RESEARCH

Degens, Drawdowns and Deleveraging

The Weekly Catch-up

Summary:

Higher inflation and slower growth is what the week’s data brought us yet retail keeps buying. This is not the case in digital assets, where, unfortunately, many retail investors have gotten hurt by the recent collapse of several centralized lending platforms, who were taking on the increased risk to attract customers with high yields in true degen fashion. Hedge fund-like behavior without the label so the industry may now face its own Volcker moment with regulators. Those that managed risk appropriately as well as more transparent decentralized platforms should benefit but confidence will take time to repair.

Macro

STAGFLATION

Let’s kick off with Europe where we saw a rise in inflation in both the UK (+9.1% yoy) and Germany (+7.9% yoy), while PPIs were at +22.1% and +33.6% respectively, numbers I had not experienced in my career. The data keeps a 30bps hike from the ECB priced in by the markets for July in play, a level which still leaves a wide rate differential with the US and causes pressure on the euro.

If producers do not pass that on to customers in short order, they will face margin squeezes and indicate that there is still a lot of inflationary pressure in the system as PPI is a leading indicator.

German and eurozone PMIs this week indicated slower activity in June, although they still pointed to expansion, with readings above the neutral 50.0 level (51.9 for Europe and 51.2 in the US).  Manufacturing fell for the first time in two years while services cooled after a post-pandemic boom. The data is a concern in light of worsening inflation that will hit consumer demand, and Germany bracing for potential shortages of natural gas this winter. 

Some cause for relief came in the form of oil prices, with WTI down 15% from its March 2022 peak, but still up over 40% this year. This means oil prices would still have to have a material correction from here to start contributing negatively to inflation prints. Copper (-20% since the April high)  and even agricultural commodities have been softening for a while but given that commodities are highly volatile, we need to watch whether the trend holds.

Lower growth estimates and commodities is likely why even as Fed chairman Powell gave a hawkish speech this week, the market is expecting them to be cutting rates by December 2023 and long-term inflation expectations remain anchored. Powell himself acknowledged that a recession is a possibility. The futures market is now pricing in fewer hikes since the last rate announcement, just above 7 hikes to year-end. 

US 5 yr breakeven inflation rates have fallen off their highs as investors are not concerned about long-term inflation 

Source: Fidelity

Another currency which remains weak is the yen, which hit a 24 year low on Tuesday as the Central Bank continues to implement yield curve control, maintaining rates at 0.25%, intervening heavily in the market last week with over 9 trillion yen of bond purchases, and catching speculators off guard.

Daily purchases of Japanese government bonds by the Bank of Japan 

Source:  WSJ

POSITIONING MATTERS

Given all of the doom and gloom, it is surprising to note that CFTC net long positioning on the Nasdaq is still substantially positive, though below record levels. A study released by VandaTrack also confirmed what we have noted this year, retail still buying, a net $24 bn over the last month, in line with the average of the last two years. 

Retail investors maintain a 70% allocation to equities despite a +30% drawdown from the top, but have reduced bond holdings. They are taking on more downside protection but not to the same extent as institutions. Will individuals change their tune if unemployment rises and house prices fall or are they all assuming a Fed backstop?

Individual investors continue to buy ETFS and individual stocks despite benign cautious about the market (one month rolling average)

Crypto

LEARNING TO WALK THE BOTTOM

Bears gripped the crypto market as weakness in broader markets and centralized crypto lender insolvencies caused BTC to dip below 18k and ETH to below 1k last weekend. Despite that, for the week, the asset class is up over 5%, in line with positive US equities. Lower beta BTC lagged (+2.3%), while ETH saw some relief after a brutal 40% drawdown in the month (+6%) on forced liquidations. Solana (+25%), Polygon (+49%), Uniswap (+39%) and Cosmos (+30%) stood out as winners for the period. 

Solana announced it is building its own blockchain smartphone. Polygon launched an ID solution for identity verification while Uniswap acquired Genie (NFT Aggregator). Cosmos was boosted by DeFi derivative exchange DyDX’s bold decision to leave Ethereum and launch on its blockchain.

The Moving Average Convergence Divergence (MACD) is one indicator that we were perhaps due a bear market bounce. The MACD is a momentum indicator that shows the difference between two moving averages of a token’s price (12 periods - 26 periods). A narrowing differential in the two average prices signals that bears are short of breath and bulls might soon take over. The chart for Ethereum shows that bears are beginning to lose their grip on the market as negative momentum divergence has formed.

Is this a green light to be bullish on digital assets then? Not so quickly as more rate tightening and slowing economies could lead to another sell-off, putting more pressure on crypto exchanges and lenders in already fragile situations. This turn of the events may create a positive feedback loop which could test the resolve of investors further.

The MACD points to a weakening bearish movement in the price of Ethereum

With regard to bitcoin, long-term holders are being tested, as 35% of the LTH supply is at a loss, though this has been worse at up to 51% in previous bear markets. Revived supply 1yr+ confirms that spending by older coins is taking place (-1.3% of their supply), accelerating to rates of 20k to 36k BTC per day as even long-term holders capitulated during the most recent sell-off.

Miner activity is also an area of interest given income contraction of 65% is greater than in the spring of 2021 (China exodus) due to lower BTC prices and higher energy costs, but has seen worse. With this financial squeeze, outflow volumes from miner treasuries reached rates of between 5k to 8k BTC per month, but has recently reverted. We also see hash rates 10% below their ATH’s as miners pull rigs. Miners also borrow fiat using BTC as collateral to back their operations.

DeFi

AN UGLY DELEVERAGING

Famed investor Ray Dalio talks about a “beautiful deleveraging” at the macro level, with the idea that the perfect combination of austerity, debt restructuring and money printing can help countries navigate the debt cycles that repeat themselves throughout history over multi-decade periods. How quickly authorities react to save the system can determine the length of the contraction.

Defi is currently living through its own deleveraging, but in this case, the original point of failure was not mortgage-backed securities or a systemically-important hedge fund such as LTCM but a run on an algorithmic stablecoin. So far, it looks ugly, with no real backstop to stem the pain, as the extent of the hedge fund-like risk-taking by centralized crypto lenders (CeDeFi) comes to light and doubtless catches the regulator’s attention. 

LEVERAGE COUPLED WITH BALANCE SHEET MISMATCHES = CRISIS

As the ability to make outsize returns got harder with less appetite to borrow in a bear market, more competition and no oversight, these actors took more risks with client funds to meet the rates promised them. The degen behavior included earning risky but juicy UST yields on Anchor, staking ETH and creating liquidity mismatches, or doling out hundreds of millions of dollars in unsecured loans to other institutions. But as markets tanked, leading to liquidations, confidence in the shakiest projects unraveled, and customers raced to withdraw their funds.

Major lending platform Celsius ($12bn in AUM)  was the first to fold on June 12 when it froze redemptions and withdrawals, as worries surrounding the source of its above-market yields reached a crescendo and led to redemptions. Turns out part of it was coming from the failed Anchor protocol. Celsius has now hired restructuring lawyers, meaning solvency is an issue and customers are unlikely to be made whole.

The Celsius token (CEL) rebounded from its ows on a short squeeze, with most supply locked on the network

Dubai-based Three Arrows Capital, one of the largest and most influential crypto VC funds became the next victim, reportedly facing at least $400mn in liquidations and forcing them to dump large amounts of sETH. The fund had also been heavily exposed to Luna. 

The latest large domino to topple is Asian-based Babel Finance, another lending platform - which raised $80 million at a $2 billion valuation and was managing £10 billion in assets in March. Babel also froze redemptions and withdrawals from its platform due to ‘unusual liquidity pressures.’ 

LENDER OF LAST RESORT OR SMOKE AND MIRRORS?

During the rout, crypto exchange FTX has been playing lender of last resort in the hope of stemming the tide of redemptions. The exchange is providing revolving credit facilities on undisclosed but likely harsh terms to lending platform, BlockFi, as well as Toronto-based Voyager Digital, which wobbled after it provided a $650 mn unsecured loan to Three Arrows Capital. Crypto sleuth Otteroo has since revealed on Twitter that FTX’s Alameda research owns over 11% of Voyager, increasing its stake before the credit facility news, with the credit terms so onerous as to likely never be used.

What is certain is that the lending landscape in crypto will change for the better, with regulators perhaps imposing a version of the Volcker rule for the industry (which banned banks from prop trading post the 2008 crisis) . It will be difficult for centralized platforms to win back the trust of investors without transparency and better risk management and Defi projects such as Aave may win share. The model will evolve, with tokenization of real assets providing hope for more real use cases for the sector, which was always one of its weaknesses.

Until next week!

The Bequant Team

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