buy Snapchat, you must first sell your Apple shares to USD and then buy Snap shares with that USD. Whereas, in the cryptocurrency markets, you can buy Bitcoin, then Ether then ZRX without ever coming back to USD. In fact, most altcoins only have ALTCOIN/BTC or ALTCOIN/ETH trading pairs.
So, Matt, what does this mean?
What this means is that for every $1 of USD that enters the bitcoin or ether order book on an exchange, a multiple of market cap is also added to every token pair that trades against bitcoin or ether. Now, in theory the market should reprice the ZRX pair to maintain its $0.50 USD price point by trading down the order book until 1 ZRX equals .0005 ETH ($0.50). However, in practice I am not seeing that happen— primarily because of the low liquidity on the exchanges where these tokens trade.
In sum, this effect causes asset prices to rise many times faster than in traditional markets and helps to explain the rapid ascent of crypto assets in 2017. On the same token, this equally magnifies the effect in a downturn.
Further, because crypto to crypto trading pairs now make up the majority of the trading volume across exchanges (if you include USDT as a crypto to crypto pair), this effect will only continue to grow.
This makes it significantly harder to determine the net inflow and outflow of capital to specific crypto assets. It will certainly be interesting to see how this phenomenon plays out going forward.
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If you have any insights or comments on the above please leave a comment or find me on twitter: @mattslater
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