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From the stormy skies of the macroeconomic backdrop, crypto is enveloped inside a hurricane

Digital Assets Insights Vol. 10

Jun 21, 2022

Macro overview

Last Wednesday, as the market anticipated, the FOMC hiked short-term interest rates by 75 bps in its attempt to tame the recent rise in inflation. At 8.6%, inflation is more than four times the Fed’s target of 2%, and while Powell asserted that a 75-bps rate hike would “not be common,” he remained confident in a soft landing. The DXY eased from 105.5 to 105 as traders digested the hike, which ignited aggressive bull-steepeners and led risk-assets to rally. Whether the Fed implements another rate hike in July is dependent on a sequential decline in monthly prints and stability in long-term inflation. However, CPI monthly fixing paths, as well as the University of Michigan’s inflation expectations, suggest further inflation looms on the horizon. Bloomberg predicts that inflation could easily reach 9.6% before the summer, even if energy and food prices stabilize (Exhibit 1).

With all signs pointing to additional rate hikes, risk sentiment turned negative on the 17th, as the market priced in another 75-bps rate hike in July, increasing the late-cycle risk of recession. Thursday’s market massacre sent 97% of S&P 500 into the red while credit spreads widened to levels not seen since April 2020. Despite all this, the market closed on a slightly positive note last week, as Friday was a triple witching day with the expiration of futures and options contracts linked to equities, along with the rebalancing of the SPX index.

As market instability continues, we will be watching Existing and New Home Sales next Tuesday, as well as Initial Jobless Claim next Friday. In the meantime, stay bearish and lighten up on risk! 

Exhibit 1: Bloomberg Economics Point to CPI Inflation Potentially Reaching 9%

Source: Bloomberg as of June 17, 2022.

This week in Cryptoland

Looking down from the stormy skies of the macro backdrop, crypto is enveloped inside a hurricane. Bitcoin traded down to 17,678 and Ether to 880 on Saturday before climbing back up yesterday to 21,000+ and 1,100+, respectively, each fighting against a full cycle retracement.

Illiquidity issues plagued the industry with the floundering of Three Arrow Capital, Celsius, BlockFi, and Babel Finance just to name a few, underscoring that the Russian-nesting-doll structure of the on-chain DeFi lending and leverage playground is too dangerous to “de-mine.” As Staff Sergeant William James said in the Hurt Locker, “There's enough bang in there to blow us all to Jesus.” We don’t see signs of any easing of the crypto-equivalent quantitative tightening via DeFi, while hedge funds and institutional investors are likely to continue to look down on DeFi. Total Value Locked (TVL) in all protocols are down 73% from the historical all-time high of $256 billion recorded in December 2021 (Exhibit 2). Further TVL capitulation puts pressure on L1s, indicating we’re better off staying away.

There is a silver lining, however: the DeFi community is beginning to preemptively manage risk. For instance, a $108 million stablecoin loan with 5.7 million SOL ($200 million) in collateral represents the most concentrated position in the Solend pool liquidation trigger at $22.3 per SOL. To prevent another liquidity issue in the market, the DeFi community reacted and voted to activate “emergency power” to Solend Labs and take over the large position, moving liquidation to OTC from on-chain DEXs. In addition, the Decentralized Autonomous Organization (DAO) activated a liquidation threshold of 35% for loan amounts over 20% of the main pool, analogous to concentration risk add-ons for capital adequacy rules at banks and prime brokerages.

Exhibit 2: Total Value Locked (TVL)

Source: DeFi Llama as of June 19, 2022.

Options

ATM-implied volatilities widened from 80% p.a. to 130% p.a. on the 18th and 19th for BTC, and 120% p.a. to 160% p.a for ETH. Options markets continue to reflect downside stress with both BTC and ETH risk reversals. On Deribit, $225 million anchored at 15,000 BTC put strike and $240 million at 20,000 BTC; $60 million anchored at 800 ETH put strike and $110 million at 1,000 ETH. We continue to watch these deltas.

Spotlight on...

Maximum Drawdown (MDD)

This week we turn our Spotlight to risk management. Likely, the most salient feature that an investor observes is loss since the peak, better known as maximum drawdown, calculated as the percentage decline from an asset’s highest value (peak) to its lowest value (trough) before a new peak is reached. MDD picks up extended autocorrelated pain often not seen in risk measures, and may best illustrate frustration, panic, and loss of confidence.

In the current market landscape, many are looking to identify a bottom – some for easing psychological pressure, and others looking for investment opportunities. BTC and ETH have experienced a three-month consecutive double-digit loss (Exhibits 3 and 4). Extraordinary drawdowns in magnitude or length, and/or multiple downs in higher frequencies, raise red flags and often require prompt measures in risk management.

Exhibit 3: Monthly Performance of BTC Spot

Source: Bloomberg as of June 19, 2022.

Exhibit 4: Monthly Performance of ETH Spot

Source: Bloomberg as of June 19, 2022.

In the chart below (Exhibit 5), we offer a rear-view mirror evaluation of historical maximum drawdown of BTC and ETH by calculating the current daily return from the annual peak and then selecting the minimum return to arrive at the MDD for that year, represented by the blue bars. The red line represents the average MDD across the years. BTC has experienced 90% to 35% MDD, averaging 72% since its inception, much like that of ETH, which averaged 78%. Maximum drawdown so far this year is reaching historical averages with potential to increase another 10% to 12%.

Exhibit 5: Historical Annual Max Drawdown

Source: Securitize Capital as of June 19, 2022.

Like catching a falling knife, “buying the dip” is a risky investment approach. However, it is sensible for value investors and reversion speculators with significant dry powder to buy good assets at a discount and to hold on until there are new highs. Exhibit 6 shows recovery statistics at one, three, six, and nine months following the max drawdown during each historical year. Returns remain lower during the one-month and three-month recovery periods, with BTC exhibiting a loss in 2013. In more recent years, BTC returns reached 20-50% within three months after its MDD. ETH returned 80-100% with strong reflexivity stretching the holding period to nine months. Since 2017, six- and nine-month recovery returns have tended to exceed 200%, with the obvious exception of 2021, a relatively ‘quiet’ year with a MDD of 54% and a lower return during the recovery period.

Exhibit 6: Returns Following Max Drawdown

Source: Securitize Capital as of June 19, 2022.

MDD is only known ex-post. Due to their recent institutional adoption, both BTC and ETH have become highly correlated to macro factors, such as inflation prints and central bank monetary tightening, to name a couple. Therefore, we don’t yet know if the historical recovery pattern after a max drawdown will persist. However, as current BTC and ETH MDDs are not at their extreme worst, investors should consider adding macro readings into their “buy the dip” strategies.

Market Update

Tracking the weekly movement of the major cryptocurrencies.Tracking the weekly movement of the major cryptocurrencies.

  • The biggest movers among the top 20 market cap coins were SOL (+32.90%) and BTC (-13.32%).
  • Bitcoin and Ethereum decreased by 13.32% and 8.03%, respectively, this week. While not included in the chart, USDC consistently tracks the US Dollar with 0% change. 

Top 20 Cryptocurrencies – 7-Day Price Change

Regulations in the news:

NFTs/metaverse in the news:

Web3.0 in the news:

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