Jul 27, 2022
Risk sentiment continued to improve as both the S&P 500 and Nasdaq ended the week 2.55% and 3.47% higher, respectively, while the volatility index (VIX) decreased 4.95% during the week. However, overall Q2 corporate earnings were less positive, with 24 out of 105 S&P 500 companies reporting negative earnings and sales surprises, citing a challenging operating environment due to supply chain disruption, high inflation, and other macro factors. S&P 500 real earning yield has been collapsing since the Covid-led mini recession of 2020 (Exhibit 1). The recent quantitative tightening and aggressive February rate hikes helped curb the freefall of real earnings yield, weighing on equity valuation.
Exhibit 1: S&P 500 Price, S&P 500 Real Earning Yield, Fed Funds Rate
Source: Bloomberg as of July 24, 2022.
Last Thursday, U.S. initial jobless claims rose modestly to 251,000 for the week ending July 16. As recession risks continue to rise both within the U.S. and globally, and as the Fed tightens monetary policy to combat inflation, demand for labor is expected to cool. Weakening labor conditions is likely to be a key catalyst that pivots the risk sentiment from inflation to growth.
This week is a data-rich week, with the release of New Home Sales and the Conference Board Consumer Confidence report, the FOMC’s July meeting and anticipated 75-bps rate hike, and the latest GDP report. Note that two consecutive quarters of negative GDP growth typically indicates that the U.S. economy has entered a recession.
Both bitcoin and ether rallied last week. The price of bitcoin briefly touched 24,200 (8% rally w/w) as traders rushed to cover shorts on July 20, then consolidated near 22,000 over the weekend. Ether outperformed bitcoin, reaching a peak of nearly 1,650 (23% rally w/w) on July 24, while ether classic (ETC) outperformed ether, enjoying a brief peak at nearly 28 (41% rally w/w). Notwithstanding, we do not expect significant upward momentum over the next few sessions as the market focuses on the FOMC rate increase and the corporate earnings release.
Exhibit 2: Ether Classic Price
Source: Bloomberg as of July 25, 2022.
The bullish momentum surrounding ETH was ignited by the network’s preparation to switch to a proof-of-stake (PoS) consensus protocol on September 19. At the Ethereum Community Conference (EthCC) last week, Vitalik Buterin, co-founder of Ethereum, noted that this new Ethereum network will be able to manage 100,000 transactions per second, relieve high gas fees, and provide the scalability required for user adoption and utility. ETC will benefit from the “merge trade” as ETH miners are expected to switch their Ethereum hashrates to the Ethereum Classic network. ETC breakout, confirmed by momentum indicators, was significant as the 20-day moving average (MA) crossed above the 50-day MA on July 21. Interestingly, Grayscale Ethereum Classic Trust (ETCG) discount deepened to 58% as of July 22, reflecting a lack of secondary market liquidity.
While the credit contagion is not completely over, deleveraging seems to be well underway, as evidenced by the following observations:
The front-end of the ATM-implied volatility curve rallied to mid-70% p.a. for BTC and 105% p.a. for ETH, reflecting shorts covering positions as the crypto market rallied last week. BTC risk sentiment is still skewed towards puts with a put/call ratio of 0.58; on the contrary, ETH shows a bullish sign of 0.32 as traders accumulate longs. On Deribit, $190 million was anchored at 15,000 BTC put strike, $160 million at 18,000 BTC, and $180 million at 20,000 BTC; $87 million anchored at 900 ETH put strike and $15 million at 1,000 ETH.
The ongoing credit contagion in cryptoland puts credit risk management at the heart of client conversations. This week, we summarize “How to Manage Cryptoasset Credit Risk,” a 2019 white paper co-written by Dr. Dmitry Pugachevsky of Quantifi and our CEO, Wilfred Daye.
As institutionalization of cryptoland evolves, centralized exchanges (CEXs), crypto prime brokers, and shadow banks such as Celsius, became systematically important quasi-financial institutions for the crypto industry. These crypto institutions provide customers with optionality for managing counterparty risk by moving credit exposure to a more established institution. For CEXs, exchange customers’ funds are commingled and customers are de facto unsecured creditors in the event of a CEX default. Furthermore, when financial institutions or brokers use assets held as collateral for one client in transactions for another, as in a rehypothecation practice, they exacerbate the risk of insolvency by increasing the likelihood of default due to insufficient assets to meet financial obligations.
Counterparty risk can be qualified into three categories:
Prime brokers, hedge funds, exchanges, shadow banks, and other actors in cryptoland are highly correlated to each other and to crypto asset price. Recent market events highlighted unfavorable dependence between exposure and counterparty credit quality. Exhibit 3 shows conditional expected exposure for bitcoin (70% annual volatility), a hedge fund counterparty with 30% annual default probability, and 70% correlation between asset price and default time of the hedge fund.
Exhibit 3: Non-Correlated and Wrong-Way Exposure
Source: Securitize Capital as of July 24, 2022.
Exhibit 3 illustrates that without considering wrong-way risk, a risk manager underestimates exposure by three times. The wrong-way risk term structure effect shows that conditional exposure in the shorter term is more dramatic than in the long term due to the correlation of default timing and asset price.
Tracking the weekly movement of the major cryptocurrencies.
Top 20 Cryptocurrencies – 7-Day Price Change
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