Where Did All That Value Go?

June 2022 Commentary

The digital assets market is known for its volatility and June certainly did not disappoint. The market touched a low on June 18, erasing 73% off its peak reached back in early Nov. 2021.

This pullback took place against the backdrop of continued heightened market and geopolitical uncertainty. The US posted annual inflation rate of 8.6% in early June, only to be surpassed by the UK with a consumer price inflation print of 9.1%. Higher inflation will be met by central bankers with higher short-term rates and by the market with higher long-term rates. It is no wonder that investors remain jittery about taking on risk. Tech and smaller stocks, as proxied by the Nasdaq Composite, dropped over 8% for the month and close to 30% year-to-date. Digital assets, given their broader adoption, are considered as long duration risk assets and trade alongside tech stocks with a correlation close to 60%, albeit with higher beta.

To be clear, the digital assets market had its own reasons to keep investors on their toes. The implosion of the Terra ecosystem back in May was a shock with ripples becoming obvious in waves over time. Early indications of the effects first manifested in mid-June with Celsius, a centralized lending platform, halting withdrawals. Days later, rumors circulated on Twitter that Three Arrows Capital (3AC) was insolvent, having made leveraged bets on assets that included LUNA and Solana. The extent of their leverage is still unknown, but lenders were reported to have liquidated 3AC’s positions. The ripple effects in June have been far and wide. Digital assets lost another 40% of their market cap (~ $500 B) by mid-June. Staked ether (stETH), an asset that typically trades closely in price to ETH, traded at over a 7% discount in mid-June. BlockFi, another centralized lender, received a $250M line of credit from Alameda Research, a crypto trading firm associated with FTX. Voyager Digital, a digital assets broker, revealed that it had an uncollateralized $660M loan to 3AC that it was trying to collect on, and it too received a $500M loan from FTX. 

This drop over the last 7 months equated to over $2 T, leaving the market hovering just below $800 B in size. Twelve to eleven zeros may be hard to wrap one’s head around so to put this in the context of company market caps, imagine that an enterprise that had an equity value of Apple plus Tesla just lost its entire value of Apple over the last 7 months. Where did all that value go? 

One of the key distinctions an investor needs to make is best summed up by Benjamin Graham with his statement, “in the short run, the market is like a voting machine but in the long run, the market is like a weighing machine”. Market prices, set in the short term by the marginal trader, reflect not only the instantaneous supply and demand dynamics, but also the constant tug-of-war between investor fear and greed, now better known as FUD and FOMO. Intrinsic value, while guided by longer term supply and demand dynamics, reflects that utility and the network opportunities of the underlying protocol. Unfortunately, intrinsic value is hard to observe. It’s relatively easier to assess for high quality sovereign bonds with cashflows, but much harder for assets with growth potential that don’t provide clear cashflow streams.

The price that an investor pays for an asset is transitory. Consider the over 70% drop in digital assets’ market cap over the last 7 months. Certainly, some price drops were warranted. The Terra ecosystem losing over 99% of its peak enterprise value of $50+B in May made sense as its stablecoin fell into a death spiral and users left the protocol en masse. However, this is not true of other digital assets. Did the utility of owning bitcoin actually diminish by 70% over the same time period? Has Ethereum, a protocol that allows for decentralized peer-to-peer transactions paired with smart contracts, actually lost so much utility and its network diminished so significantly? Rather, the price dropped precipitously as the marginal investors demanded liquidity. There were many winners, the ones who were able to sell at higher prices. In most cases, the gains were on paper, and as long as positions were not closed out, the losses were on paper as well.

There were many indications in the latter part of this month that prices may have overshot on the downside and bottomed out. This isn’t simply due to prices rebounding 12% on average off their mid-June lows. Stronger platforms were able to capitalize on the lower prices. Witness FTX lending credit to BlockFi and Voyager Digital. Goldman Sachs is pulling together $2 B to buy distressed assets from Celsius. Falcon X, a crypto exchange platform, was able to raise $150 M in a series D that doubled its valuation to $8 B while other valuations were being repriced downwards. Even though Coinbase, BlockFi, and Crypto.com were laying off employees, Binance, Kraken, Polygon, and the aforementioned Falcon X continue to hire. A few external researchers, looking at on-chain and technical data, are arguing that the bottom is forming for this bear market.

Looking at the data, June has been a historically bad month for bitcoin. With a decline of nearly 40%, we have to look back to 2011 to find a comparable monthly return. On-chain activity for bitcoin, such as number of daily active users and on-chain volume has declined as is typical of deep bear markets - indicative of the fact that remaining network users represent the hardcore group of bitcoin enthusiasts with dilettantes and speculators having fled to safer environs. On the supply side of the equation, signs of seller exhaustion are appearing. Specifically, mid-term bitcoin hodlers (holding periods between one to two years) have largely reduced their wallet contents, while the long-term hodlers (coins that have been held for over two years) continue to hold their balances steadily throughout the month.

In the case of Ethereum, on-chain leverage is visible by analysing the holdings of smart contracts themselves. For instance, collateralized debt positions in MakerDao and Aave are clearly visible on-chain, allowing for market participants to calculate prices where forced liquidations are likely to occur thus driving the market further downwards. One such critical price point was in the region of $890/eth, where a large position on Aave could have faced liquidation. Interestingly this represented the bottom of the market for ether in June as some entity managed to successfully defend this position, possibly using it as bait to liquidate short sellers. The vulnerable position was not liquidated despite the price dropping below the liquidation target price; this was due to a market operator cleverly exploiting knowledge of oracle update timing frequency.

Interestingly, and quite unusually both bitcoin and ether led the market downwards in mid-June, underperforming most altcoins. Given that during market crashes in crypto typically we see a “flight to quality” or a flight to the comparative safety of long-established coins like the two largest names, this was mostly likely due to forced liquidations of large asset holders. This suggests in both bitcoin and ether may be oversold relative to alternatives and may outperform in the short term.

We’ve been enduring a deep bear market for many months now, with most metrics related to on- and off-chain activity consistent with the deepest stages of previous bear markets. Nevertheless, our thesis on blockchain based digital assets heralding a new era of financial inclusion and individual empowerment remains unchanged. Our view is that this represents a healthy correction following a period of irrational exuberance. Most of the projects which culminated in the so-called DeFi Summer of 2020 were spawned in the depths of the Crypto Winter from early 2018 to 2020 and bear markets are essential for weeding out poor projects and even exposing fraudulent entities and actors before they begin to represent systemic threats. Forecasting the exact timing of the end of the bear market is something of a fool's errand, nevertheless, end it will and the digital assets space will emerge stronger for it. We couldn’t have asked for a more exciting opportunity to buy quality digital assets.