Supply Matters: A Closer Look at Crypto Sector Supply Dynamics

It’s no secret that the concept of supply plays a pivotal role in capital market dynamics. This is evident not just in the realm of traditional equities, where the issuance of outstanding shares can impact a company's share price, but also in the rapidly growing world of crypto.

Grayscale Research analyzed significant supply events, like Bitcoin's halving and Ethereum's Merge and Shapella upgrades, as these events have historically served as catalysts for change in the supply dynamics of these assets. More than technical milestones, we believe these events are turning points that have the potential to reshape future supply and, consequently, the market's response in terms of pricing.

With the introduction of Grayscale Crypto Sectors, we extend this analysis to other crypto assets. Unlike public equities, where supply changes are typically more gradual relative to their respective market caps, crypto assets can experience sudden shifts, leading to equally rapid market reactions.

What is crypto supply, and why does it inflate?

At its essence, supply inflation is a deliberately implemented feature. Its primary role is to harmonize the interests of three crucial groups: the development team, investors, and the broader user community:

• For Development Teams: Controlled supply inflation serves as a critical funding mechanism. By gradually increasing the supply, projects secure the necessary resources for continuous development, maintenance, and innovation. This steady inflow of resources is fundamental to ensuring the project's long-term growth and viability, which in turn helps foster confidence among investors and users.
• For Investors: The incremental growth in supply can translate into direct benefits. In ecosystems where staking or holding cryptocurrencies generates rewards, these increases in supply can offer investors a tangible return. This mechanism incentivizes not just initial investment but also long-term engagement with the project.
• For the Community: From the broader perspective of users and participants, supply inflation is instrumental in promoting active involvement in the ecosystem. A portion of the newly minted supply is often allocated for community initiatives, grants, and projects. These efforts are geared towards stimulating growth, fostering innovation, and enhancing the overall value of the ecosystem.

While there are potential benefits of supply inflation, striking the right balance is crucial. Excessive inflation can lead to the devaluation of the asset, potentially eroding trust among both the community and investors. This delicate balance is a key consideration in the crypto space, especially given the diverse examples of supply inflation and allocations across various crypto assets:

Source: token.unlocks.app, data as of 12/2022

In the next sections, we will delve into how different forms of supply inflation have historically impacted prices, explore which sectors have witnessed more significant inflation, and uncover nuances that extend beyond supply.

A Year in Review: Token Inflation in Aggregate

As illustrated in Exhibit 1, there has been a general trend of token supply inflation across various crypto sectors. This increase in supply is observed consistently across all sectors. This trend aligns with the ongoing developments in the crypto space, where some projects are actively expanding and scaling up their operations. Concurrently, other blockchain networks are methodically distributing tokens to validators or miners as part of their operational model.

Exhibit 1: Most crypto sectors have generally increased their supply YTD

Source: Coingecko, Grayscale Research, Data as of 12/1/2023. For illustrative purposes only. Indexes are unmanaged and it is not possible to invest directly in an index. Allocations are subject to change.

The chart reveals several notable trends. First, the sectors Consumer and Culture, Utilities and Services, and Smart Contract Platforms (SCPs) have experienced the highest levels of weighted average inflation year-to-date (YTD), while the Currencies sector has seen the least. This observation aligns with our expectations: the Currencies category includes Bitcoin, the longest standing crypto asset, which underwent most of its inflation in earlier years. On the other hand, sectors like Consumer & Culture and Utilities & Services include relatively newer assets and are typically in the initial stages of their lifecycle. Therefore, any inflation in these newer sectors, starting from a smaller base of circulating supply, has resulted in a relatively larger percentage increase. Another interesting aspect is the occurrence of sudden spikes in circulating supply—a point we will explore in-detail. But first, it’s worth examining the overall year-to-date results and what they indicate about sector performance (Exhibit 2).

Exhibit 2: Larger inflation sectors tend to have lower prices YTD

Source: Coingecko, Grayscale Research, Data as of 12/1/2023. For illustrative purposes only. Indexes are unmanaged and it is not possible to invest directly in an index. Allocations are subject to change.

Not surprisingly, the results suggest a notable relationship between supply inflation and pricing trends: sectors with higher supply inflation generally show a tendency towards lower prices over the year. This finding sets the stage for a deeper examination of the notable spikes in circulating supply observed across sectors.

Cliff Vesting

In Exhibit 1, we notice abrupt and significant increases in token supply, which strikingly resemble steep cliffs. These are instances of 'Cliff Vesting' or 'Cliff Unlocks,' a term used to describe sudden, large releases of tokens. While some projects may release tokens gradually, mirroring a steady growth strategy or aligning with a predefined schedule of rewards for network participants, other projects might release large quantities of tokens at once — often during major events like the completion of a development phase or a significant funding round.

These large releases, typically predefined in the token's smart contract or governance protocol, lead to the 'cliffs' observed in the supply charts. A practical example could be a blockchain startup that initially locks its tokens for a year and then releases 20% of the total supply to its core team in a single event. Such a release would appear as a sharp spike in the supply chart, visually stark against the more gradual increases or steady supplies in other tokens. Like the sudden reintroduction of wolves to Yellowstone National Park gave scientists a unique opportunity to study the role of predators in a natural ecosystem, the sudden introduction of new blocks of tokens give us an opportunity to study the tokenomics of various blockchain ecosystems. An experimental variable has been tweaked.

While more gradual distributions can be influenced by numerous factors, making their impact on prices complex to dissect, the cliffs provide a clearer picture. Their significant size and the immediate effect they have on circulating supply make them useful guideposts for more easily identifying and understanding patterns in how supply changes can affect pricing.

In our analysis of the crypto sectors, we specifically focused on ~400 separate instances where circulating supply unlocks ranged between 5% and 10%. This examination covered the period from January 1, 2021, to December 1, 2023. We charted the average price differences, accompanied by a 95% confidence interval, to observe market reactions (Exhibit 3). This analysis includes a comparison of prices 30 days before each unlock event and 30 days after, providing a comprehensive view of how these significant supply unlocks impact market prices on an aggregate level.

Exhibit 3: Prices tend to be higher prior to the unlock date, and lower following the unlock date, which follows expectations

Source: Coingecko, Grayscale Research, Data as of 12/1/2023. For illustrative purposes only. Past performance is not indicative of future results.

What emerges is an intriguing pattern: typically, prices tend to be elevated 30 days prior to a supply unlock event, suggesting an anticipatory market reaction. Conversely, there is a noticeable decline in prices in the 30-day period following the unlock. Further dissecting the chart by individual sectors (Exhibit 4) reveals that this trend holds true across different areas of the crypto market:

Exhibit 4: Price differences before and after broken down by crypto sector

Source: Coingecko, Grayscale Research, Data as of 12/1/2023. For illustrative purposes only. Past performance is not indicative of future results. Indexes are unmanaged and it is not possible to invest directly in an index. Allocations are subject to change.

Although it may initially appear surprising, the Currencies sector exhibited the most significant price changes both 30 days before and after a cliff unlock event. However, it's important to note that this sector experienced only 9 instances of such cliff unlocks. In contrast, a sector like Utilities and Services underwent 191 cliff unlocks (Exhibit 5). This stark difference in the frequency of unlocks between sectors suggests that the data for the Currencies sector could be somewhat skewed due to the lower number of instances compared to others. However, as we’ve seen in Exhibit 2, the Currencies sector in aggregate has already had a majority of inflation happen already.

Exhibit 5: Number of Cliff Unlocks by Sector

Source: Coingecko, Grayscale Research, Data as of 12/1/2023. For illustrative purposes only. Past performance is not indicative of future results. Indexes are unmanaged and it is not possible to invest directly in an index. Allocations are subject to change.

Negative price movement tended to be more pronounced following larger unlock events, a finding that aligns with what one might anticipate. By comparing the impact of unlocks ranging from 5 to 10% with those between 2 to 5%, it becomes evident that the larger the unlock, the greater its negative impact on price (Exhibit 6).

Exhibit 6: Larger unlocks have a more pronounced effect on price before and after

Source: Coingecko, Grayscale Research, Data as of 12/1/2023.For illustrative purposes only. Past performance is not indicative of future results.

Deeper Dive and Other Considerations

While our aggregated analysis generally shows that higher inflation tends to lead to lower prices, it's important to recognize that this trend is not universal. A notable example within the Utilities and Services sector is Chainlink’s LINK, which significantly contributed to the sector's inflation in 2023. LINK experienced three major cliff vesting events in 2023, unlocking tokens valued at over half a billion dollars. Based on the general trends outlined in this paper, one might expect LINK’s price to have sharply declined. Surprisingly, this wasn't the case. The relationship between LINK's price and its supply unlocks does not follow the expected pattern, indicating that the correlation between supply unlocks and price movements can vary significantly depending on the individual token and its unique market circumstances.

Exhibit 7: Chainlink’s LINK supply unlocks doesn’t seem to follow the general supply unlock trend

Source: Coingecko, Grayscale Research, Data as of 12/1/2023. For illustrative purposes only. Past performance is not indicative of future results.

The cliff unlocks of LINK during 2023 were private, with the vesting amounts going directly to Chainlink Labs. Given the nature of these unlocks, it's plausible that the Chainlink team either didn’t sell, or coordinated with market makers to mitigate any significant impact on the token’s price, despite the large volume of the unlock. This scenario highlights an important aspect: the recipient of the cliff unlock plays a crucial role in determining its market impact. If the receiving party, like Chainlink Labs in this case, has the means to trade large quantities of tokens either independently or through professional traders, this capability can significantly influence how the unlock affects the token’s price. While this isn’t necessarily the case for all private unlocks, it definitely is a possibility for well-established projects with strong market presence and significant resources.

Conclusion

Delving into the tokenomics of cryptocurrencies reveals that understanding the nuances of supply unlocks is critical to understanding price dynamics. Factors such as the recipient of the unlock and their capacity to trade large quantities of tokens, possibly using sophisticated methods, are key considerations. For teams managing tokens, this analysis suggests a strategic approach: opting for smaller, more frequent unlocks could potentially contribute to the stability of the token's price, avoiding sharp market fluctuations. As protocol teams grow and expand, strategically managing supply unlocks can be a powerful tool for fostering sustainable growth of their project. As investors continue to explore the digital economy, understanding these mechanics could help distinguish between projects with a viable economic engagement flywheel, and which are at risk of falling off a cliff.