Securitize Capital Market Commentary — June 27th, 2022

Macro

The UK Consumer Price Index climbed to 9.1% in May, as expected, reinforcing global central banks’ resolve to manage inflation. The combination of high inflation and low unemployment has traditionally been an indicator of global recession. In response to current conditions, the Fed stated, “The Committee’s commitment to restoring price stability…is unconditional,” leaving many to speculate the implication that the Fed is willing to risk a recession to manage inflation. Banks passed the Fed’s annual stress test for capital adequacy, and should be operational during a deep recession.

Last Friday, the University of Michigan released the results of its five-year consumer index survey, showing that long-run expectations dropped from 3.3% to 3.1%, and leading to a steepening of 2s10s as the front-end curve tightened signficiantly. The probability of a 75-bp rate hike in July also dropped from 90% to 70%-75% in a single day. Risk sentiment improved and the week closed with a strong rally in all risk assets as the S&P 500 rose above 3,880 and the HY CDX tightened by 27 bps on Friday. This counter-trend rally is expected to be short-lived and reflects an impending short covering.

We anticipate the current macro backdrop to lead to a market downturn. In May, we opined that volatile markets across risky asset complexes are too rich for long-vol positions and hedges are expensive. Owning a CDX HY 3s5s flattener (buy a 3-year and sell a 5-year protection) monetizes market default expectations, “jump-to-default” risk, and dispersion as the credit curve inverts in a market downturn, as seen in the pandemic-driven recession in 2020 (Exhibit 1).

Exhibit 1: CDX HY 3y vs 5y Spreads

Source: Bloomberg as of June 27th, 2022.

Cryptoland

Spot:

Crypto assets did not experience a counter-trend rally, as idiosyncratic risk steered crypto markets away from Nasdaq names. Bitcoin and Ether both traded range-bound at $20,000 to $22,000 and $1,070 to $1,250, respectively. Such indecision is reflected in quarterly redemptions and rebalancing as the lack of liquidity and momentum challenges the $20,000 and $1,000 price support for BTC and ETH, respectively (Exhibit 2).

Exhibit 2: BTC Price

Source: Bloomberg as of June 27th, 2022.

The market continues to digest credit risk contagion from last week as BlockFi, Celsius, Voyager, Babel Finance, and others struggle to hold onto a life line. Highlighted here is the importance of market structure under a liquidation scenario: BlockFi unwound a $1 billion loan with $1.3 billion in collateral ($870 million in BTC and $430 million in GBTC shares) from Three Arrow Capital. While spot BTC market is open during the weekend and large enough to absorb this during liquidation, GBTC is traded during equity sessions on the over-the-counter (OTC) market with an estimated 7.2 million shares of average daily volume. Liquidating $430 million GBTC (31 million shares at $14 per share) would take traders days to execute (Exhibit 3).

Exhibit 3: Grayscale Bitcoin Trust BTC Trading Volume

Source: Bloomberg as of June 27th, 2022.

As seen in the 2018 cycle, the convergence of market and marginal cost of production motivates mining activities to shift toward seasoned and low-cost miners in the early phase of a crypto winter. This does not impact the overall global hashrate. However, miners will continue to deplete their BTC reserve to service debt and manage operations. If the BTC price stays at its current level or lower for another quarter, the hashrate will decrease as distressed miners cease production. In the current market cycle, we can expect continued miner consolidation and restructuring both in the public and private sectors.

Options:

ATM-implied volatilities moderated to 83% p.a. for BTC, and to 95% p.a for ETH. BTC risk sentiment is still skewed to puts with a put/call ratio of 0.70. On the contrary, ETH shows a bullish sign of 0.35 as traders loaded up on calls. On Deribit, $180 million anchored at 15,000 BTC put strike and $187 million at 20,000 BTC; $60 million anchored at 800 ETH put strike and $110 million at 1,000 ETH. We will continue to watch the quarterly rebalancing and redemption cycle.

Spotlight — Avalanche (AVAX)

Professor Emin Gün Sirer, a leading Blockchain expert at Cornell Univeristy, started Ava Labs and created Avalanche in 2019. Measured by time-to-finality, Avalanche is one of the fastest L1s at under three seconds. It is low in gas fees, is eco-friendly, and procecess 4,500 transactions per second per subnet. Avalanche validators apply a sophisticated statistical technique of “repeated random subsampling” to poll validators to determine if a transaction is valid, resulting in a secure network that would require a hacker to control up to 80% of the network (Exhibit 4).

Avalanche Bridge allows users to easily transfer other L1 assets onto the Avalanche blockchain. Currently, the AVAX network has several DeFi apps being used by institutions, enterprises, and governments. In addition, well-known organizations such as BitGo (crypto custodian), Binance (the largest crypto exchange), and USDC.e (the native USDC) token on AVAX. Furthermore, L2 platforms are able to build on top of the Avalanche blockchain to provide users with several WEB 3.0 protocols such as decentralized exchanges, NFT marketplaces, borrowing/lending platforms, optimized yield platforms, and portfolio management services.

Exhibit 4: Competing L1 Products

Source: https://www.avax.network

Avalanche is able to maintain its incredibly fast speeds by breaking down its primary network into three separate subnets (Exhibit 5):

1. The Exchange Chain (X-Chain) — Creating and exchanging AVAX tokens. Compared to other blockchains, which categorize transactions chronologically, X-chain links individual transactions to other transactions as blocks to be validated as groups.
2. The Platform Chain (P-Chain) — Coordinating subnets. P-Chain allows the Avalanche ecosystem to grow by creating and customizing subnets for specific use cases with both public or private blockchain systems.
3. The Contract Chain (C-Chain) — Creating and deploying smart contracts. The C-Chain provides an exact copy of the Ethereum Virtual Machine (EVM) and allows developers to seamlessly port applications into the Avalanche ecosystem with a full Ethereum development toolkit.

Exhibit 5: Avalanche Subnets

Source: https://docs.avax.network/overview/getting-started/avalanche-platform.

AVAX, the native token of the Avalanche platform, is used to power transactions in its ecosystem. AVAX serves as the means to distribute system rewards, participate in governance, and facilitate transactions on the network by paying fees. It is used to secure the Avalanche network through staking, transaction, pay-for-fees, and native tokens for all Avalanche subnets. The AVAX token has a fixed supply of 720 million tokens, of which 281 million are currently in circulation. All gas fees on the network are burned, creating a deflationary effect on the supply of the token. More than $118 million of AVAX has been burned. AVAX validators stake tokens for up to 11% APY.