Securitize Capital Market Commentary — July 19th, 2022
Macro
The S&P 500 had a wild ride during the week, driven by the release of the June Consumer Price Index (CPI), only to end flat at 3,825 on Friday compared to 3,833 on Monday. June CPI made headlines last week as inflation reached 9.1% year-over-year, a new 40-year high, while core CPI was up 5.9% year-over-year. Effects of inflation have spread into energy services, motor fuel, food, rent, and other economic sectors.
The Overnight Index Swap (OIS) market immediately suggested an increased probability of a 100-bps rate hike by the Fed to 30%, while the 2s0s curve inverted by -25 bps. By Thursday, the market had priced in a 70% probability of a 100-bps rate hike and bear-flattening dominated tactical curve trading. On Sunday, the OIS rate implied a 71% chance of a 75-bps rate hike and a 29% chance of a 100-bps rate hike, averaging an expected 82-bps hike for the FOMC’s July 27 meeting (Exhibit 1).
Exhibit 1: Overnight Index Swap (OIS) Implied Probability of Rate Hike
Source: Bloomberg as of July 17, 2022
Last Friday, the University of Michigan reported a 30-bps decline in 5y5y inflation expectations, from a local peak of 3.1% to 2.8%, weakening the argument for a 100-bps rate hike, thereby alleviating recession concerns. Risk sentiment also improved on Friday. DXY lost some momentum over the week, yet remained in overbought territory.
We are currently inside an FOMC blackout period, effective July 16 through July 28 as the Fed prepares for its July 26–27 session. While we await the next rate hike announcement, this week we are watching the release of Housing Starts and Building Permits, as well as Existing Home Sales, as increasing mortgage rates continue to pressure home sales and mortgage applications.
Cryptoland
Spot
Last week, we referred to the increasing correlation between crypto and equity markets as cryptoland clears out ‘bad actors’ following the June credit contagion, exemplified in the bankruptcy filings of Celsius Network Ltd. and Voyager Digital.
Risk sentiment in equity markets improved as bulge-bracket investment banks posted better results on July 17 amidst a 30-bps decline in 5y5y inflation expectation last week. Positive sentiment spilled over to crypto assets as both bitcoin and ether rallied since the weekend. Ether showed strong momentum as measured by both the relative strength index and stochastic oscillator, heading to near-term resistance of 1,800 (Exhibit 2). The rally also pushed the ETH/BTC cross sharply higher to 0.0676 (Exhibit 3) and reflected the bullish sentiment expressed in the put/call ratio.
Exhibit 2: Ether Price
Source: Bloomberg as of July 17, 2022
Exhibit 3: ETH/BTC Cross
Source: Bloomberg as of July 17, 2022
On July 14th, Circle, the issuer of USD Coin (USDC), released a full breakdown of the USDC reserve assets. We ran a scenario analysis for all non-cash positions, currently valued at $42 billion (Exhibit 4). The portfolio would experience the worst loss in a scenario where the Euro is down 10% vs. USD. Notwithstanding, overall, due to the flight-to-quality nature of the portfolio, our scenario analysis shows the portfolio to be generally recession-proof, appreciating in an environment that replicates the Great Financial Crisis. This gives us comfort with the USDC reserve assets, as CUSIP-level transparency is critical in helping end-users assess risk in order to make prudent investment decisions.
Exhibit 4: USDC Reserve Scenario Analysis
Source: Bloomberg as of July 15, 2022
Options
The front end of the ATM implied volatility curve rallied to mid 60% p.a. for BTC and mid 90% p.a. for ETH, reflecting shorts covering positions to manage assignment risk and pairing down deltas. BTC risk sentiment is still skewed to puts with a put/call ratio at 0.62. On the contrary, ETH shows a bullish sign of 0.35 as traders accumulate longs. On Deribit, $200 million was anchored at 15,000 BTC put strike and $160 million at 18,000; $90 million was anchored at 900 ETH put strike and $140 million at 1,000.
Spotlight
Other People’s Money (OPM)
Adam Smith coined the term “Other People’s Money” in his 1776 book, The Wealth of Nations, to describe an example of moral hazard, later formalized by modern economists as the principal-agent problem. To illustrate, let’s look at the following example:
A superstar crypto trader and influencer puts up $5 of his own capital and borrows $95 from investors at a 3% p.a. fixed interest rate over 12-months (a leverage ratio of 19:1 with a triple-digit volatility asset class).
Scenario 1: In a positive environment, after 12 months, his $100 investment yields 10%, or $10 profit. His investors will receive $2.85 ($95 x 3% p.a.), while he nets a $7.15 profit.
Scenario 2: In a negative environment, the investment yields -10%, or $10 loss. The trader may choose to:
- recapitalize an additional $7.85 (principal shortfall plus interest payable) to pay back the loan, for a total capital outflow of $12.85 ($7.85 + $5); or
- declare default, delete all social media accounts, and walk away with a total loss of $5.
This OPM scenario led the trader to take higher risks. Perhaps his superstar trader status was a result of leveraged bets rather than insightful analysis and risk practice, in other words, not due to actual skill. Decades of behavior economics have shown that traders are much more likely to make risky investments when they allocate other people’s money as opposed to their own due to differences in mental account for OPM.
Two counterweights of the OPM effect are transparency and reputation. Transparency can prompt traders to invest funds in a safe asset, the most efficient way of eliminating risky behavior. Managing OPM is a serious business with a plethora of investor protection laws that include regulations around securities, commodities, and forex, to name a few. In addition, traders and portfolio managers need various licenses and must be registered with the appropriate regulatory bodies. While reputation is not as enforceable as transparency, preserving a good reputation motivates managers to be more cautious and take less risk with OPM.
Crypto asset managers are faced with the same responsibility. The heated debate over Centralized Finance (CeFi) versus Decentralized Finance (DeFi) takes the crypto industry off the course of maturation. Building an auto-liquidation engine on the DeFi platform removed human judgment from credit risk assessment, but has opened up smart contract and cybersecurity risk. The aftermath of June’s crypto meltdown showcased that CeFi was clearly the main, if not the sole, liquidity provider for some of the larger DeFi projects. Both should co-exist and there is no reason to pick the path less traveled. The crypto industry needs to learn to follow the existing regulatory pathways to protect investor interests and establish trust.
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