DeFi's Liquidity Issues and BTC's Market Value to Realized Value

IN THIS PUBLICATION:

• The current bear market is not simply a crypto-specific event, but a broader financial market’s one that is being compounded by idiosyncratic issues within DeFi.

• The Bitcoin Market Value to Realized Value has broken below the 1x level for the first time since 2020.

• The Ethereum Merge is the most important development to follow within the world of DeFi.

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Macro Sell-Off Compounded by DeFi Issues

General stats about the current crypto correction:

• The total crypto market cap fell below $1 trillion for the first time since January 2021 (the price of BTC at the time was $33,000).

• Bitcoin is on track for its worst quarterly performance since Q3 2011. ETH is on track for its largest quarterly loss ever, with a price decline north of 60%, as NFT activity declines and broader DeFi space weakness on the back of the TerraUST collapse, followed more recently by worries about Celsius and Three Arrows Capital’s solvency.

• Celsius, which manages c. $12 billion of assets and is one of the largest centralized finance platforms that allows users to deposit cryptos in exchange for high yields, has come under pressure as customers, amidst the TerraUST collapse, began demanding their assets back.

• The problem Celsius faces is that, amidst mounting requests for withdrawals, it needs to liquidate part or the totality of its +$400 million stETH holdings (a derivative of ETH meant to allow holders with less than 32 ETH (c. $37,000 at today’s price) to lend the asset in exchange for a yield – this gets more technical so, if interested, you can learn more here). This derivative is (as one would expect for a derivative of a crypto asset) not very liquid, and a forced selling from Celsius would likely crash the price of stETH, complicating even further its ability to make customers whole.

• Three Arrows Capital, a $10 billion crypto hedge fund that made a name for itself after betting big on successful DeFi projects, has failed to meet demands for margin calls, which could have serious ripple effects given its leverage was provided by BlockFi (we had previously also included Nexo, but as they pointed out, they have no exposure to 3AC) whom, in a default scenario, could incur in significant losses.

Amidst mounting DeFi volatility, ETH has been underperforming and has driven the ETH/BTC ratio to its lowest level in a year.

• These liquidity issues have exacerbated the long-term trend of moving holdings into cold storage. In fact, BTC Exchange Balances have now hit the lowest levels since 2018, with 87.4% of all BTC in circulation now being held outside of exchanges.

• Public miners have been selling BTC at 4x the average pace in recent months, as the fall in BTC prices, compounded by higher energy costs (the main input cost for BTC mining), compresses margins and forces these businesses to monetize their BTC savings.

• Currently, more than 50% of BTC addresses would realize a loss if they were to sell their holdings at these price levels. The last bear market bottomed when 52% of BTC addresses were realizing a loss, whilst the one before that (in 2015) bottomed when c. 75% of addresses were realizing a loss.

Most of this negative price performance has been driven by a general risk-off sentiment in the market (Bitcoin is a high volatility asset, and we’re seeing the downside of it now after seeing the upside during 2020 and 2021), driven by strong macro headwinds for most asset prices, such as:

• 75 basis points Fed rate hikes, the largest in size since 1994.

• An inflationary recession that is global in nature, mainly driven by higher commodities prices, the continued war between Russia and Ukraine, continued lockdowns in China, and supply chain constraints - all of which can’t be resolved with rate hikes, and that will only ease when demand slows down (i.e. when there’s a recession, reducing consumer demand as they have less money to spend).

• Headlines about initial signs of a recession are emerging as companies begin to lay off employees, freeze hiring, and startups raise money at lower valuations than their previous rounds.

So, to be clear, the bear market is, first and foremost, not just a crypto-specific issue, but a general financial market’s one. When the Nasdaq is down more than 30% YTD, what would you expect the returns of a much more volatile and speculative asset class (that is aspiring at achieving dramatic changes in how society works) to be?

Of course, idiosyncratic issues arising in the world of DeFi (TerraUST, Celsius, Three Arrows Capital, the uncertainty about the timing of ETH Merge) should not be dismissed, and we should learn from the mistakes we’re making. And yes, the vast majority of crypto projects are worth less than the paper their protocol is written on, but as in every bubble, what we should focus on is not curtailing innovation or playing the “I told you so” game, but rather, ensuring that, as an industry, we’re actively trying to learn, grow and evolve, by experimenting and debating, at the least cost to society. This means that we should all make a proactive effort to support entrepreneurs, innovators, and investors that are taking calculated risks to push the industry forward, and simultaneously call out scammers, promoters, and speculators whose agenda is only based on self-interest… until a reasonable regulatory framework is implemented, it’s incumbent upon market participants to self-regulate the space.

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Market Value to Realized Value

We’ve done a bit of a look around to try and scout for indicators (some of which are more technical than others) that might give us some perspective in terms of where price might be headed. We take most of them with a healthy amount of skepticism, especially given the fast-changing nature of the crypto industry, the polarizing agendas of crypto believers and crypto skeptics, and the industry’s correlation with risk-on assets within traditional financial markets.

Through this research, one indicator that stood out for getting a ton of attention from crypto market participants is the Market Value to Realized Value (MVRV), which basically divides the current Market Cap of BTC (the price of each BTC x total BTC already mined) by the Realized Value of BTC (the price of each BTC the last time it moved from one address to another x total BTC already mined).

According to the inventors of the indicators, the logic behind calculating the Realized Value is that it “seems to suggest the final layer of people’s cumulative cost basis”, which in laymen’s terms means that all you’re doing is comparing the current value of the Bitcoin network to the total value stored in the asset.

With that:

• If the indicator is higher than 1, current BTC investors are, in aggregate terms, at a profit given that the current market cap (in USD terms) is higher than the total USD value stored in the asset. The higher the MVRV goes, the higher the incentive for investors wanting to lock in some profits by distributing coins (values higher than 3.5 – in grey in the chart above - have generally served as a strong signal for late-stage bull cycles).

• If the indicator is lower than 1, current BTC investors have, in aggregate, lost more money than they have made.

Just over a week ago, it broke below 1 for the first time since the pandemic. This matters because the MVRV rarely falls below 1, and one can intuitively understand why: throughout its history, Bitcoin has tended to generate more profits for investors than losses.

There have been several periods when MVRV fell below 1 and stayed there for quite a bit (for over a year between 2014 and 2015, which if it were to happen again today, would be enough time to break Tim’s spirit, forcing him to cut his hair and go back at a corporate job clocking in 100 hours a week). That said, independently of how long it took to bounce back, when MVRV breaks below 1, it has usually signaled a good “accumulation level” for BTC. Will this time be the same? No idea… but there’s some color we would like to add around this indicator.

Since the last bear market, the industry has matured, putting together a good deal of technical indicators that try to assess when BTC is “overvalued” and “undervalued”. There are also many more institutions within the ecosystem now (this is on a relative basis versus previous bear markets, as overall adoption is still not very significant), all of which employ really smart people that also have access to the MVRV indicator. The fact that the indicator has broken below 1 could potentially mean one of three things:

• There aren’t enough market participants looking at this indicator (either because they don’t care about such indicators or they’re simply unaware of them), which, if history were to repeat, could make buying BTC at these levels interesting (especially given that buying BTC here seems to be pretty much a non-consensus call).

• There are enough participants aware of the MVRV indicator, but not enough believe in it as a signal strong enough to buy BTC and support its price.

• There are enough participants aware of the MVRV indicator with the belief it tends to highlight great entry points for long-term accumulation of BTC holdings, but they currently lack the liquidity to deploy additional capital to buy BTC.

This might be an oversimplification, but it should give a good foundation on how to think about these things. It will be interesting to see how successful this indicator is going forward, so keep an eye on it as it’s one of the preferred macro indicators for industry participants (similar to a Cyclically Adjusted PE Ratio for traditional finance people).

The Ethereum Merge

The most important event within the world of DeFi is the upcoming Ethereum Merge, where the goal is to move the Ethereum blockchain from Proof-of-Work (like Bitcoin) to Proof-of-Stake consensus mechanism.

Explaining the mechanics of it is beyond the scope of this update (but we recommend you start here), so just keep in mind the following:

• Moving the ETH blockchain from PoW to PoS consensus has been something in the works for years, with perpetual delays for actual implementation.

• It is now expected to be realized around Q3/Q4 of this year, but many believe that it’ll be once again delayed.

• Delays are not something to bash on – moving the second-largest blockchain from one consensus mechanism to another requires a monstrous amount of testing from developers, and it’s important to ensure that once live, there aren’t any bugs.

• The goal of the Merge is that, by moving to PoS consensus mechanism, the energy consumption of the ETH blockchain will come down by 99.95% (according to the Ethereum Foundation), centralization risk will decrease, and it will enable the development of shard chains, which will help keep gas fees under control (you remember the fuss about ETH gas fees during the NFT boom?).

• The Merge is also expected to improve the inflation profile of ETH. As explained by Grayscale: “The ETH supply has an inflation rate of approximately 4% or 4.7M ETH per year according to Coin Metrics and is burning roughly 2.3M ETH per year due to EIP-1559. With ~400,000 validators currently on the network, the number of validators would need to increase over 300x to achieve an annual issuance of over 2M ETH – less than half of the total issuance today. Additionally, it is less than the amount of ETH currently burned on an annualized basis that could cause the supply of Ethereum to become deflationary.”

Independently of how technical you want your understanding of the developments of the Merge to be, this is something everyone with an interest in crypto (especially in DeFi) should be following closely.

Thanks for reading through! Obviously, none of this is investment advice.

If you missed our Q&A with Doomberg last week, make sure you give it a listen here. There's a ton of great stuff there.

As always, we'll see you out there...