January 2023 Commentary

News Highlights

1. Biden outlines plans for crypto regulation
2. Crypto lending unit of Genesis files for U.S. bankruptcy
3. Coinbase Follows Kraken to Japan Exit
4. Coinbase Insider Trader Gets 10 Months In Prison
5. SEC Charges Avraham Eisenberg with Manipulating Mango Markets’ “Governance Token”
6. SEC Alleges Gemini, Genesis Sold Unregistered Securities
7. Sam Bankman-Fried Issues Not-Guilty Plea in FTX Case
8. SBF to forfeit $700M worth of assets if found guilty of fraud
9. Prosecutor seeks to restrict SBF’s bail after apparent attempts to influence witnesses
10. Justice Department probes Silvergate’s relationship with FTX
11. Flashbots seeks up to $50 million at a billion-dollar valuation
12. Amazon NFT initiative expected in the Spring
13. eBay NFT Job Openings Hint At Web3 Showdown With Amazon
14. Pfizer Ventures backs decentralized science startup
15. Crypto banking suffers blow as Custodia Bank’s Federal Reserve application denied
16. Ordinals Project has launched on Bitcoin, enabling native on-chain NFTs.

Chart of the month:

Figure 1: Bear market price drawdown profiles for Bitcoin. In black the 2014 bear market, in blue the 2018 bear market and in red the current cycle. Prices so far have followed a similar behaviour, suggesting that the bottom might be close. source: arcane research

Commentary:

Who could have imagined a better way to start the year than what we observed this January?

The overall crypto market cap has grown by over 30%, regaining the 1 trillion USD mark towards the end of the month. Trading volumes have risen, specific events have ignited price action for altcoins, and the macro environment eased — making buy-side taker demand resurface on both spot and derivative markets.

Having left the FED quite hawkish before the Festive period, the market was positively surprised to see that a contraction in the CPI numbers and the job market maintaining strength caused chair Powell to hint that the measures taken so far are working and significant further tightening might not be necessary. The combination of a strong labour market and decreasing inflation are being read as an increased probability for a soft landing to actually take place, avoiding the previously unstoppable recession. The overall rally in risky asset (equities, bonds, and cryptocurrencies alike) has therefore been sudden, leaving many on the sidelines, underexposed to gains that a month ago would have been considered optimistic over a year period, let alone over a month.

Many investors are therefore now faced with the decision of whether to take on risk now or wait for a better entry price. A decision almost entirely predicated on the view of the overall strength of the economy, inflation behaviour, and FED response to those two variables. The outcome is binary: we could be out of the woods, preparing for a soft landing which is followed by a more accommodative interest rate policy that justifies higher prices, on the other hand, market sentiment might have swung too far towards optimism this January, and the reality is that, as indicated by some forward-looking indicators, inflation will struggle to fall much further and the FED will have to maintain a tighter grip on the economy. At the same time, the reserves accumulated during COVID have mostly been spent, and despite a strong job market, the effects of the increasing layoffs could cause recessionary forces to kick in, overall hindering the top line of most companies.

Figure 2: Drawdown chart for the amount of assets held by Federal Reserve Banks. It can be noticed that the current tightening is still in its initial phases, and it has more room to go. source: Federal Reserve

Figure 3: Fed Funds Rate (pink) superimposed on the 5 years forward 5 years rate. The chart shows how the Fed in the past has often stopped hiking and shortly after started to cut rates once reaching the market forward rate, thereby suggesting that the current hiking might be coming to an end soon. source: Convexity Maven

Figure 4: Time series of curve steepness between the 10 year and 3 months rate. The charts highlight in grey periods of recession, indicating how they follow periods of curve inversion, when the longer dated rates fall below the front months. The curve has now reached levels of backwardation not seen since the ’70s. source: Convexity Maven

To put things into context, we show in Figure 2 the relative reduction in the FED balance sheet from its most recent highs. The chart shows how little has been done so far in this tightening cycle, suggesting that it is perhaps optimistic to think that the FED is ready to stop, more so if it can continue without hurting the economy.

On the other hand, in Figure 3, we show the 5 years forward 5 years rate against the FED Funds rate, highlighting how the former has provided a ceiling to the latter over the last 25 years. Currently, with the FED rate having already exceeded the Futures implied rate, this indicator suggests that further hikes are unlikely.

Supporting this view, albeit in a negative scenario, is the yield curve steepness indicator shown in Figure 4. Since the late 60s, we have observed recessionary periods following the inversion of the curve, with short term rates higher than the longer ones. Current levels, last seen in the 70s, suggest that the probability of a recession hitting the US economy over the coming quarters is high.

Somewhere else, however, the recession has already hit, and as such, the light on the other side of the tunnel gets closer. In Cryptoland the economy has experienced a leverage crisis in its financial sector, with all the largest centralised brokers/lenders currently in bankruptcy, and multiple other players forced to close down operations or severely cut costs, going through often significant layoffs. In Figure 5 we show the relationship between the contraction in trading volumes and the percentage of workforce laid off over the previous year for a set of large, centralised exchanges. Despite the distress that has hit the industry over the last year, the silver lining that came with it is the rapid elimination of unsuccessful business models, unprofitable operations and fraudulent ones, providing a fertile ground to rebuild and focus on the businesses that instead have shown resilience and stability during times of crisis, enabling a new cycle of growth. Similarly, to the broader tech sector, the crypto ecosystem is somewhat loosening its correlation to the broader economy, albeit at the dire cost of going through a recessionary period.

Figure 5: Comparison of the contraction in volumes and yearly layoffs for major centralised trading venues. Binance stands out with lowest drop in volumes and no meaningful layoffs. Coinbase and Huobi are instead leading the group with number of layoffs at approximately 40%. The latter experiencing a reduction in trading activity of almost 90%, a similar level observed on Kraken. source: Kaiko

Despite the strong contraction in activity in DeFi, the number of developers abandoning the space is moderate compared to the layoffs observed among centralised entities. As we show in Figure 6, for most DeFi ecosystems, the number of developers has not decreased significantly during the year, with the exception of the Ethereum DeFi ecosystem, which has lost almost 20% of its developer. To put this into context however, it should be considered the incredible wave of adoption during 2020 and 2021, which has brought the developer count on Ethereum to one order of magnitude more than any other ecosystem. With total assets in DeFi dropping more than 70% during the year, the commitment of the developers’ community is a testament to the potential of the sector and the unstoppable innovation.

Figure 6: Number of developers active in different DeFi ecosystems since 2015. The dominance of Ethereum is uncontested, while the race for second most popular sees Cosmos leading the way followed in short distance by Solana, Polkadot and BNB Chain (Binance). source: Electric Capital

Figure 7: Time series of the mining difficulty (in black) plotted against the mean hash rate (in blue) since 2016. Despite the increasing energy prices and decreasing Bitcoin prices, which caused multiple miners to face financial issues or bankruptcy, competition has increased over the year, with difficulty currently at an all-time high. Extensive investments in the space, and orders from late 2021 and early 2022 being shipped only recently are the culprit of the current hash market. source: Galaxy Research

A subsector of the crypto economy that instead has suffered considerably in 2022, has been Bitcoin mining, which has seen widespread losses and defaults resulting from the decreasing BTC price and increasing electricity prices. Despite these difficulties, and due to the long delivery time of orders for ASIC hardware, increasing capacity has hit the network throughout the year, causing mining difficulty, a proxy for competition, to reach an all-time high, as shown in Figure 7. It should be noted that Bitcoin mining, from the miners point of view, is a zero-sum game. The size of the pie does not increase as a result in investments in newer and better mining machines, which only tilt the relative market share of each miner against all the others. The increasing difficulty registered on the Bitcoin network is therefore a testament to the ever-increasing security, independently of the token price.

Figure 8: Share price performance over 2022 for a group of publicly traded mining companies, compared with Bitcoin (yellow) and a proxy for the Nasdaq index (QQQ ). All miners have severely underperformed Bitcoin, with some reaching bankruptcy. source: Galaxy Research

The performance of the stock price of public mining companies has been terrible over last year, although the positive price action of Bitcoin over January has caused a strong recovery, as shown in Figure 8. The high beta of this segment of the market is mostly due to the variable rate of return nature of the proof-of-work mining business. Producing a single Bitcoin has a cost that is independent of the token prices as a first-order effect (second-order, the increasing price brings increased competition, increasing the cost of producing 1 BTC) and therefore in an efficient market, where the long-term rate of return earned as compensation for holding such businesses is approximately constant, the share price must move faster than BTC itself.

The environment in the crypto industry is a mix of successes, mostly on the decentralised side of the spectrum, and failures, mostly on the centralised side. Lenders, miners, exchanges, as well as other businesses reliant on the retail speculative frenzy, had a very difficult year, and most will not recover to participate in the next cycle. Decentralised, trust-minimising and transparent protocols have instead shown their merits, working relentlessly through the most challenging times, and supporting an ever-larger share of market activity. The latter trend has seen a reversal in January, with the market gaining confidence and causing a spike in centralised exchange volumes.

Figure 9: Price action for Bitcoin (orange) over the last four months superimposed on the S&P500 index (red), Nasdaq100 index (blue) and the price of Gold (yellow). With the strong start of the year, Bitcoin has recovered the November sell-off, and outperformed the other indicators over the period. Source: TradingView

The outstanding performance of traditional markets, combined with an oversold tech sector, caused a spectacular rebound during January, with gains across most crypto assets north of 30% and, in certain cases, reaching multiples of 2/3x. As shown in Figure 9, the last couple of weeks has made up for the ground lost during the broader market sell-off caused by the collapse of FTX, realigning the performance of Bitcoin with that of Gold, over the last 6 months.

Positive price action in January has also caused a shift in market structure that, combined with the reduced competition resulting from market makers reducing their crypto exposure, created numerous opportunities for those still participating in the market. As shown in Figure 10, since the CPI print in the first half of January, volatility has picked up considerably as well as the demand for derivative exposure, as demonstrated by the higher funding rates. We show in Figure 11 a longer time series of funding rates aggregated over the major derivative exchanges, adding context to the recent increase in demand for upside leverage, relative to the average behaviour over the last six months. It can be noticed how market sentiment is currently at its best since the collapse of Luna and the beginning of the cascade of bankruptcies we observed over the last few months.

Figure 10: Over the last three weeks of January, the market has found a strong bid, as testified by the funding rates becoming consistently positive, showing demand for long leveraged exposure to Bitcoin. Volatility has also increased over the period, with larger daily swings indicating limited involvement from market makers previously active in the market. source: Kaiko

Figure 11: Average funding rates for the main Bitcoin perpetual swap contracts, since the Summer. The large negative hedging rates during the FTX crisis can be observed in the first half of November, while consistently higher funding rates can be observed since mid-January, despite having been positive since December. source: Coinalyze

Figure 12: Monthly trading volume chart for the main Bitcoin derivative contracts. After the low activity period during the second half of November until the beginning of January, the last few weeks have registered an activity comparable to the whole month of October. source: The Block

Figure 13: Time series of total Open Interest for the main Bitcoin perpetual swap contracts. Stablecoin collateralised contracts (linear) are represented in red, while coin-margined contracts (inverses, denominated in fix amount of dollars) are in green. We observe an inversion in the trend, with the number of open derivative contract growing over the last few weeks. source: Coinalyze

Increased activity over the last few weeks can also be observed through the increase in trading volume over January which, as shown in Figure 12, is almost twice as large as December, while still representing the second-lowest reading in the last 12 months. The response of the market to improved macro conditions is however a positive sign, setting a trend we expect to see continuing over February. Participation in the market can instead be inferred through changes in the derivative open interest, shown in Figure 13 for Bitcoin perpetual swap contracts, which indicates that only a moderate number of new positions have been added to the market during this rally.

Figure 14: Price action for a selection of projects that have outperformed the market since the beginning of November. source: TradingView

In turn this suggests that most investors did not participate in the gains and are still observing the market. Further positive price action could be enough to trigger widespread retail FOMO and force allocators to take on some crypto risk, further fuelling price appreciation.

Some signs of this behaviour can already be observed on a number of altcoins that have experienced astronomical gains over the previous few weeks. As shown in Figure 14, the performance of a selected number of projects has been such that their price greatly exceeded the pre-FTX level, with some establishing new all-time highs.

Positive narratives do not only affect new and relatively small projects. Ethereum, the second largest crypto, is well positioned to see further volatility, with the Shanghai network upgrade scheduled for March, where the withdrawal of ETH staked by validators will be enabled, possibly providing a catalyst for explosive price action, or perhaps providing the market with a fresh source of liquidity. Either way, it will be an interesting event to follow, and in particular its effect on the liquid staking derivative market, which will dramatically change as a result of the Shanghai upgrade.

Another significant trend poised to permanently change the market structure is the increased level of due diligence and risk mitigation solutions demanded by market participants, which, among other things, is redirecting trading activity towards more regulated and more transparent entities. This is well exemplified by the chart in Figure 15, which shows how the market share of the CME Future contracts compared to the overall Bitcoin derivative market has doubled since the collapse of FTX and represents now over a fifth of the total open interest.

Figure 15: Time series of the percentage of Bitcoin derivative contracts traded on the CME since late 2019. After a period of contraction over the second half of 2021 and the first half of 2022, and as a consequence of the reduced trust in offshore trading venues, CME dominance almost doubled over the last few months, reaching now over 20% of the total market. Source: arcane research

Regardless of the subjective opinions on the most likely scenario that will play out for the state of the economy, inflation, and rates, the crypto market has shown once more that can quickly gain the attention of the market, with the most promising projects still attracting considerable funding or quickly appreciating when trading in public markets. The almost uninterrupted sell-off, initiated with the collapse of Luna, seems to have come to a conclusion, letting the market breathe, and allowing prices to move higher again. We do not expect significant amounts of collateral to be left to liquidate, in particular of the most liquid coins. Some idiosyncratic risks linked to the Grayscale trust and Shanghai upgrade, as well as significant token unlocks could still cause abnormal sell-offs, but these should be contained, when compared to the unwinding of the enormous leverage accumulated by players like Celsius, BlockFi, and Alameda. While sector-specific outperformance will be driven by relative levels of adoption (currently scaling solutions and new high-performance blockchains seems to be the hottest sector, while DeFi remains relatively cold), the industry has started the year on the right footing, and rich of the lessons learned in 2022, is set to innovate, build better products and attract new investments and widespread usage across both institutions and retail.