Baby's out with the Bathwater

Issue #9 – June 24, 2022

The crypto ecosystem is in week eight of systemic deleveraging, analogous to traditional finance’s (TradFI) 2008 Global Financial Crisis (GFC). 

But one thing is clear about the driver of today’s selloff in BTC and ETH… It’s the plumbing, not the protocols.

Like the GFC, poor risk management at centralized finance (CeFi) institutions caused pipes and plumbing to fail…but the decentralized protocol of Bitcoin and hybrid Ethereum protocol remain intact.

  • First, the failure of Terra stablecoin’s promise of stability from its algorithmic structure is like the failure of the Bear Stearns subprime loan funds, packaged as AAA mortgage funds in late 2007 and 2008 prior to the Bear Stearns and Lehman Failures.
  • Today, we see the gating of redemptions by Celsius, BlockFI and others as analogous to the forced unwind of Long Term Capital’s leveraged bets in 1998 as well as the pulling of liquidity by the market from Bear Stearns, then Lehman.
    • These were a function of a leveraged asset liability mismatch (Borrowing short, lending long) that unwound after the Terra collapse and likely accelerated after a perceived glitch in ETH 2.0 test net.

Unlike the GFC, the crypto ecosystem has no central bank to debase the protocols. Therefore, the storm of deleveraging activities by CeFi institutions such as Celsius and fellow lender Babel should not result in the debasement of Bitcoin or Ethereum. This is relevant because the integral properties of the Bitcoin and Ethereum networks to maintain purchasing power become even more important given the probability of a Fed pivot back to accommodative policy, further debasing the USD.

The historic price declines in the broader economy will likely continue until the Fed shifts policy to address them. It is the 3iQ Research team’s opinion that the inevitable breakdown in TradFI funding and/ or credit markets, à la Q4 2008, January 2019 and March 2020 will likely result in such a Fed Pivot. Different from these periods is the recent surge in inflation, catalyzed by global macro issues (e.g., China and Russia) now spiking prices to historic levels.

 

 

The Coiled Spring

The fed has hinted at or tried to reverse accommodative policy three other times (May 2013, Q3 of 2018 and– more aggressively– Q3 of 2019) before reversing course to attend to slow growth and failures in the plumbing of funding and credit markets. Today’s global macro setup makes the Fed’s attempt to hike and reduce liquidity even harder for two main reasons – with inflation being the core driver – see graph above for historical perspective:

1. A complex and leveraged economic set-up
  • Today’s peak U.S. Debt/Gross Domestic Product (GDP) ratio is at the highest since WWII, and low growth in the face of record inflation creates an untenable situation for the Fed to address with monetary policy alone. Hiking rates into a peak debt load as growth slows invites recession at a minimum.
  • Supply-chain constraints driving U.S. Producer Price Index (PPI) (see above) to record levels have less to do with Federal Policy (Fed) and more to do with global macro events, limiting Fed effectiveness. In fact, Fed tightening could impair the ability of companies to address choked supply chains, further exacerbating PPI.  
  • Additional factors distinguishing this hiking period from others are laid out in our inaugural publication, the Monetary Ratchet. As the title suggests, we believe the Fed will inevitably pivot back to accommodation per our opening comment.

2. A neutered banking system.

  • Big Brother. The TradFi banking system had its washout in the 2008 GFC.  After bailouts and bankruptcies, banks had their risk wings clipped by tighter regulations. This limited their ability to absorb and transfer risk during market dislocations like we see today. So, it is not surprising that when the Fed announced plans to reduce, then eliminate Treasury purchases AND raise rates, the UST10Y posted its worst 3M period since 1980.  If the Fed isn’t buying and regulations have hamstrung the banks, who is the incremental buyer?  
  • Volatility Suppression. Prior to the Fed’s announcement of balance sheet reduction, their balance sheet grew from under $3 trillion prior to Covid-19 to almost $9 trillion in assets at the end of 2021. These purchases have suppressed rate and credit volatility by keeping the supply of money high and cost low. As the Fed steps back, the blowback has been clear, resulting in today’s historic moves and persistent volatility. (See Volatility Go Down for more).
  • Soft Landings and Moral Hazard. This absorption of risk by the Fed did more than just delay systemic risk, it augmented it. The emergence of this price-insensitive buyer to the markets created distortions including the inability of consumers and industry to accurately assess risk. So, an obvious question to ask is, ‘Given market risk has been suppressed by the Fed and other central banks since 2008, how low can risk assets go without Fed support and will participants step in before a default cycle establishes a floor in prices?’

 

Implications for Crypto

The culling of players from the U.S. financial system during the GFC did increase the stability of banks and other players, but it came with a cost. With regulation limiting businesses and opportunities, many banks remain trapped with suboptimal tech stacks and legacy business models.   

However, before we start celebrating the opportunity for DeFi, Digital Assets and crypto broadly let’s address the collapse of Terra/ Luna and the halting of transactions on lending platforms such as Celsius and Babel. 

These failures potentially accelerate regulation in the U.S. and other jurisdictions, especially for stablecoins, since the most integral structures are issued by banks and bank-like institutions and are linked to USD Fiat. 

 

Old Time Risk /Reward

The ~ $50+ billion in losses associated with the Terra/Luna collapse were analogous to the failure of the asset backed funds in early 2008. Stablecoins offering 15 to 20% yields is incongruent, like the subprime loans sold as AAA assets for money market funds that subsequently broke the buck. Sure, there are differences, but both presented a face of integrity (see the Bulletin Code Is Law for more on integrity) and failed to perform over time as circumstances changed. 

 

Pipes Froze, Protocols Performed

The gating of withdrawals by Celsius, BlockFi and Babel appear to be a result of rehypothecation, a term we had to dust off from folders used during our long nights of work during the GFC. Suffice it to say that rehypothecation is essentially using the same collateral two or more times. So, when prices drop and margin calls commence, lending markets freeze given multiple claims for the same collateral. Not all platforms were impacted, and our initial work suggests that asset liability mismatches triggered the freeze. So, while the impact on Bitcoin and Ethereum price has been meaningful, we believe it is temporary as the platform failures arose from business decisions of CeFi firms, not from protocol integrity. 

Similar to traditional finance, some models are less robust than others. Last May, we saw this play out across stablecoins; Luna collapsed, but USDC held firm. Today, everyone is focused on price, so let’s figure out the why or the how of the price drop.  To do so, we need to explore the figurative pipes and plumbing of crypto lending.

Last week’s volatility was brought on by forced selling at several crypto lenders with potential asset liability mismatches. So where does that leave us?  Understanding that human error can exist in the crypto ecosystem, even when the protocol integrity remains intact.  The source of the failure and subsequent selling of BTC, wBTC, ETH and stETH could have been triggered by the choice to employ a leveraged asset-liability mismatch to augment returns by CeFi players.  This trade requires either a static state (no volatility) or identical liquidity on both assets and liabilities.  Since neither of these conditions were met, we see this risk modeling not matching market reality and not a failure of the protocol itself. With protocol fundamentals intact…technical analysis (TA) takes center stage.  

 

 

The number of weekly active wallets has been growing since 2016. Like any exponential mover, early growth should transition to become more stable growth over time. Since 2016, active wallets have grown around 83% to roughly 4.8 million. Growth is around 9.8% annualized since 2016, an enviable achievement for any software.  

Source: 3iQ Research. Data sourced from CoinMetrics as of June 20, 2022. 

 

Shifting our focus on the data from long term trend to the tactical, looking back at this cycle’s all-time-high (ATH) with the bitcoin (BTC) price around $69,000 USD, there was a notable decline, or bearish divergence, in the number of active weekly wallets in Q3 2021 when compared earlier to Q1 2021. Active addresses saw a high of approximately 6.8 million in Q1 2021, whereas in Q3 2021 active wallets dropped to 5 million. So indicative of declining activity in the face of a still rising price. 

 

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The price decline of BTC can be more attributed to technicalities around funding markets than the character of the protocol itself. 

Historically, buying BTC below its 200-week moving average has been a winning strategy for long-term investors. Will this time be different? We would allude to “no”; however, pain can be prolonged as outlined below, with sometimes several weeks’ worth of activity below this critical moving average before reversing higher.  

Therefore, those looking for shelter from today’s market disruption may want to keep an eye on the 200-week moving average.

 

Source: 3iQ Research. Data sourced from Messari as of June 20, 2022. 

 

Building on the above analysis, which demonstrates;

  • the unique and previously temporary nature of a breach in BTC’s 200-week MA, and 
  • the continued integrity of the Bitcoin network as measured by adoption

Below we calculate the performance of BTC over the ensuing 3, 6, and 12 months after initially breaching the BTC 200-week MA each year.  In the two previous breaches, returns across all three time periods were positive.

 

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Source: 3iQ Research. Data sourced from Messari as of June 20, 2022.

 

Today vs. Previous Breaches of the 200-week MA

 

2015 Comparison – Perceived Problems at Home vs. Actual Problems in the Neighborhood

The nascent and unproven state of a growing Bitcoin protocol was one driver for the 2015 200-week MA price breaches. Where a growing Bitcoin protocol invited scrutiny and temporary volatility as it worked out its kinks in 2015, today we see a steady and secure protocol enduring volatility from leaks in a plumbing system created by a group of emergent CeFi lending platforms. 

 

2020 Comparison – Passing Storms

The onset of Covid-19 shut down the real economy and spiked volatility across all markets, including treasuries, which saw the UST10Y yield dive to 0.39%. The sharpness in the drop was accompanied by a spike in rate volatility as measured by the MOVE index, to 165, a level not seen since the GFC. 

 

The MOVE Index: A Barometer of Funding Stress

In this instance, leveraged players were again at the epicenter of the volatility, exacerbating the bid for treasuries as they unwound a widely held rates carry trade. Today, we see rate volatility spiking again as measured by the MOVE index. First to 140 in March and again last Tuesday to 144. The three instances noted here are the three highest since the GFC. 

While this storm will pass, its path and duration are unknown with the Fed buying program sidelined, banks still hamstrung by regulation, market participants weary from loss, and a growing supply of treasuries. 

 

MOVE Index: Volatility Index of U.S. Treasury Futures 

 

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Implied volatility of the 2Y,5Y,10Y & 30Y U.S. Treasury Futures on a weighted average.

Source: 3iQ Research. Data sourced from Bloomberg as of April 2022. 

 

The above graph has been a good predictor of equity factor volatility in the TradFI space since 2016. One reason owes to the fact that it helped mark disruption in the funding markets that pushed rates higher like in 2008, 2013, Aug 2019, Jun 2020 and those we now see in 2022.  There were instances when funding stresses moved rates lower like in Oct 1998 and Mar 2020. Either way, it was disruptive, as rates strayed from Fed Policy, creating market uncertainty. Today, the MOVE index rests at/ above levels that previously indicated a rate reversal. The only difference today is the emergence of inflation that adds complexity to the signal value of the pattern. 

 

Digital Asset Universe 

 

 

Ethereum Flippened by its own StableCoins 

The total crypto market capitalization declined below $1 trillion USD last week. An interesting observation is that the total market capitalization of the five stablecoins listed above have now exceeded the market capitalization of Ethereum. 

Most stablecoin assets which are issued today are settled on the Ethereum mainnet and on its layer-2 solutions, such as Optimism and Arbitrum. To us, this speaks to what’s happening on the applicational side as people try to profit from leveraging Ethereum in wrapped-forms and by using other ERC-20 tokens to extract yield. A similar funding scheme was used in TradFi that led to the Bear Stearns and Lehman failures. 

Bitcoin Dominance – or share of the Digital Asset ecosystem – has surprisingly fallen back towards 44% from 48% last week. This figure is still 14% lower than historical averages from 2016, leading us to believe that

  • Stablecoins may have emerged as a safe haven in addition to Bitcoin and
  • There is still potential for further selling in some of the smaller protocols in the ecosystem.  ​​​​​​

 

Source: 3iQ Research. Data sourced from Coin.Dance, Etherscan.io as of June 20, 2022.

 

 

Source: 3iQ Research. Data sourced from Messari as of June 20, 2022. Figures expressed in USD unless otherwise stated. Past performance is not indicative of future results. 

 

The table below quantifies BTC’s performance relative to currencies and commodities, as if each asset were denominated in BTC.

Through the one-year mark, BTC underperformed all due to several factors including a series of unwinds from leveraged players as noted above.  We share this for perspective on returns over time.  As an exponential grower, the current drawdown is only now outside its 200-week MA (approximately a four-year average), like two other periods of sharp underperformance.  However, over longer periods of time, e.g., three for ETH and three years and five years for BTC, continue to be the better performing assets as outlined below.  

 

Source: 3iQ Research. Data sourced from Bloomberg as of June 20, 2022. Past performance is not indicative of future results.

 

The table below shows performance across a broader basket of assets and as above, the question for investors is whether you believe the current environment will persist, taking BTC and ETH prices down further, or will the storm pass.  

Our plumbing, not the protocol analysis leaves us with the opinion that protocol integrity warrants continued adoption and resumption of the three and in the case of BTC, 5-year return profile. 

 

Source: 3iQ Research. Data sourced from Bloomberg as of June 20, 2022. You cannot invest directly in an index.  Past performance is not indicative of future results. 

 

Research Team

Mark Connors

Mark Connors

Head of Research

Herbert Zhang, CFA

Herbert Zhang, CFA

Director and Portfolio Manager

Connor Loewen

Connor Loewen

Cryptocurrency Analyst

Contact us: research@3iq.ca

 
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About 3iQ Corp.

Founded in 2012, 3iQ is a Canadian digital asset investment fund manager with more than C$800 million in assets under management. 3iQ offers investors convenient and familiar investment products to gain exposure to digital assets. For more information about 3iQ and its digital asset investment funds, visit www.3iQ-au.com or follow us on Twitter @3iQcorp_au.

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Fred Pye

Frederick T. Pye

CHAIRMAN, CHIEF EXECUTIVE OFFICER & DIRECTOR

Frederick T. Pye is the Chairman, Chief Executive Officer and Director of 3iQ Corp. He is also the Chairman and Director of 3iQ Digital Holdings Inc. Mr. Pye is recognized for creating and promoting creative and unique investment products for the investment industry.

Mr. Pye has managed private client portfolios with Landry Investment Management and various other investment dealers. Prior to this Mr. Pye was Founder, President & Chief Executive Officer of Argentum Management and Research Corporation, a company dedicated to managing and distributing quantitative investment portfolios including the first long-short mutual fund in Canada.

He was also Senior Vice-President and National Sales Manager of Fidelity Investments Canada and an integral part of the team that saw assets rise from $80 million to over $7.5 billion in assets under management during his tenure. He also held various positions with Guardian Trust Company, which listed the first Gold, Silver and Platinum Certificates on the Montreal Exchange.

Mr. Pye obtained a Masters in Business Administration from Concordia University.