September 2021 commentary
Without disappointing, September has proven again to be a difficult month for markets. Regulatory actions in the US tend to be announced towards the year-end, and the SEC has made sure to keep the tradition alive, threatening to sue Coinbase if they proceeded with their “Lend” product, and the SEC also failed to offer any further clarity on currently offered interest accounts from the likes of BlockFi and Celsius. In addition, SEC Chair Gensler made a few worrying remarks, “It’s a misnomer to say they are just software they put out in the web” emphasising that DeFi platforms have a “fair amount of centralisation”. A case in point was when AMM platform Uniswap decided to delist a number of tokens that resembled securities when the SEC started looking at the space, or aggregator platform 1inch, that blocked-out US traders and plans to launch a US-dedicated platform to remain compliant. Stablecoins are also being discussed, with FED Chair Powell comparing them to money market funds or bank accounts and calling for comparable regulation. Although some regulation is necessary for the market to mature, some unreasonable proposals are at risk of being approved by the House before the end of October, with Biden determined to pass the infrastructure bill well before that and, hidden in it, requirements for everyone that facilitates crypto transactions (without clearly excluding miners, or even developers) to collect personal details of the parties involved in the transactions, as well as reporting requirement to the IRS for anyone involved in a crypto transaction of more than $10,000 in value. An unattainable challenge in a decentralised pseudonymous p2p market.
If you think that the crypto industry in the US is under pressure, the Chinese government brought the game to a whole new level towards the end of the Summer season. In the most serious crackdown to-date, the Central Bank (PBoC), along with nine other central government and judicial agencies, released a statement declaring all crypto transactions illegal. While the announcement came late in the season, it seems that insiders were warned long before, helping to explain the sell-off two weeks earlier. In response to the renewed emphasis on the anti-crypto stance of the government, exchanges like Huobi and Binance announced that they would prohibit users from mainland China to trade on their platforms, while market data platforms like CoinGecko and CoinMarketCap are now fully blocked. Further to that, the notice seems to extend also to those who live in China but are employed by offshore crypto firms.
While still too early to see how this will play out in the future, one interesting datapoint is displayed in Figure 2, where we observe the trading performance of the ETH/USDT pair in the separate trading sessions of New York, London, and Hong Kong. Throughout the last two years, the entirety of the buying interest was shown during the Western session, when retail activity peaks. Asian hours have instead demonstrated a constant selling pressure, perhaps reflecting the lower retail participation, as well as the higher number of miners, who might offload inventory via OTC trades during their respective daytime.
Meanwhile, mining activity has not been unaffected by the latest tightening by the Chinese government. After the exodus of Bitcoin miners earlier in the year, Ethereum mining pools Beepool (4th largest) and Sparkpool (2nd largest) announced that they will terminate operations in early October. The largest reseller of mining equipment and b2b e-commerce giant Alibaba has notified third-party merchants that sales of crypto mining equipment will be prohibited, further weakening the prospects for the industry in the country.
On an alternative trend, mining capacity which has been lost in China is resurfacing online in North America and other regions. In Figure 3 we display the daily estimated hashrate of the Bitcoin network, and we can observe how it has increased by 100% after the Q2 crash and the low reached earlier in the Summer. Most of the capacity added to the network this Summer is generated by ASICs ordered last year and only recently delivered, so we can expect additional capacity to be brought online as Chinese miners redeploy their machines offshore.
Despite the positive figures on the hashrate recovery, we notice that the current macro backdrop has been historically adverse for crypto prices, with particular emphasis on the tapering off of major Central Banks balance sheet growth. Previous examples of significantly lower magnitude can be found in 2014 and 2018. Global markets also had a negative month, with drama surrounding Evergrande debt and heavy losses across the Chinese tech sector, as well as stagflation fear in the US, where the debt ceiling farce is being repeated once more.
In response to the adverse environment during September the crypto market accumulated losses of approximately 10%, on average. There was a partial recovery on the 1st of October, as a celebration for the start of the new quarter, and of the words of Chairman Powell who, while calling for tighter regulation for stablecoins, stated that there is no intention to outright ban cryptocurrencies in the US.
While the homepage of news websites alternate between positive and negative events, crypto adoption proceeds, unstoppable, on its path to mainstream usage. The Bitcoin Lightning network, the only viable solution for Bitcoin micropayments, has seen a parabolic growth in network capacity, as displayed in Figure 4, and in the number of channels online which recently surpassed the 70k mark. Widespread adoption of the Ethereum network does not surprise anymore, with more than $1 billion in Ether being burned since EIP-1559 went online in early August, and as a result of the intense usage of the network. Another signal of the success of Ethereum comes from the implementation of an NFT verification system (on Ethereum) for profile pictures on Twitter, a platform whose funder is fully dedicated to the growth of the Bitcoin ecosystem. Twitter, earlier in September, also released a tipping functionality that leverages the Lightning network. Another social media platform that bought into the NFT mania is TikTok, which plans to release a collection of their most popular videos as NFTs, with the intention to empower the creators on their platform. As shown in Figure 5, NFTs show remarkable resilience, despite the cooldown of the wider market, and the palpable frothiness of the NFT market, sales keep increasing, and are approaching their previous all-time high of 85,000 daily transactions. Some of the valuations have come down considerably, in particular in some of the lower quality projects, but adoption is increasing as also demonstrated by the weekly recurrence of Sotheby’s and Christie’s auctions.
When looking at the latest drivers of adoptions, one might forget that crypto was first about finance, but innovation is not lacking in this sector either. The sophistication of the structured products in DeFi is increasing, while simpler products like Perpetual Swaps experienced their moment of fame when non-custodial (and non-KYCd) derivative platform DyDx recorded two days of volumes approaching $10b (more than Coinbase on those days) due to their trading incentives and the parabolic price increase of their governance token. In the lending markets, MakerDAO has received an application from SocGen for a $20m loan in DAI collateralised by tokenised bonds rated AAA by Moody’s and Fitch. As one of the most significant interactions between traditional finance and DeFi to-date, this pilot project is expected to provide the legal architecture to reproduce similar deals at scale, allowing to address the huge Repo market.
Another huge market that might soon be within crypto’s reach is the US ETF market, with multiple deadlines for the SEC ruling approaching for both physical and future (CME) backed products. The latter, in particular, seems likely to be approved, with SEC Chair Gensler declaring that the agency was looking forward to reviewing new applications for these kinds of products.
Looking at the price performance of various tokens more closely, a few names showed considerable strength and, including August, distanced themselves from the rest of the market, with price increases between 150% and 400%, as shown in Figure 1. The common characteristic among these tokens is that they represent the native currency of an L-1 protocol, those who used to be called ETH-killers. We show in Figure 6 the YTD growth in TVL within the DeFi ecosystems that developed on top of these alternative (to Ethereum) Blockchains. But how does this reconcile with the ever-growing popularity of Ethereum itself? Are these protocols trying to replace Ethereum in a winner-take-all game?
The market currently thinks that this is not a likely future, and it is instead considering the idea of a multichain world, where the user interacts with different purpose-built blockchains via service-specific front-ends (OpenSea for example shows someone’s NFTs on both Ethereum and Polygon). As bridging capabilities develop, and natively interoperable Blockchains mature (Cosmos SDK IBC module released earlier this year), the difficulties of managing assets across multiple chains will be abstracted away from the user with cross-chain wallets (XDEFI just raised $6m) enabling seamless portability across chains.
L-1 competitors to Ethereum however represent a small part of the market, with an insignificant share of Spot volume and, as displayed by Figure 7, of the derivatives market. Counting by Open Interest (OI), almost 80% of the value is written on BTC and ETH.
As discussed in the August commentary, “Unless more capital is deployed in the weeks to come, the speculative activity would not suggest a bullish positioning”, and indeed we saw a cooldown of the bid on derivative products. Overall, this caused the derivative markets to shrink by a third, with spot demand ultimately failing to compensate for the shift and causing prices to move lower. In Figure 8 we show the decisive reduction in OI on major derivative venues for Futures and Options on Bitcoin and Ether.
As expected from the loss of Open Interest, demand for leverage has been low during September, after having collapsed on September 7th when the market moved 15% lower while liquidating $3.2B of long positions. We show in Figure 9 the superimposition of premia for Perpetual Swap contracts on Bitcoin and Ether traded on major derivatives exchanges.
With the recent recovery in sentiment and the market moving higher at the start of October, rates are recovering across the board, with the Futures curve steepening and showing a consistent upward trend on all maturities.
Options markets have also shown signs of a reversal, after weeks of negative skew on short-term maturities (with puts more expensive than comparable calls), recent readings are in more neutral territory, with a better outlook for BTC than ETH currently. Implied Volatility (IV) structure remains in contango, as we are unlikely to see a spike in short-term volatility without a significant contribution from the Perpetual and Futures markets.
Provided that we still believe that more capital needs to be deployed on spot markets for prices to move materially higher, we observe in Figure 10 that, with hindsight, the regime of net outflows from exchanges started in March 2020 was not interrupted by the sudden increase in inflows earlier this year. Exchange outflows are still a predominant characteristic of this market, ever reducing the available supply of Bitcoins for sale and setting the stage for higher prices once demand picks up.
Other on-chain indicators however seem to paint a less optimistic picture, showing an overall cooldown in activity, that historically has coincided with periods of bear market. In Figure 11 we show the moving average of the number of active entities on the Bitcoin network, highlighting a baseline increasing trend of adoption, as well as times of explosive, speculative activity that have historically coincided with substantial price increases.
Currently, and throughout the Summer, activity has slowed down considerably, reaching a level well within the expected baseline trend. There is however no indication of when the activity will pick up again. However, as discussed at length, there are numerous reasons to believe that it might not take long after all.