Liquidity drought ahead

July 11th, 2022

When the music stops and the market liquidity dries up, things get complicated.

A decade of coordinated global quantitative easing and abundant liquidity fuelled one hell of a party. With the suppressed cash rates, investors were forced to seek yield by venturing out along the risk spectrum. As the music played on, credit spreads compressed, earnings multiples expanded, and levered carry trades were rewarded.

This reinforcing feedback loop of upbeat sentiment, prices and fundamentals amplified by the central bank’s drumbeat resulted in liquidity duration mismatch as present consumption and liabilities were funded by uncertain future income and assets. In essence, we got intoxicated on the borrowed happiness, postponing an inevitable hangover as the party went on.

Now the music has stopped, liquidity has dried up and ‘The Damage’ has been served.

Summary

Monetary policy tightening and growth slowdown weighed on investor sentiment
The global crypto market capitalization declined 34% to $0.86 trillion in June
BTC and ETH led the losses, down 37% and 45% respectively over the month
Sell-off extended by forced liquidations from 3AC, Celsius and Babel Finance
Liquidity gap from Terra collapse contagion in May led to a depeg of staked ETH
DeFi lending platforms showed greater resilience than their CeFi counterparts
Despite softer markets, institutional interest in digital assets continues to grow

Macroeconomic headwinds

Don’t fight the Fed. Especially as the Fed attempts to battle greater inflationary forces stemming from global supply-side price shocks and elevated US consumer demand following the fiscal stimulus hangover. While there are signs of inflation peaking and the company earnings proving more resilient than expected, the availability of market liquidity will continue to be the dominant force in determining risk asset prices and investor sentiment. The liquidity drought is upon us.

The macroeconomic headwinds of tighter monetary policy and evaporating liquidity are also driving the negative sentiment in digital assets, with a 34% decline in total market cap in June. Increasing institutional investor participation in the crypto assets is reflected in the significant correlation (> 0.50) with the tech equity market performance. Interestingly, the BTC as the digital gold narrative has yet to reveal itself, with an insignificant current correlation to gold. However, these relationships are evolving and are worth monitoring in the coming months.

The June market liquidity crunch weighed on digital asset market sentiment, pushing the spot price of BTC below $20k (2017-2018 cycle high) and contributing to a record negative QoQ return of -56%. The performance of alternative crypto assets such as ETH and other Layer 1 tokens has recorded a similar underperformance amplified further by lower liquidity. The size and pace of such price declines have historically presented good entry opportunities for astute and patient investors, particularly for the higher-quality digital assets that have survived multiple down cycles. Lindy effect in action.

Deleveraging contagion

Macro headwinds were the dominant factor behind digital asset underperformance over the period. However, we also saw a string of idiosyncratic crypto market events that resulted in forced position liquidations and diverging downside performance. The extended crypto sell-off was initiated by the huge liquidity gap due to Terra stablecoin depeg in May, which led to forced deleveraging from 3 Arrow Capital, Celsius and Babel Finance. In effect, we saw a classic wind down of liquidity duration mismatch as levered crypto investors and CeFi lenders were unable to repay their current liabilities with less liquid long-term assets (GBTC and stETH). When the music stopped, the market fell in a correlated fashion exposing the common-mode failure of excessive leverage.

As an example of a duration mismatch, we saw a depeg of staked ETH derivative (stETH) against the underlying unstaked ETH. In healthy markets, the two digital assets traded at parity as the staked ETH is expected to be fully convertible to ETH following Ethereum’s transition from Proof-of-work to Proof-of-stake. However, the combination of deleveraging cycle and ETH transition delay led to a price discount for the less liquid stETH assets. This dynamic was clearly illustrated by the stETH/ETH liquidity pool that provided an early signal for the inevitable price depeg to astute investors.

DeFi resilience

The negative economic market forces impacted both CeFi and DeFi lenders in a similar way, both systems were put through a real-world stress test of falling collateral prices and forced liquidations. However, in contrast to CeFi lenders that froze client withdrawals and filed for bankruptcy protection, the DeFi counterparts operated as intended by code with no downtime. These events once again highlighted the resilience of decentralised, trustless and transparent DeFi protocols in contrast to their centralised and opaque CeFi counterparts. The centralised lenders failed en masse, while their decentralised counterparts liquidated collateral and operated with no hiccups.

Market cycle opportunities

As the withdrawal of liquidity and inevitable credit contraction are weighing on asset prices, investors must not forget the inverse relationship between the asset price and its expected return through a multiple market cycle period. The same animal spirits that pushed asset prices to all time highs, thereby reducing expected returns and increasing downside risk, are now self-reinforcing in the opposite direction. The cooling-off asset prices and systematic deleveraging set the stage for outsized future returns at significantly lower risk. As one descends a recent peak, a higher mountain awaits ahead that holds the best of views.

As long as there are market players, there will always be new opportunities that will reward astute and patient investors. The current market environment presents an increasingly attractive risk and return trade-off across the sea of digital asset opportunities. A ship in a harbour is safe, but that is not what ships are built for.

We are always happy to hear from you and would be delighted to assist in your journey. Please reach out if you like to learn more about our investment strategies or use us as a digital asset resource.

Thank you,

OX1 Team

Summary

Macroeconomic headwinds

Deleveraging contagion

DeFi resilience

Market cycle opportunities

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