Value renewal through creative destruction

August 4th, 2022

Just like in nature, capital market destruction precedes creative value renewal.

The capital markets are driven by people, who by their nature are constantly evolving through the ascending cycles of increasing quantity and higher quality. The initial availability of resources and absence of competition fuels indiscriminate innovation that attempts to create value by combing existing elements in novel ways. Everything grows and capital is diffused across a broad range of ideas.

As the competition for capital picks up, the overcrowding and increased over-connectedness of increasingly similar projects set the stage for the cycle of creative destruction. Creative destruction facilitates the evolutionary feedback loop, which rebalances and strengthens the ecosystem by favouring more efficient uses of increasingly scarce resources. Increasing quantity is thereby transmuted into higher quality.

The quality of surviving ideas must match the value of the scarce supply of capital. Those that survive have either to dominate or find themselves a niche where they can persist. Higher quality projects create the most value with the given resources and ultimately generate higher returns for scarcer capital. Quality lays the foundation for longevity.

Summary

Peak Fed hawkishness and anticipated Ethereum merge lifted sentiment
The global crypto market cap increased 22% to $1.1 trillion in July
The gains were led by ETH up 57%, with BTC recovering by 17%
Fed guidance supported risk, despite elevated CPI print and 75bps hike
US labour market proving more resilient and peak inflation is in sight
Ethereum PoS merge filled narrative void, driving ETH outperformance
Attractive levels and short position liquidations accelerated the relief rally
DeFi capital scarcity sets the stage for greater efficiency

Peak Fed rates support market optimism

The market is a perpetual voting machine. At any given moment in time, the single objective market price is our best available signal of the multiple subjective economic fundamentals. The information value of the price signal lies both in its level and the rate of change in concurrent response to the new state of fundamentals. In particular, the counterintuitive market price reaction to a given change in fundamentals carries the most significant signal about the current investor positioning, sentiment and intentions.

Enter the July FOMC meeting. An event that led to a fourth consecutive Fed fund rate hike, this time at 75bps, was intended to reign in market animal spirits by significantly increasing the opportunity cost of deployed risk capital. This change in fundamentals was driven by the Fed’s desire to tame persistent inflationary pressures, which resulted from the reinforcing effects of stimulus boosted demand and commodity supply price shocks. The rate hike was delivered, and yet the equity and crypto markets staged a sustained price rally. Was this our signal?

The market has cast its vote and the game is afoot. Like the seasons, the old narrative must eventually give way to the new and market price expectations to reflect the anticipated trajectory of the fundamentals. In our case, the frontloaded interest rate hikes provided much-needed respite for future inflationary expectations and the implied Fed funds rate path. As the Fed transition from cruise control to manual data-depended mode, the market participants are shifting attention to easing long-term rate expectations and supporting long-duration growth assets. The peak inflation and rates narrative is gaining pace, revealing investors’ positioning, sentiment and intentions.

Ethereum merge filling the narrative void

In crypto, the only real fear is missing out. The fear of locking in portfolio losses and missing out on the next rally sets the stage for significant price rallies on the back of improving market sentiment. This was most evident in the strong July ETH performance, up 57%, as the anticipated Proof-of-stake merge filled the recent narrative void. Ethereum is expected to undergo a major network upgrade in September that will pave the way for a more energy-efficient decentralized Layer 1 consensus mechanism, scaled by the existing Layer 2 rollup solutions (e.g. Polygon, Optimism, Arbitrum, Metis). The price rally was accelerated by significant liquidations of short ETH positions, as illustrated by the change in funding rates. In addition, the low inventory of ETH on the centralised exchanges, due to staking, provided additional narrative tailwinds.

Persistent DeFi capital scarcity

If we zoom out, despite the July price rally Ethereum still has a long way to go to regain its November 2021 highs. This has negative implications for the DeFi ecosystem, which is predominately concentrated in the Ethereum-based protocols (65% of TVL). Given that a third of 122m of circulating ETH supply is deployed in DeFi, the $320bn decline in Ethereum market capitalization is accountable for almost 80% of the total fall in available DeFi capital. The rising Ethereum price tide will lift the DeFi boats, with higher activity and return opportunities across the chain.

The remaining missing piece of the puzzle is the total stablecoin supply. Stablecoins are the natural on-ramp into the digital asset ecosystem and their circulating supply is a major factor in the health of the DeFi landscape. Following a depeg of Terra’s stablecoin, the total circulating supply declined by over $30bn within a few months. The resulting liquidity gap made up the majority of the remaining 20% decline in DeFi funding supply. Once again, the ascending evolution from quantity to quality holds true in stablecoins, with the competitive market forces animating the cycle of creative destruction. Stability comes from deep roots.

Value creation from capital scarcity

The DeFi funding dip creates scarcity, while scarcity creates value. Since the essence of capital value creation is a function of a sustainable rate of return on scarce resources, a lower capital base supporting a given level of activity will yield the most value. As the total supply of DeFi capital has decreased significantly, the value accrual from the inevitable pick-up in activity will accrue to a smaller base of investors, who will likely enjoy a higher yield. Looking at the leading DeFi lending protocol (AAVE) as an example, we can see a significant rise in available debt utilisation rate as the supply of funding has contracted. Any additional pick-up in borrower demand is likely to further lift the utilistaion rate and drive up the yield on the deployed capital.

Another example of the value of scarcity and improved efficiency can be seen in the leading stablecoin DeFi exchange (Curve). Similar to AAVE, the total deployed capital (TVL) has declined by over 80% since the start of this year. However, the decline in protocol activity has not been as severe, as the Curve liquidity pools continue to serve as a cornerstone piece in DeFi ecosystem. The painful cycle of creative destruction has merely shed the light on less productive use cases, which lays the foundation for greater DeFi resilience and higher return on scarce resources. The darkest night reveals the brightest stars that guide one’s path in DeFI.

Bitcoin as a life raft investment

As a closing thought, it is worth briefly mentioning our old friend Bitcoin. With the Ethereum merge story monopolizing the investor’s consciousness, we must not forget the core value of scarcity.

In markets, the only certainty is future uncertainty. As an investment fiduciary, one must prepare the portfolio for the full range of future risk probabilities. Endurance is preparation in action.

Some assets carry more than their weight in value. Bitcoin is one of those assets that by its design, is unlike any other in the traditional investor portfolio. It's neither inflationary like a fiat currency nor is it someone else's liability like equity or bonds. It’s truly a scarce asset.

Bitcoin's unique attributes and scarcity make it a perfect 'life raft' asset. Even a 1% portfolio weight allocation provides outsized risk mitigation benefits. This allocation can be funded from equities, with an optional increase in bond exposure for those wishing to maintain a target total portfolio risk. As with the life raft, excluding Bitcoin exposes one to the greatest future wealth preservation risk.

The future is uncertain, but one can prepare today to weather the storm and sail with the winds of tomorrow.

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