By John Todaro, James Todaro and Joseph Todaro
FTX is a leading derivatives and spot market exchange for trading digital assets and other selected commodities and products. The FTX team’s commitment to the accelerated release of innovative products as well as aggressively managing the user experience will allow FTX to continue to expand market share in the competitive digital asset exchange space. Our assessment of FTX’s ability to capture users and drive platform liquidity as well as our findings through a discounted cash flow (DCF) analysis indicate that the FTX exchange token (FTT) is an attractive opportunity.
FTX Playbook: Driving Liquidity
The competitive landscape for exchanges continues to heighten. Exchange users have minimal, if any, brand loyalty and will quickly move if more favorable trading opportunities are presented elsewhere. Exchanges are non “sticky” businesses in which users generally have the ability to establish accounts on competing platforms fairly easily. While users have the ability to operate across many different exchanges, significant pools of liquidity often only aggregate to a few exchanges. The strong network effects based on concentrated liquidity greatly minimize the number of concurrently successful exchanges with high user volumes — liquidity brings about more liquidity. This tends to result in relatively few exchanges capturing the majority of trading volume across users.
While the majority of liquidity is concentrated among a select few exchanges, there is still some degree of exchange turnover as competitive new entrants wrestle market share from the more established participants. Users looking for the most favorable trading experience migrate to exchanges offering the greatest market opportunities. As users begin to shift to different platforms, liquidity is affected which results in degradation of the trading experience and a further decrease in user demand and liquidity.
The interplay between liquidity and user satisfaction often results in a swift en masse departure of exchange users as liquidity begins to drop. This reality was observed in 2017 as users deserted the once market dominant exchanges Poloniex and Bittrex resulting in a downward spiral of liquidity. Insufficient user satisfaction along with limited asset and product offerings due in part to strict regulatory oversight resulted in reduced liquidity as users shifted to more regulatory laissez faire exchanges such as Binance.
Adding to the exchange turnover is the continued maturation of digital assets as an established asset class. Each market cycle begets the arrival of more sophisticated and professional investors followed by more competent and higher quality exchanges. Currently we are observing the rise of the next generation of high competency exchanges that will subsequently attract users and liquidity away from the more established but less competent exchanges.
The barrier to entry in the derivatives market is entirely dependent on the ability to effectively source liquidity. This strong need for liquidity is due to the use of leverage within the derivatives market. Without significant pools of liquidity, derivatives exchanges cannot properly manage certain positions — resulting in the higher likelihood that effected trading accounts will ultimately have negative market value. This is different from unlevered spot exchanges, in which user balances cannot become negative.
While spot exchanges obviously also benefit greatly as liquidity increases, they are not as dependent on liquidity as derivatives exchanges. Insufficient liquidity on a spot exchange results in price slippage and less competitive asset prices but not outright losses for the exchange or users as occurs in the crypto derivatives market. These losses arise when there is inadequate liquidity to properly manage positions forcing some accounts into negative balances.
With minimal ability to collect these losses from the losing accounts themselves, as is done in the traditional market, many crypto derivatives exchanges are designed as a last resort to perform asset clawbacks or auto-deleveraging (ADL) events. ADL or clawbacks essentially socialize these losses against other users as profitable positions are force closed or realized profit is decreased. This results in financial losses to users who were on the winning side of the trade. In order to help protects against ADL/clawback events crypto derivative exchanges often have ‘insurance funds’. However, insurance funds in no way completely protect users from these such events and historically these funds on many exchanges have often been completely depleted during intensely volatile times.
Given the reality of how crypto derivatives markets operate, the importance of deep exchange liquidity cannot be overstated. This liquidity requirement difference between spot and derivative exchanges is why we see the long tail of low liquidity spot exchanges while we do not see this same long tail with derivatives exchanges.
The need for early liquidity within derivatives exchanges creates a certain moat around exchanges that can effectively source this liquidity. FTX was able to generate ample liquidity at launch through its closely related incubator firm, Alameda Research, a quantitative trading fund and liquidity provider. Alameda is one of the largest liquidity providers with estimates of $100 million assets under management and daily trading volumes over $1 billion across a multitude of exchanges.
The instant access to liquidity through Alameda allowed the FTX exchange to break into the derivatives industry more easily than for other competing exchanges. With Alameda as a liquidity provider, FTX could offer competitive futures products while minimally exposing their users and themselves to potential exchange wide losses due to insufficient liquidity.
The FTX team has also demonstrated their commitment to continuously launching innovative trading products. While these more differentiated product offerings by themselves often see muted volume relative to more commonly traded products, such as Bitcoin perpetual futures, differentiated products act as the hook which brings in higher volume user activity to other products. The newly acquired users initially brought in by specific trading products not offered elsewhere, often consolidate their trading accounts and migrate their higher volume trading activities to exchanges that offer a more expansive range of products. These users then provide liquidity to the more commoditized markets like bitcoin futures. In such a way, differentiated product offerings act as a funnel which drives increased liquidity to the higher volume but less differentiated markets.
Since its launch in May of 2019, FTX has arguably been the leading derivatives exchange in bringing new products to market. They continue to display an exceptional ability to develop and launch intricate products in minimal time allowing FTX to offer products ahead of competing exchanges. Many of these products are largely pioneered and developed by FTX themselves. Two such examples are hash rate futures and leverage tokens.
Hash rate futures are products that allow users to bet on bitcoin difficulty levels — indicative of hash rate — at a given future date. Despite long held acknowledgement as a market of interest for traders and miners alike, hash rate markets did not exist in any capacity among exchanges. The implications of launching an entirely new unexplored market with unknown user demand left many exchanges rather hesitant. On the other hand, FTX leaned into the challenge of launching a new product with the hopes of differentiating themselves from other less innovative and aggressive exchanges.
Leverage tokens are another unique product that was brought to the spotlight by FTX. Leverage tokens act to offer leveraged exposure to specific assets while abstracting away trade maintenance requirements normally present with positions on margin. These leverage tokens have become rather popular resulting in competing exchanges launching their own leverage tokens following the success of those first offered by FTX.
Among derivative exchanges, FTX arguably has the widest range of products including other compelling offerings such presidential markets, options, volatility markets, various token baskets, oil markets and innovative algorithmic trading tools.
This consistent introduction of new products entices traders to migrate to FTX for specific trading products not offered on any other exchange. This bump in liquidity, as new traders migrate over, is then further used to appropriately attract more traders creating a liquidity feedback loop.
Products bring traders. Traders bring liquidity. Liquidity brings more traders.
These product examples showcase the understanding and commitment from the FTX team to continuously offer compelling new products to expand their user base driving exchange liquidity and increasing market share. This strategy has largely been successful for FTX as it has seen an incredible amount of growth in its brief year of existence as it now ranks near the top five largest derivatives exchange by daily volume.
FTT Token Valuation
Given the unique token structure of FTT, including the buyback and burn schemata, the FTT token cannot be valued conclusively using existing financial analysis framework. However, to ensure that the FTT token does maintain a level of intrinsic value, we must build out an absolute valuation model in order to find a basis for the token’s intrinsic valuation. As such, we will borrow from the traditional financial markets in analyzing a valuation model for FTT. It is important to note that traditional financial models, including ours, do not fit exactly in valuing the token and so should not form a complete basis for assessing the value of the asset — but the valuation model can offer a sanity check.
We specifically use an absolute valuation model in order to derive an intrinsic value for the FTT token. Relative valuation models, such as a multiple comparison between FTT and competitor exchange tokens, fail to identify an intrinsic value for the FTT token. While relative valuation may suggest the FTT token is cheaper compared to competitors, both sets of tokens may be overvalued on an absolute basis. The absolute valuation model of choice in analyzing the FTT token is constructed from a discounted cash flow analysis (DCF).
Discounted Cash Flow Analysis
The FTT token accretes value from token buybacks in which the exchange uses a portion of revenues to buyback and burn tokens in the open market on a weekly basis. In the figure and model below we present the bull case for FTT. The exchange uses revenue derived from the following to buy back tokens:
33% of all fees generated on FTX markets
10% of net additions to the insurance fund (‘Socialized Gains’)
5% of fees earned from other uses of the FTX platform
While buybacks are different from dividends and token holders do not maintain the same rights as shareholders, including voting rights, we model buybacks equivalently to company generated cash flows in our DCF calculation. Our model assumptions are outlined below:
Using the formula for DCF calculation, PV = [CF1 / (1+r)1] + [CF2 / (1+r)2] + … + [CFn / (1+r)n] + TV, we can discount our cash flows back to the present day to arrive at a Present Value (PV) for the FTT token.
PV = Present cash flow value
CF1 = Cash flow at the end of year 1
CF2 = Cash flow at the end of year 2
CFn = Cash flow at n specified year
r = Discount or required rate of return
TV = Terminal Value
As demonstrated in the model above, in our bull case, the intrinsic value of the token is $24.20 and $6.66 on a fully diluted basis. The intrinsic market value is $2.3 billion. Our discount rate of 12% is appropriate given the increased risk the FTT token represents relative to the equity and bond markets. This valuation is somewhat in line with equity valuations for the private company behind the FTX exchange. Prior reports put the equity valuation around $1–2 billion.
Both spot and derivative market exchanges continue to mature as digital asset investing becomes an ever larger industry with more sophisticated participants. With this maturity comes exchange churn as the less competitive platforms lose market share to newer more competitive entrants.
The newer entrants that will be best positioned to attract users and gain market share are those that have compelling new product offerings and deep order book liquidity. FTX, with its increased product offerings and unique liquidity set-up, will be able to gain considerable market share resulting in increased token buybacks, allowing for increased value accretion to the token holder.
The managing partners do not endorse or recommend any investment action in FTX exchange token (FTT). This document should not be regarded as investment advice, offering document, or as a recommendation regarding a course of action. These views are those solely of the managing partners of Greymatter Capital and do not represent the views of the FTX team.