The most valuable lesson we learned from our venture journey of crypto is to constantly re-evaluate situations: where we are and how we are positioned. That’s why we write newsletters to our investor and friends every quarter to identify the trends that are below the surface of market events and price actions. Below are some Top Takeaways from Smrti’s 2Q2022 Newsletters:
The topic of Smrti’s 2Q2022 newsletter is a quote from Winston Churchill: Never let a good crisis go to waste. This newsletter will cover where we are, what we plan to do and where crypto is heading to.
TLDR:
- Market capitulation has happened, but the worst (and the accumulation stage) is yet to come.
- Bitcoin will be less relevant: adoption of digital gold will be less in magnitude than adoption of cryptography and blockchain technology enabled applications
- We are going to have a major shift in market dynamics with the coming Ethereum Merge that’s set to happen by end of 2022. The merge will make ETH the first digital native deflationary productive asset with real yields. ETH.D will replace BTC.D to be a key metric to monitor.
- We are unlikely to see exponential improvement in blockchain scalability within this year, but the infra space is actively experimenting with a variety of designs.
- More digital content and social interactions will be generated natively on-chain. The next wave of adoption is built upon a more integral Web3 and Web2+ experience compared to the fragmented one we have today.
What Qualifies a Good Crisis?
A “black swan” event refers to an unforeseen and unlikely occurrence that typically has extreme consequences, while a “grey rhino” is a highly obvious yet ignored threat.
Crisis Moments in Crypto 2022
“Grey rhino” - Risky back-to-back loans across all lending desks. No one knows how much back-to-back loans have been originated via lending desks. The majority think Genesis, Nexo, Celusis, Blockfi are too big to fail.
“Black Swan” - 3AC went bankrupt with potentially $3 billion debt to repay
The cascades of panic selling and liquidation events started from May 8th, 2022 when UST started to show signs of a depeg along with the LUNA collapse. After a month, Su Zhu and Kyle Davies from Three Arrows Capital (3AC) considered Asset Sales and Bailout, according to WSJ. Before the UST depag, 3AC had $3 billion asset under management.
3AC bankruptcy caused the domino effects on many players, including Celsius and Blockfi stopping withdrawals. When the news about a large crypto fund default came out, the first thing everyone did is to withdraw money and crypto assets from counterparts to test out solvency on all the exchanges and lending/OTC desks. A bankrun scenario caused Blockfi, Celsius, Maple Finance, Voyager Digital, and Finblox to either limit withdrawals or stop withdrawing due to liquidity issues. Withdraw issue further spreads fear across the market that not a single counter party is safe. So institution also sold crypto assets and stablecoins and withdrew cash to banks. This series of actions caused the dramatic liquidity shrinks, and no one has the guts to be the hero to catch the falling knife.
On June 22 2022, Voyager Digital publicly announced its intent to pursue legal action against 3AC, if the firm defaults on a loan worth over $650 million. FTX extended the credit line for Celsius, Blockfi and Voyager in order to stop the unrelenting bear market. However, it seems the bailout term is very hard to meet, and many of the companies will still face bankruptcy by the end of 2022.
SEC and MSA may officially investigate and sue 3AC, Blockfi, Celsius, Rari Capital and algorithmic stablecoin projects. We are expecting more tight regulation across all the exchanges and CeFi service providers. The ongoing lawsuit and bankruptcy will last for at least one year, slowing down the process of legitimacy of the BTC spot ETF. We are seeing crypto losing general public confidence for at least 12 months. This is the Lehman Brothers and Bear Stearns moments for CeFi. On June 29, 2022, FTX CEO SBF claimed some smaller exchanges are ‘Too Far Gone,’ ‘Insolvent,’ and Unlikely to Be ‘Saved’. Although he later clarified this was an exaggeration of his actual statement, we did see multiple small exchanges facing shutdown and bankruptcies.
The past eight months of crypto market crash was a combined effect of external macro conditions and internal grey rhinos. However, what does not kill you will only make you stronger. These are stress tests of a highly efficient permission-less market that our industry aims to build after all.
Are We There Yet?
The magnitude of the recent market turmoil has surpassed historical levels in many regards. BTC’s recent new low of $17,708 is characterized by the most oversold RSI in history of BTC trading. The two weeks of June 19- July 3 marked the first time BTC prices traded for 14 consecutive days below its 200-week moving average ($22k). So the question that hovers over many’s minds is: are we there(the multi-year bottom) yet?
Below are some on-chain and technical metrics summarized by Glassnode that could help identify where we are at the cycle in historical terms.
Mayer Multiple of 0.6 ($23,380) price trading at a 40% discount to the 200-day moving average, with just 3.4% of trading days closing at or below this level.
Realized Price ($22,500) being the aggregate cost basis of the coin supply, typically provides resistance during bottom formation. 14% of all trading days have closed below.
200 Week Moving Average ($22,390) which has historically provided support during final bear market capitulation phase, and only 1% of days have closed below it.
Balance Price ($17,980) which accounts for the destruction of coin-days, and reflects a market price that matches the value paid for coins, minus the value ultimately realized. Just 3% of trading days have closed below this model.
Delta Price ($15,750) which is the difference between the Realized Price, and the all-time-average price. This level never been breached on a closing basis, and has provided ultimate final support in bears.
(source: Glassnode)
It’s good to have historical reference, however, financial markets do not lack cases in which the degree of a market event can go much beyond statistical inference. That’s the 0.3% probability events that lie on the end of the spectrum. Statistics do not drive market, but real demand, liquidity premium and sentiment do.
For the last two years, crypto had benefited from the massive liquidity injected by COVID monetary policies. Overall stablecoin supply grew almost 50x from $2B in 2019 to its peak at $99B in March 2022. With tightening monetary policies, liquidity in crypto market is also shrinking. Overall supply is down 11% from all time highs, led by USDT circulating supply being down more than 20%.
There is massive innovation in crypto for sure, but the very nature of decentralized finance and NFTs also created the perfect accelerant for the liquidity game we had experienced.
A core component of crypto is the permissionless issuance of placeholders (token) for any type of value, that also includes the derivatives of these placeholders. The famous DeFi metric “Total Locked Value”, usually used to demonstrate the economic vitality of a DeFi protocol or a smart contract platform, is quite misleading in that nothing in crypto is ever “locked”. As we can lock a token and print its x-version derivative to “unlock the liquidity”, liquidity becomes a self-fulfilling prophecy. TVL can keep growing as long as participants just keep adding systematic leverage.
But there is no such thing as a perpetual motion machine - or the perpetual motion machines just stopped working when external shocks kicked in. Monetary policies had to tighten. Fleeing liquidity led to deleveraging. Over-leveraged participants with mismatched liquidity in a shrinking market. K.O.
So back to the question: are we there yet?
Muscle Memory of a Crypto Bear Market
Throughout my four years of trading crypto (mostly just long from bear market and be early in a narrative development process and take profit), the one important lesson I learned, if anything, is to identify the types of market you are in, and enhance the muscle memory to deal with that specific type of market.
If statistics don’t dictate bottoms, then what really drives the ebb and flow of crypto markets? Crypto market are like any other market - it is a game of accumulation and distribution, with market dynamics controlled by supply and demand.
Below are some key metrics we use to calibrate the dynamics:
The algorithmically set Bitcoin “halving” may not be the magic power that turns on the market engine every-time, but the secular trends of crypto innovation, user adoption and narratives could set off new rounds of accumulation and distribution. Will the same effect happen to Ethereum when it experiences a 90% reduction in issuance, which equates to more than three Bitcoin halving events?
The Secular Trends of Crypto
Cyclical vs Secular in Crypto
A secular trend is one that is likely to continue moving in the same direction, usually for a long time frame, 10 years or longer. We believe crypto is still in the early stages of mass adoption, a secular trend that will continue for the next ten years. So how will the next decade of crypto be different from the last?
Current state of crypto and where we are headed
What are we buying when we buy crypto? Can crypto as an asset class be seen as monotonous? This has been the view of many for a long period of time.
Bitcoin used to be taken as the only holy grail of crypto asset class, characterized by the community’s obsession with BTC.D, an index that calculates BTC’s market share of the total crypto market cap. It is the “safe heaven” within the crypto asset class, where the crypto OGs choose to store their value during a market downturn.
In 2018, the narrative that dominated our industry was not whether we will have another killer application on smart contract platforms. BTC was the only coin that mattered and there was not much we were able to do with Ethereum’s smart contract capabilities and useless tokens from the 2017 ICOs. The three features of smart contracts, money lego, interoperability and composability, which had driven massive innovation and took us out of the last bear cylce, were yet to rise from the dust of massive capitulation and failed product attempts from 2017. Will this time be different?
Smrti Thesis 1 | Bitcoin will be less relevant. Adoption of digital gold will be less in magnitude than adoption of crypto-enabled applications.
Below are top 10 protocol based on 7-Day Average Transaction Fees.
Bitcoin used to have a different value proposition than all other cryptocurrencies - it is the ultimate Store of Value with a capped supply, with changes to the protocol deliberately kept to as minimal as possible. This was not without merits, but the original design of Bitcoin as a P2P payment network has failed, while the original incentive mechanism to maintain its network security remaining unchanged. Therefore, it remains a question whether Bitcoin could become a settlement layer with transaction fees high enough to keep the network secure.
Bitcoin used to have a different value proposition than all other cryptocurrencies - it is the ultimate Store of Value with a capped supply, with changes to the protocol deliberately kept to as minimal as possible. This was not without merits, but the original design of Bitcoin as a P2P payment network has failed, while the original incentive mechanism to maintain its network security remaining unchanged. Therefore, it remains a question whether Bitcoin could become a settlement layer with transaction fees high enough to keep the network secure.
Bitcoin has experienced much less radical changes as Ethereum has. As Ethereum is constantly evolving to compete with other L1s in block space, Bitcoin is starting to show a lagged growth of network activity, and we believe this trend will continue if Bitcoin keeps its minimalist principle of protocol development.
Smrti Thesis | The merge will make ETH the first digital native deflationary productive asset with real yields.
In a nutshell, the merge will change the consensus layer of Ethereum from an energy-consuming Proof of Work model, to a Proof of Stake system with hybrid consensus approach - LMD-GHOST and Casper FFG**.** By introducing this novel consensus mechanism, for the first time ever, Ethereum has solved the FLP impossibility that any single distributed system is impossible to simultaneously have safety, asynchrony and liveness unless some additional strong assumptions have been made. With the recent successful merge on the Ropsten testnet (in spite of a few bugs and small issues that can be fixed locally without major changes), we expected the merge to happen around late Q3 or early Q4 2022.
Based on our base case scenario, if we enter the Merge with the current staking ratio:
- Nominal staking APR (consider deflation): 8.84%
- Monthly Issuance Change: ~388,350 ETH/month → ~49,667 ETH/month
- Monthly Burned ETH: ~157,344 ETH/month
- Net Monthly Supply**: -147,411 ETH**
This will reduce Ethereum issuance by ~87.2% after the merge, making it a deflationary productive asset with an annual nominal yield of about 8%.
Although high-level implications of the merge have been widely discussed, we do not think the market has fully internalized some fundamentals behind this change.
Below are our thoughts on the actual impact of the merge:
Unable to drive new adoption: The merge is just one step towards the long term scalability plan of Ethereum. It will NEITHER increase TPS significantly NOR reduce transaction fees. The merge will enable Ethereum to have finality, but there will still be a gap of 10x-700x between Ethereum and other L1s finality times. In any case, transactions on Ethereum main-net will still remain non-ideally expensive. Therefore, the merge would not drive new adoption of Ethereum, although it takes us one step closer towards the endgame.
The validator queue would potentially increase the adoption of liquid staking derivatives : Unlike other POS chains, new validators on Ethereum must enter a queue before they get activated and start earning rewards. There also exists a churn limit function to constrain the
number of newly activated validators in a given epoch. We estimate that it will take at least 15 months for Ethereum to reach the same staking rate as Polkadot (~52%), and 18 months as BSC (~81%).
With a several-month-long queue ahead, it is reasonable to say that liquid staking derivatives provide an attraction alternative to skip the queue and get started on earning rewards. Therefore, we could see liquid staking derivatives like Lido's stETH trading at a premium to spot ETH, instead of today’s discounted price.
EIP-4844 & EIP-4488 as mid-term solutions to reduce roll up fees and boost more usage:
EIP-4844 (aka Proto-danksharding) is a proposal to implement a majority of logics and rules that can be used by Danksharding in the future. The main feature introduced by EIP-4844 is a new kind of transaction type — blob-carrying transaction.
Blobs of data, or Blob, are specially designed for rollups as an alternative to the current calldata solution that is used by rollups for data storage. Compared with rollups now using 2-10KB in calldata, it has achieved a 100x capacity ( very optimistic), potentially reducing the rollup fees by 99%. This provides temporary relief in terms of scalability for rollups, by allowing them to scale to 2 MB per slot after merge.
Another Proposal, EIP-4488, also presents a quick-to-implement solution to decrease the gas cost of calldata and cap the total calldata in a block. EIP-4488 could potentially reduce the average cost of calldata by 80%.
Although EIP-4488 is another attempt to decrease roll-up gas fees, it is just a short-term solution and can’t help with the future upgrade to full data sharding. Comparatively, EIP-4844 creates a new transaction type that would lower the rollup transaction fees immediately and, once it is rolled out, no further work would be needed in the execution layer to data sharding in the future.
Both EIP-4488 and EIP-4844 are still in draft. As all development efforts are focusing on the merge right now, we estimate that these two proposals won’t come into reality until 2023.
In summary, we are going to have a major shift in market dynamics with the coming Ethereum Merge that’s set to happen by end of 2022. While BTC miners need to sell BTC to cover for operational costs, ETH will reduce inflation and switch to POS where there are little operational costs.
The merge will make ETH the first digital native deflationary productive asset with real staking yields. Why does this matter? Ethereum’s new monetary policies will make it more than the narratives that we have assigned to it: a commodity or medium of payment. ETH will become the Internet Bond in this new era of crypto economies. While US treasury yields are outpaced by outrageous inflation, ETH offers an alternative option for the crypto natives: a deflationary asset with real yields. ETH.D will replace BTC.D to be a key metric to monitor.
Smrti Thesis | We are unlikely to see significant improvement in scalability across L1s and L2s by the end of 2022, but the infra space is actively experimenting with a variety of designs.
Most notably are modular blockchains, horizontal scaling solutions and zero knowledge technology. We have taken a deep dive and will publish a series of research on each topic in the following months.
Smrti Thesis | More digital content and social interactions will be generated natively on-chain. The next wave of adoption is built upon a more integral Web3 and Web2+ experience compared to the fragmented one we have today.
We believe the key to unlock billions of users does not lie in the existing state of crypto infrastructures, rather we think there are new primitives to be built that are essential to a more integral web3 and Web2+ experience. This is where we have spent a significant amount of time, tracking and talking to teams who are developing these new primitives:
- Infrastructure and tools that enable the data fluidity (1) between web2 and web3; and (2) within web3. This includes but is not limited to: standards and infrastructures of trustless credentials, attestation protocols, etc.
- Innovation in token standards and features (i.e.: a non transferrable reputation system)
- Identity system with easy-to-use key solutions that can compete with custodial products
- Zero Knowledge enabled programmable privacy solution
- A Sybil resistant value system built upon micro tasks and 3A crypto games that can translate the value of human attention and work into crypto native assets
NOTES AND DISCLAIMERS:
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