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CryptoChat #65

When Life Gives You Lemons

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Hello and happy holidays!

Dai Hard 2:


I’d like to start this week’s CryptoChat by recommending Tony Waldschmidt’s ‘Compound Finance – A Liquidating Opportunity’, which draws on some of the questions posed in my previous newsletter and walks through a promising short strategy leveraging Compound’s liquidation-discount process.

Fascinating stuff and clear evidence of the various opportunities for those who can truly master the art of decentralized finance protocols to generate meaningful returns, regardless of the overall direction of the crypto asset market.

I’d also like to briefly highlight and address a thought from Hassen Naas’ ‘What’s going on with Dai on Compound.Finance?

Naas imagines a scenario in which:

1. Borrowers of Dai on Compound default on their loans
2. Downwards price activity causes collateral to fall below 100%
3. Suppliers no longer have enough Dai to close out their CDPs and do not have the means to add further collateral
4. The CDPs of these Compound Dai Suppliers are liquidated, causing further price slippage as ETH is sold at market price
5. This price slippage has a cascading effect, leading other Maker CDPs to fall to liquidation levels and resulting in further forced ETH liquidation

For all the benefits collateralized loan markets like Compound and Maker provide it’s worth recognizing that their collateralized and interconnected nature can catalyze and aggravate Ether price declines in bear markets in the same way that they can cause and accelerate price appreciation in bull markets. I am aware that liquidation penalties exist to incentivize management of CDPs but humans are not perfect and liquidations do happen.
Maker CDP liquidations

This has worrying implications for Ethereum’s Proof of Stake consensus algorithm, where network security at any time is closely (note: not entirely) tethered to the network’s market value. Even the ostensibly-luddite CFTC (kind of) recognizes this risk, as indicated by their recent ‘request for input’.

Naas notes that multi-collateral DAI will help alleviate these problems, although additional collateral options seem unlikely to help balance CDPs while the crypto asset market remains so highly correlated.

Some analysts point to the impending proliferation of security tokens, or asset-backed tokens like Digix, which have historically been uncorrelated to the crypto asset market, and thus could serve to stabilize collateral.

BTC, ETH, XRP, EOS, XLM correlations vs. S&P

However, the introduction of security and asset-backed tokens as collateral muddy the value proposition of DAI as a censorship resistant store of value: like the stable coin offerings from Gemini (GUSD) and Coinbase (USDC), security tokens will be issued and managed by centralized entities with unilateral power to redeem and/or freeze tokens and the assets backing asset-backed tokens will presumably involve some kind of human-controlled custody.

One alternative proposed by a MakerChat contributor is a basket, or Set, of centralized stable coins – GUSD, TUSD, USDC etc. – which could feasibly help mitigate censorship risk by diluting dependency across a multitude of assets.

However, whether this will be amenable to MKR holders, who essentially serve as buyers of last resort when things go wrong, remains questionable.

Generating Returns:

Tony’s creative short strategy had me thinking about the larger question: ‘how do 200+ crypto funds intend to generate returns in this market?’

My focus is on the ‘hedge fund’ types versus the ‘venture fund’ structures because hedge funds typically have shorter redemption timeframes, and thus are far more susceptible to the short-term temperaments of their LPs.

Shorting has been a strong bet over the past twelve months, although at these price levels, and with every crypto analyst and their mother screaming for sub-$3,000 BTC, the risk-reward simply isn’t attractive enough to continue fighting the market. Don’t take that from me: take that from top-shorter Mark Dow, who wisely
explained ‘I don’t want to try to squeeze more out of the lemon.’

Going long doesn’t seem particularly attractive either: despite some (misplaced) hope around the launch of Baakt in January and the miniscule possibility of a Bitcoin ETF approval in February, the conditions and catalysts for a rally are lacking. It certainly doesn’t help that capital market investors seems to be preparing for a global recession and that there is now several thousand metric tons worth of additional perception risk associated with the crypto asset class.

USV’s Albert Wenger describes the state of the market as follows:

‘None of the prior corrections had remotely the same level of public visibility. So to think that institutional investors will by piling in right now is to ignore perception risk. To invest now means taking both return risk and perception risk. That’s why climbing out of the winter of the burst Dotcom bubble took time and that’s why the same is likely to be true for crypto.’

Participating in seed, pre-seed, and pre-pre-seed stage deals and quickly flipping tokens to retail is no longer a viable and sustainable strategy, with regulators now actively monitoring the crypto asset space for securities-related violations, applications moving away from redundant-but-liquid token models to sensible-but-illiquid equity financing, the market, feeling over-saturated, adjusting its valuations, and even well-capitalized, high profile protocols failing to list across the most voluminous exchanges.

What strategies remain?

Intra-exchange spreads on BTC markets

Arbitrage, although:

a) Depreciating exchange volume and price volatility (with the last couple weeks as the exception) add risk to what is supposed to be a risk-free strategy

b) As more funds move to arb strategies the spread, or profit margin, decreases significantly

c) The vast majority of crypto funds are not structured to effectively pursue arbitrage opportunities. These GPs were deal-makers rather than market-makers and any attempt to suddenly pivot will likely end in trading fee and HFT-induced tears. For evidence, look no further than Galaxy Digital, who, despite a well-stacked trading desk, managed to lose $136m in the first nine months of 2018.

The Third-Party Economy Opportunity Space, courtesy of CoinFund

‘Generalized mining’, roughly defined as active participation in decentralized networks seems promising. Think monitoring and managing collateral in the MakerDAO system, supplying assets in Compound’s money markets, staking Ether under Ethereum’s Proof of Stake, or, on the ‘grey’ side of things, front-running ‘non-custodial exchange’ orders.

However:


a) It will likely take years for these applications to generate enough interest and demand for participation to return significant returns on a multi-multi-million dollar fund – case and point: Ethereum’s Proof of Stake implementation is yet to launch.

b) Despite assertions otherwise, I cannot help but presume that outsized returns driven by these service providers will eventually fall as active participation becomes de-risked and more accessible and supply adjusts accordingly.

Crypto-specific ‘activist investing’, a derivative of generalized mining recently popularized by Layer1 Capital, whereby a fund takes concentrated bets on protocols, builds tech around them, and accumulates exposure via both exchanges and mining, might seem like a profitable and innovative strategy, but:

a) It fails to take into account all the competing development taking place concurrently outside of their protocol-of-choice’s ecosystem

b) Uncomfortable dynamics arise in an ostensibly decentralized network when one well-capitalized fund holds a large percentage of supply and disproportionate influence over the direction of development

c) The market, in its ever-irrational state, might simply not care: just look at Tron, which, despite a plagiarized whitepaper and an absence of development, still commands a $1bn market cap, while Zcash, which is literally pushing pioneering privacy technology, languishes (this is both ironic and not ironic) at just a $300m valuation.

I previously suggested launching a fund that attacks, while simultaneously shorting, low-security chains through a combination of publishing empty blocks and/or double spending coins.

The illegality of double spending might rule out that specific component of the strategy but I still support the concept of disabling a chain and profiting from it: think of it as a natural blockchain selection, or, if successfully defended by the network’s stakeholders, a forced public display of resistance, at which point you can switch long, continue to mine, and ride the media-induced wave of buy pressure.

There are likely multiple other innovative strategies out there: I know of funds buying up crypto-related domain names, and other groups, like Galaxy, which are lending capital to platforms like BlockFi at attractive APR. I would imagine some funds might even try and fund lawsuits on behalf of ICO investors in return for a disproportionate share of the spoils.

But overall I can’t help but feel that the the crypto hedge fund outlook looks rather bleak.

Change my mind at
matteo@cryptochat.us

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Please note, I am not a professional investor and this newsletter should by no means be considered investment advice. Cryptocurrencies are an emerging and highly speculative asset class. I am not liable for any gains/losses that you may incur.

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