Jun 1, 2022
May Overview
Your Monthly Brief into the World of Digital Assets
Article by Sixte CP
MARKET UPDATE
TERRA ECOSYSTEM CRASH
FINANCIAL INSTITUTIONS
- Nomura joining JP Morgan and Goldman Sachs to start offering Bitcoin derivatives to clients
- What traditional investors are looking for in crypto?
COMPANIES
- MicroStrategy stock tumbles as its BTC loan gets closer to margin call
REGULATORS
MARKET UPDATE
On the charts, Bitcoin is building lower lows since November 2021, tumbled below July 2021 levels and closed its longest streak of red weekly candles ever (May 29th). FED’s hawkishness against inflation ended with a 50-bps hike in interest rates and an increased balance sheet runoff pace. Geopolitical instability keeps increasing as the war in Ukraine doesn’t seem to end, urging investors to de-risk their holdings. Terra ecosystem’s crash intensified Bitcoin selloff and LUNA’s market cap of $28 billion was blown away in a matter of days.
In May, things were looking bad in crypto. A bear market (if it hasn’t yet started) seems just around the corner. However, if we take a step back, it’s not only the crypto market that is contracting but the stock market as well. One could ask, if Bitcoin is crashing because of new relevant information affecting the market or simply because of increasing correlations with equities (or both)?
The correlation chart shows that Bitcoin recently hit new highs of correlation with equity markets. Bitcoin seems to trade more like a risk-on investment rather than a reserve asset. Indeed, Bitcoin reaching historic highs of negative correlation with gold means investors see Bitcoin not as sound money, but as a new speculative investment class like stocks.
Bitcoin is trading like a risk asset also because new institutional players entered the market. Now, as central banks start quantitative tightening and markets are contracting, institutions look for liquidity exits and close their crypto position first. Traders are also responsible for the growing correlation between Bitcoin and stocks as they cover their losses/margins on traditional markets by closing their crypto positions. As such, crypto profited from institutional adoption which intensified the 2021 bull run, but will also see greater capital flight in the down cycle. Institutional adoption still being at its infancy, we have yet to see its long-term impact on Bitcoin. One thing is sure: for Bitcoin to decouple from stocks, market players should further educate themselves on Bitcoin fundamentals and its nature as a risk-off asset.
TERRA ECOSYSTEM CRASH
So what happened to Terra? In our March newsletter we explain the mechanism of UST — Terra’s algorithmic stablecoin.
UST is an algorithmic stablecoin and LUNA is a token helping it maintain its peg. UST maintains its peg to the US dollar thanks to arbitrage incentives and protocol mechanisms. Any market participants can mint 1$ worth of LUNA and burn 1 UST (case n°1) or mint 1 UST and burn $1 worth of LUNA (case n°2).
- Case n°1: When UST is under the peg (for example $0.98) a user can swap 1 UST for $1 worth of Luna (arbitrage opportunity = $1 worth of LUNA — 1 UST worth $0.98 = 2 cents). He will then proceed to cash in this arbitrage move by selling $1 worth of LUNA. In the process, the user will earn 2 cents per UST swapped and the protocol will burn 1 UST and mint $1 worth of LUNA. The supply of UST will decrease so its price will increase back to $1.
- Case n°2: When UST is over the peg (for example $1.02) a user can swap $1 worth of LUNA for 1 UST (arbitrage opportunity = 1 UST worth $1.02 — $1 worth of LUNA = 2 cents). He will then proceed to cash in this arbitrage move by selling 1 UST. In the process, the user will earn 2 cents per $1 worth of LUNA swapped and the protocol will burn $1 worth of LUNA and mint 1 UST. The supply of UST will increase so its price will decrease back to $1.
In theory, it was said that in bear market conditions, LUNA’s price is likely to lose value. If LUNA is used to keep UST peg, users can naturally speculate the peg may fail so they sell their UST. If UST supply is not satisfied by sufficient demand, UST will go under the peg. The protocol will then proceed to mint more LUNA to keep peg. LUNA will lose more of its value and a “death spiral” is born.
In practice, the Terra ecosystem’s death spiral was slightly different. In fact, it did not start with Luna losing value (1) but with a bank run on UST (2). Before UST lost its $1 peg, 75% of all UST were deposited on Anchor Protocol. Offering almost 20% APY on UST deposits, Anchor was the main driver of UST adoption but also its one point of failure. Starting from the 7th of May, Anchor users started withdrawing their deposits. Since for most of them the only reason these USTs were bought in the first place was Anchor’s promised high fixed interest rates, users naturally proceeded to sell their USTs on the open market. Then started the death spiral mentioned above.
Fear of a death spiral is the reason why Terra was increasing its BTC reserve in the past few months.
In theory, instead of interacting with the protocol that mints new LUNA to keep the peg, users could interact with the BTC reserve. BTC reserve will give out $0.98 worth of BTC to any users that provides 1 UST. So, if UST is trading under $0.98, market participants will be incentivized to buy BTC at a discount using UST. The increase in UST demand will recover its price to peg. Therefore, BTC is not used to mint or burn UST but only to recover its peg to $1.
In practice, the Luna Foundation Guard (LFG) not only deployed its entire Bitcoin reserve to defend the peg but also loaned $1.5b in Bitcoin and UST to market makers in an ultimate attempt to recover the peg. Both attempts failed, LFG’s BTC and USD reserve are empty, UST did not recover the peg, and Luna lost 100% of its value. So, what happened after?
The community wanted to be paid back and Do Kwon, Terra’s CEO, wanted to continue his venture into the world of cryptocurrencies. Both camps were in a dead-end since the entire LFG reserve has gone up in smoke and the community no longer wants to hear Do Kwon’s name. Do Kwon and his team therefore found a compromise:
- Fork the current chain
- Abandon UST stablecoin
- Current LUNA holders become LUNC holders fo the “classic” chain
- Token holders of the new chain become the new LUNA holders
- New chain issues 1 billion LUNA, airdropped to LUNC holders, UST holders and developers
“Compromise” because the new LUNA network is fully community owned so Do Kwon and his team are less involved in the project. This might please stakeholders that lost all trust in them. “Compromise” also because, now that the LFG reserve is empty, the airdrop might be the only option for old terra chain stakeholders to be whole or at least receive a decent number of cents on their dollar.
During the whole process of building an ecosystem revival plan, the community backed by Vitalik Buterin, CZ, and Justin Sun made it a point of honour that small retail investors should be refunded before whales. Instead, because of the following points, Do Kwon revival plan highly frustrated the community:
- Only one distinction has been made between whales and retail: the wallets that had more than 1 million LUNA before the depeg event will have a vesting schedule lasting 4 years instead of 2.
- The amount of LUNA airdropped will be pro rata and won’t favour small holders first.
- There are no distinction between whales and retail for UST holders airdrop eligibility and token vesting schedule.
- The airdrop will be based on a snapshot at the time of the launch instead of at the time of the depeg — meaning investors that bought UST post depeg at a discounted price will also be eligible to receive their share of the airdrop.
The revival plan named went forward following a governance vote with 65% of approval rate. Another governance vote that was successfully adopted will reduced UST supply by 11% through a burning mechanism. The new forked chain, Terra 2.0, does not support UST and LUNC tokens. The original Terra blockchain that supports LUNC and UST was halted on May 13th. Therefore, it is unclear what will be LUNC and UST utility in the new ecosystem and hence their value.
JKL Capital had no exposure to UST or LUNA. As a matter of fact, our products — arbitrage and directional quant trading strategies — are built to make the most out of the market volatility triggered by this event.
FINANCIAL INSTITUTIONS
Nomura joining JP Morgan and Goldman Sachs to start offering Bitcoin derivatives to clients
After JP Morgan and Goldman Sachs, a third major investment bank started offering its clients bitcoin futures and options trades. Institutional adoption seems to continue even despite the market turmoil.
Nomura recently created a new subsidiary dedicated to digital assets. As TradFi giants enter the space new capital is flowing in; but most importantly, it contributes towards investors’ growing trust in crypto. Just like bear markets purify the market by annihilating weak participants, institutional adoption likewise de-risks the ecosystem. Indeed, institutions will support projects properly audited and showing strict regulatory compliance. These projects will thrive, survive bear markets and make investment in the space safer. As per Nomura’s digital asset unit CEO Jen Mohideen, institutions “will be aiming to bring trust into this ecosystem”.
In DeFi, institutional adoption helps boost AML and KYC compliant projects like Aave Arc. In the metaverse it goes by buying land like JP Morgan did in Decentraland. Institutional adoption is a double edge sword. As seen above, on the one hand it increases Bitcoin correlation with stocks giving it traits of a risk-on asset. On the other hand, it enhances trust in the crypto market and increases its legitimacy as a safe investment, hence making it less risky.
What traditional investors are looking for in crypto?
As the current market sentiment is shifting, we’ll investigate what traditional investors are looking for in such conditions. During the last bull market of 2021, we saw traditional investors favouring high ROI digital assets, such as the Ethereum killers like Solana or Avalanche. Now that most market analysts are confident in announcing a bear market, traditional investors are shifting their interest towards high-quality digital assets — Bitcoin and Ethereum. Indeed, this explains why we are currently witnessing a spike in Bitcoin market dominance.
Historically, during the bear markets Bitcoin demonstrates stronger support than high beta altcoins. Thus, investors try to avoid catching the falling knife and prefer increasing their allocation to Bitcoin.
Traditional investors looking at crypto during prolonged downtrends also find peace in exchange utility tokens. In fact, the ability to valuate an exchange by applying traditional methods like a DCF model makes the token pricing more reliable (and relatable) for traditional investors. As such, we have seen traditional investors also favouring BNB in the current market.
This is the opposite of an average web3 early-stage project that makes a lot of promises in the long term but offers no short-term performance indicators. The less information an investor has on a bet, the more room he makes for speculation. Hence, in the current market conditions, traditional investors prefer avoiding these kinds of projects. We are currently witnessing a significant correction in early-stage valuations as top-tier funds are slowing down capital deployment.
Further readings
· Goldman Sachs makes its first bitcoin-backed loan. (Read More)
· Compound Treasury receives B- credit rating from S&P Global Ratings. This is the first time a major credit agency rated a DeFi protocol. (Read More)
· Coinbase’s Q1 Revenue Misses Estimate as Trading Volume Drops (Read More)
COMPANIES
MicroStrategy stock tumbles as its BTC loan gets closer to margin call
Month to date MicroStrategy (MSTR) stock is down 40% and keeps following Bitcoin in its free fall. The company has recently closed a $205 million Bitcoin-collateralized loan to buy Bitcoin and its overall Bitcoin investment is now out of the money. Like a true HODLer, the CEO Michael Saylor knows if he doesn’t sell MSTR Bitcoin holdings, it incurs no real loss. However, since MSTR has to keep a collaterised value of $410 million for its loan, if BTC reaches $21,000, the company will be margin called.
Many medias spread FUD by implying that such an event would require MSTR to sell some of its BTCs. If it were to happen, trust in Bitcoin would take a great hit and could worsen the current bear market. However, it is clear that MSTR has no intention to sell a single BTC. According to MSTR’s financial results of Q1 2022, its BTC treasury is strong enough to cover the loan’s margin call as long as Bitcoin does not fall below $3,562, in which case “the company could post some other collateral” according to Michael Saylor. The future of MSTR’s Bitcoins seems reasonably safe for now. However, MSTR future itself doesn’t look promising. Its market cap is below its BTC holding value, its revenues are stagnating, and it is yielding negative EBITDA since Q3 of 2020. MSTR is over exposed to a highly volatile asset and financial results are not conclusive.
Further readings
· Some Gucci stores will accept Bitcoin, Dogecoin and other cryptocurrencies (Read More)
REGULATORS
· El Salvador’s president promotes bitcoin adoption by emerging countries (Read More)
· Bitcoin declared legal currency in Central African Republic, one of the poorest countries in the world. (Read More)
· New York state assembly passes bill blocking new crypto mines that use non-renewable power (Read More)
· Blockchain executive order issued by California governor. (Read More)
· SEC Crypto Team Getting 20 More Officials in Bid to Crack Down (Read More)
DISCLAIMER
The contents of this material have not been reviewed by any regulatory authorities. You are advised to exercise caution in relation to the contents of this material. Although information contained in this material has been compiled from sources believed to be reliable, JKL does not represent or warrant the accuracy, completeness or reliability of the information contained in this material. If you have any doubt about any of the contents of this material, you should obtain independent professional advice. Neither JKL nor any of its affiliates, nor any of its or their respective directors, officers, employees, and representatives will accept any responsibility or liability whatsoever for any direct, indirect, or consequential loss arising from the use of or the reliance upon any information contained in this material. This material does not constitute an offer or an invitation to subscribe for or purchase any financial product. It is not intended to provide the basis of any credit or other evaluation and should not be considered as a recommendation to purchase any financial product.
