Vincent A Saulys' Blog
Altchains & DeFi as Separate Markets
Tags: crypto defi
October 17, 2021

Perhaps a big misconception of cryptocurrencies is that there is one chain: the Blockchain.

This couldn't be further from the truth.

Cryptocurrencies, especially ones such as Ethereum, are composed of many chains. These go beyond just the underlying crypto tokens but encompass their own ecosystems of various maturies and interoperabilities. This creates a rich environment for differing markets which is rarely discussed. Here I'll go over exactly how these operate as separate markets.

Altchains as Separate Markets

Let's start with a more mainstream comparison: the stock market.

You can go and buy TSMC on the Taiwan Stock Exchange (TWSE) or you can buy it on the NYSE or you can buy it on the NASDAQ or any number of other markets. The underlying asset, absent oddball requirements such as in China, is the same: you own a share of the company.

Altchains are identical to this. They form separate chains where you can buy Ethereum or any number of tokens. This is enabled because most tokens follow some common format such as ERC20. Such tokens implement some common functions or features and can be used on any chain that forks ethereum in virtually the same way.

Why would you want to fork etheruem?

Ethereum is very slow and this is reflected in the high cost to trade on it. This is largely a function of having a Proof-of-Work behind transaction settlements; all validator nodes, those that confirm a transaction went through and was truthful, in the ethereum network must complete a really hard math problem in order to ensure they are behaving well. Many newer chains, such as Cardano & Polkadot, want to move to a Proof-of-Stake model whereby you burn cryptocurrency tokens in order to prove you're behaving correctly. [1] Such a model would lower transaction costs and improve speeds. Ethereum 2.0 will move to a fully proof-of-stake model once it gets there.

Altchains such as Binance Security Chain (BSC) or Fortmatic (MTK) -- amongst many others -- work by forking Ethereum and then limiting the nuber of validator nodes in the network. This enables those validator nodes to assume trust amongst each other with no possibility of bad actors as everybody knows which node is which. Bitcoin, Etheruem, and other cryptocurrencies cannot assume this as anybody can run a validator node. Not everbody can run a BSC validator node. [2]

You would do this to lower transaction costs. Ethereum on BSC is cheaper to use with DApps (Decentralized Applications). This enables far more powerful DApps, at least in principal.

DeFi Ecosystems as Separate Markets

DeFi ecosystems such as Pancake Swap (CAKE) work by swapping ethereum for a special CAKE token which can then be used for all sorts of investments such as farming or crypto lottery tickets. You then swap back out your cake for ethereum.

Other ecosystems such as Aave (AAVE) work by locking up ethereum or other tokens and paying out the principal plus interest from whomever opts to borrow. Typically, the borrower borrows a stablecoin like USDC.

Such ecosystems end up operating as separate markets much like altchains. Money is locked up and limited to some very specific and smaller pool.

Implications of Separate Markets

One word:


Absent fees -- which can be immense -- you can look for arbitrage value across ecosystems. The annual percent return (APR) on a given stablecoin should converge to the same across all exchanges. If you can borrow the exact same asset for cheaper on one exchange, you could borrow there, lend on the higher rate exchange, and pocket the difference at zero risk. These arbitrages should be treated away but with enough capital you could make many riskless bets. This could be done programatically as all these contracts sit on the blockchain like any other program would.

Of course, doing so is not actually costless. Fees for moving a given crypto to a different exchange are between \$400-600. The only people who can do this are big whales as they can survive whatever fees eat up the imbalance.

Looking for Huge Imbalances in Small Pools

Whales, people with big amounts of crypto, can move prices because they can single handedly create imbalances.

That's significant enough that services like glassnode has special charts for looking at exactly these sorts.

For instance, let's start by looking at AAVE:

Aave as of October 17th, 2021

Now let's look at Geist Finance:

Geist Finance Metrics as of October 17th,

At a fraction of the market size, it would take a lot less to meaningfully move the price in such a market. You could create a far bigger shift in price here. Note that its a DeFi exchange: you could make bold bets and shift the APR on an underlying crypto coin in some direction.

LTCM and the pitfalls of "riskless arbitrage"

Long-term Capital Management was a math focused (quantitative) hedge fund founded in the mid '90s. They went belly up a few years after starting.

Their fundamental thesis was that these riskless arbitrages like I described existed all over the world. You just had to find them. Using much the same techniques, they looked around the world at different markets looking for an asset like a US Treasury that should trade at the same price everywhere, and either bought or shorted that asset if it was being mispriced in that specific market. They sold themselves as a giant vaccuum scooping up pennies.

The problem, and the reason they ultimately went belly up, was that huge unexpected events messed up the arbitrage. In their case it was Russia defaulting and the Southeast Asian financial crisis circa 1997. Such events put destablizing shocks on price that caused prices on the same asset to meaningful change but not for no reason. Their computerized trading systems continued to operate like nothing had happened.

Could such a thing happen with crypto?

The answer is an emphatic Yes. Tether, has had problem after problem and yet still trades like nothing has happened. Should its price fall as it would seem inclined to do, then many systems looking for arbitrage on the price of tether would fall badly. Tether is one of the most highly traded cryptocurrency by a wide margin.

Coingecko sorted by "24h Volume"

Farming Tokens to Throw This Basic Analysis

Another aspect to consider is that farming tokens as an added benefit.

Many allow you to farm the token used to pay for transactions. On the ethereum chain, you use ethereum to pay for transactions while on the avalanche altchain you use the avalanche token.

Because of the high fees on Ethereum at the moment, it takes a lot to want to sell a particular protocol token. That makes it hard to justify so people tend to hodl them instead.

How much are these farmed tokens worth? Likely something close to the price per transaction. If a token is being valued highly, it should be because the altchain its used on is used often. Any consideration on the value should reflect (e.g. some ratio on cost per transaction or something) with an understanding that the velocity of the transactions should also be considered.

Whither Cardano & Polkadot

Cardano & Polkadot are kind of outliers here. While anybody can create their own altchain and connect to ethereum, Polkadot and Cardano closely control who is allowed to connect.

Does controlling who can use these cryptocurrencies defeat the purpose of decentralized finance? Well, I would say it does.

Not sure why these get bought or sold. I own none. But many disagree as Cardano is the fourth highest valued cryptocurrency by market cap as of this writing.

Considering Multiple Markets

Are these altchains here to stay or will they fade with Ethereum 2.0? It's tough to say. Perhaps Ethereum will always be a "master chain" with everything connecting to it as a sort of final settlement layer of sorts. Perhaps once transaction speeds go up and prices go down, this will end. It's not clear at the moment.

Though perhaps even if ethereum continues to be a more expensive, final settlement layer, there will only be a few final altchains standing. That would put us in the Wild West Days of Altchains.

Lastly, I should note that there is a niche cottage industry for people forking (e.g. cloning) popular crypto defi projects like Pancake Swap or Avalanche but changing the network they use. This is why they often look identical minus a color swap. Examples include Polygaj which I'm fairly sure cloned Avalanche (but I could be wrong!).


[1]: This is a very simplified view of how proof-of-stake works, which could be its own write-up. The idea though is that you have a lot to lose if you misbehave in a crypto network so it incentivizes you to act good lest you lose everything. It is an ongoing debate in the crypto community on whether this is better or not as it makes it harder for newer entrants with less crypto capital to come in. Stakers typically earn a staking reward though some networks are locking that up so it can't be traded until some date in the future.

[2]: Whether you could trust such a model is a subject of intense debate. BSC attempts to democratize it by allowing half of the validator nodes to be community owned, operated, and voted on. Most do not have this mechanism.

[3]: I also understand that there is a lot that they did, this is a big simplification. There is an excellent book about them.

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