Worry about the bear market or look forward to a super cycle?
Q2 2021 will go down as one of the worst quarters for bitcoin in its history, with regulatory crackdowns, the “great mining migration” out of China and the thorough bursting of the altcoins bubble. Generalized predictions remain as pointless as ever. Instead, we need to analyze the market and recognize those broader blockchain-related events and trends that are likely to be difficult (covered in Sections 1 and 4 of this report) or potentially positive (Sections 2, 3, 5 and 6) in order to provide more confidence in investment decisions.
1. Some areas cooled…
From a superficial price perspective, everything looks a bit tragic (even taking account of some upward movement over the past couple of days). Bitcoin has fallen by more than 50% from the April highs and shows no signs of recovery yet. The $30,000 “support” that many commentators talk about is steady for now, but has been repeatedly tested to the point where some investors are understandably getting wary of further drops.
Ethereum has corrected more than 60% to $1,700 and also continues to show weakness even amid expectations of EIP-1559 implementation in August. Conversely, we consider this event to be one of the most important for the entire crypto market in 2021 and we will elaborate on it in a separate section of the report.
DeFi Index (by FTX exchange) is expected to show an even deeper drop of over 70% from the highs. This is due to both the lower liquidity of these assets and the compression of returns that investors receive in Yield Farming strategies. At the same time, it is worth keeping in mind that DeFi as an independent branch of the crypto economy continues its active development and even enters the stage of institutionalization — about this below.
2. …While others heated up
Separately to the crypto currencies, there are also segments of the crypto market that continued to grow in the second quarter.
NFT market activity shows new records in terms of projects launched and trading volumes. Projects from the Gaming segment are attracting more attention and increasing the user base, generating demand for the “play-to-earn” model.
The growth of venture capital financing in the blockchain industry also shows that investor interest is not waning. Of course, this may be due to the huge amount of liquidity in the global capital markets and the inertia inherent even in the professional investment community. For example, in the 2017–2018 cycle, it was the first half of 2018 that was a record-breaking inflow of venture capital funding into crypto projects (through ICO mechanisms) despite the rapid market decline already in Q1 2018.
Meanwhile, DEX volumes continued their explosive growth in Q2 reaching $405 billion in the quarter — that’s a 117x increase year-over-year (!) and 83% increase since Q1.
Despite the above positive trends and many statistical models pointing to the incompleteness of the current bull cycle, there is a risk of continued capital outflows from the cryptocurrency market. There are many factors that could trigger a new bear market — risk running, further regulatory pressure in other countries that decide to follow China’s (rather than El Salvador’s) lead.
There may also be a shift in investor sentiment (a massive shift) from expectation of “digital transformation with crypto” to disappointment amid a general economic depression. Much will also depend on the blockchain projects themselves, which need to offer the world high-quality and secure products that users can enjoy while improving process efficiency. At BR Capital, we believe that the crypto community will surprise everyone yet again by demonstrating its competencies as innovative builders. With this in mind, let’s look at some specific areas of innovation.
3. Institutionalization of DeFi
Serious DeFi investors have been expecting institutional involvement since the beginning. Now we’re seeing the first steps in the leading DeFi money markets, Compound and Aave, but we think this is just the beginning of the journey towards professional use of DeFi.
Both sides, DeFi protocols and financial institutions, are showing interest in integration. This firstly because demand creates supply: deposit rewards in DeFi protocols are higher than interest rates in traditional financial markets. Secondly, ignoring technological opportunities offered by DeFi threatens the ability of financial institutions to evolve and keep with new customer expectations around efficiency and ease-of-access. Banks are deciding that it’s better bring in new talent to build and test new solutions, rather than risk falling behind competitors.
Let’s take a brief look at the two approaches Compound and Aave have taken when working with institutional clients.
Compound now offers a product called Compound Treasury: It converts your U.S. Dollars to USDC, a digital dollar stablecoin, and supplies them to the Compound Protocol to generate relatively secure, high-yield interest — 4% per annum at the moment. This enables institutions to access crypto interest rates while abstracting away operational complexities including cybersecurity, compliance, private key management, fiat-to-crypto conversion, and interest rate volatility. In turn, Compound borrowers get access to this new capital.
Aave is set to launch Aave Pro in July. The protocol will use private pools to provide institutional investors with direct access to decentralised markets. These pools will be separate from existing liquidity pools on Aave. From this statement we can expect a full market for both lending and borrowing by institutions.
Both platforms will be onboarding institutional clients with KYC/AML procedures. Also, these institutional markets will be governed by the Aave and Compound Governances and this is an important signal given to institutional newcomers: “We’ll work with you, but we’ll stay decentralized in our technology and decision making processes.”
Talking about significant events that speak in favor of the super cycle, we can’t get past the upcoming London update of the Ethereum network.
4. Deflation for Ethereum
EIP-1559 is an Ethereum Improvement Proposal scheduled for August 4. It changes the paradigm for transaction fees on the Ethereum blockchain. EIP-1559 gets rid of the first-price auction as the main gas fee calculation. After the update there will be two parts of the transaction fee — “base fee” and “priority fee”. “Base fee” will increase by up to 12.5% after blocks are more than 50% full, and decrease up to 12.5% after blocks are less than 50% full. Also the maximum size of the block will be increased by 2 times. And all the base fees paid by users will be burned.
The main goal is to make the fee market more predictable and improve user experience with a less volatile gas price. As the number of DeFi projects grows and the number of users and transactions increases, more ETH will be burned, which, theoretically, will lower the supply and increase the cost of ETH.
According to Delphi Digital calculations, if EIP-1559 had been activated a year ago the total ETH supply would be ~2.6% lower than current levels.
This chart shows ETH’s estimated annual inflation rate (30-day avg.) if EIP-1559 results in 75% of fees being burned. While still well below current inflation, it’s increased to about 3.5% since total transaction fees have dropped.
At this point, it’s hard to say whether Ethereum will become a deflationary asset or not. For a clearer view, we must wait for Ethereum’s migration from Proof-of-Work to Proof-of-Stake while also closely monitoring network activity and the evolution of Layer 2 solutions that promise to make Ethereum easier and cheaper to work with.
Despite positive expectations in the Ethereum ecosystem, the difficulties that the Bitcoin network has faced suggest it could be a rocky road, further contributing to the bear market.
5. The Great Migration of Miners
Over the past few months, bitcoin’s hash rate dropped rapidly, rose again, but eventually fell back to the values of two years ago. During peak drops, it took up to 20 minutes to form a block on the network, as opposed to the standard 10 minutes. But the mathematical model of bitcoin provides for the dependence of hash rate and mining difficulty, recalculating it every 2016 blocks (about two weeks). This is perfectly visible in the following graph.
The sharp decline in hashrate in April was caused by a power outage in China due to comprehensive safety inspections after explosions and floods in coal mines in several Chinese provinces. The decline was almost 30%. However, the hash rate quickly picked up and reached an all-time high, above 180 EH/s (180mln TH/s)
After that, in May, another downward movement started, again possibly triggered by electricity outages due to low rainfall and coal shortages in China’s Sichuan province. However, this time the Chinese authorities imposed a complete ban on mining, which led to a more than 2-fold drop in hash rate to a local low, comparable to the level of September 2019 — about 85 EH/s (85mln TH/s).
All this news also affected the price of mining equipment, which dropped 75%. Moreover, Bitmain suspended sales of its bitcoin miners, explaining this step as an attempt to help companies leaving the mining business to sell their equipment on the secondary market.
However, since the first of July, the hash rate began its gradual recovery. During this time, Chinese mining giants have moved their facilities mainly to North America and Central Asian countries (mainly Kazakhstan).
The relocation of equipment also naturally affected miners’ own accumulation of BTCs. A decrease in accumulation since mid-May and the subsequent sale of BTC to cover costs and losses from equipment downtime can only have contributed to the downturn in the BTC price. The new phase of accumulation correlates with the phase of hash rate growth that began in early July, although this has not yet shown any positive impact on BTC price.
Certainly, capacity migration is good from a decentralization point of view, especially when about 60% of the hash rate was located in China. But at the same time, a total ban on mining is a very negative factor. It is hard to imagine how the market would have reacted to such a significant event a couple of years ago, but today it appears to have been perceived merely as a solvable problem: a correction happened, but it was predictable and legitimate. All this suggests that the background to the market is getting stronger, allowing such global shocks to be reflected without leading to irreversible consequences.
Meanwhile, as China goes on the offensive, we see a warmer reception for cryptocurrency in other parts of the world.
On June 9, El Salvador’s parliament passed a resolution recognizing Bitcoin as an official means of payment along with the U.S. dollar. The bill will take effect in early September 2021. Note that this is the first time in the world that Bitcoin will be recognized at the state level. Moreover, the president of the country announced the creation of a crypto-wallet Chivo and an airdrop in BTC equivalent to $30 for all residents of the country who install this wallet. El Salvador has about 6.5 mln inhabitants, which means the country has to purchase BTC worth about $195mln.
6. A quick peek at what’s outside Bitcoin and Ethereum
This is a very important period of development in the Polkadot ecosystem, with the first ever auctions in the Kusama canary network. At the time of writing, 14 projects are competing for the opportunity to obtain parachain (blockchain which is connected with a main chain), and four projects have already received parachain.
The winner of the auction is the project that locks the maximum amount of KSMs (relative to other projects) during the auction period, and if it wins, those tokens are locked in the network for 48 weeks. Since many projects do not have enough KSMs to participate in the auction, the most popular way to raise funds has been a crowdloan — a way to raise money from investors by rewarding investors with the native token of the future parachain.
Current winners include:
- Karura, an all-in-one DeFi platform
- Shiden, an EVM-supported parachain
- Moonriver, another EVM-supported parachain
- Khala, a confidentiality layer for Web3.0 developers
As we can see, all current auction winners are focused on DeFi development in the Polkadot ecosystem. With the Cross-Chain Message Passing (XCMP) technology, all parachains connected to the relay chain (Kusama) are able to communicate with each other, potentially opening up great opportunities for developers of Defi products.
With active ecosystem growth and new applicants for parachains after the 48-week round of slots, some projects will be able to fund their own slots from their own treasury. This is due to the fact that with the increase of applicants the average cost of “reserving” will decrease, which is likely to reduce the number of crowdloan programs. So possibly no needs to buy a KSM for participation in crowdloans. At the same time, more available to transfer KSMs will be delegated to secure the network.
BR Capital Pipeline Update
Taking all the above events and trends into account, BR Capital continues to adhere to its investment strategy based on fundamental analysis of projects and companies. We continue to build and invest despite short- and even medium-term market difficulties. The latest new assets in the Fund’s portfolio include: ReSource, Paladin, Bitquery, Nakji, Curio, Mcdex, Immunefi, dYdX, Lido, Mithraeum, Impossible Finance, Superfluid, Mangrove, Masterfile, OpenSwap and Pyth.
You are welcome to visit the portfolio section on our website to see the full list of Fund’s investments and DAO involvements.
