May 19, 2022

NYDIG Market Update

GREG CIPOLARO

Global Head of Research at NYDIG

ETHAN KOCHAV

Research Analyst at NYDIG

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Market Update

Over the past two weeks, digital asset markets have experienced significant volatility. Traditional financial market contagion has spread to digital asset markets, and idiosyncratic vulnerabilities inherent in LUNA/USDT ecosystem resulted in billions of dollars of wealth destroyed and forced the selling of bitcoin to defend the UST peg. Bitcoin, which had been trading in a narrow band, broke through to the downside. Given all of this, we thought it would be helpful to provide a mark-to-market on the events in the recent past and share what we are seeing.

Macro Backdrop

The Fed increasing interest rates to fight inflation has been the issue affecting markets since November, including stocks, bonds, and crypto. Rising rates have leached global liquidity from markets by increasing the cost of capital. Given this mechanism, which simplistically could be viewed as the Fed’s blunt instrument of aggregate demand destruction to arrest the rise of prices, it should come as no surprise that financial assets have struggled. Rate growth expectations have gotten a bit of a respite recently, however, flattening off since the beginning of May.

Backing up a bit to 2020, much of the money printed to combat the economic impacts of COVID-19 found its way into financial assets rather than the consumptive measures of GDP. This bifurcation of the flow of money into the real economy (GDP transactions) and financial assets is best illustrated by the growth in money supply (M2) contrasted with the collapsing pace at which that money moved through the economy (the velocity of money).

Equity Drawdowns and Higher Correlations

Bitcoin’s rising correlation with equities has been well documented over the past 2 years, likely driven by monetary and fiscal policies. The initial increase of liquidity caused by supportive policy led money to flow into assets and collectively increase their prices. The recent contraction in monetary policy, alongside other factors, led to a surprise contraction in first-quarter GDP, stoking the prospects of a recession. Against this backdrop, equities and bitcoin have fallen. It is important to understand the historical context in which the recent drawdown has occurred. The Nasdaq Composite has recently been off as much as 29.0% from its November highs, a swift and deep contraction, but not without precedent. However, this obscures the fact that many stocks have fallen more than 90% from their COVID-era highs seen earlier in 2021. Whether causal or simply caused by the same factors, this equity market move has clearly found its way into bitcoin’s price action.

Market Observations

Bitcoin Liquidations Have Been Light

Forced liquidations of over-leveraged futures positions are often a hallmark of market corrections. Automated liquidation engines run by crypto exchanges can hastily sell open positions to bring traders in compliance with margin requirements, often exacerbating directional price moves. However, unlike big price moves in the past, liquidations were not a significant factor in the recent sell-off, resulting in more orderly price action. Liquidations both in total dollars and as a percent of open interest outstanding were light compared to those seen during previous drawdowns. We did see large dollar liquidations in futures for coins other than bitcoin, such as ether, indicating that perhaps leverage is more significant in other areas of the crypto market.

These low bitcoin futures liquidations are consistent with data we see elsewhere; leverage in bitcoin markets, often a culprit in big market moves, has been fairly benign. Funding rates on perpetual swaps trading offshore have been hovering around 0% for some time now, and open interest on futures has declined. This implies that there is a relatively limited number of derivatives traders highly levered to the upside, helping to show why liquidations may have been limited.

Spot Flows on the NYDIG Trading Desk

The NYDIG trading desk had the highest spot volumes of the year last week, up 259% from its weekly average this year. Most of these volumes (71%) came from clients looking to sell. Investors were nervous going into the week was nervous as traders started de-risking as early as last weekend when bitcoin broke below $35K. However, there has been some sporadic interest to buy the dip from high-net-worth individuals and family offices.

Option Flows on the Trading Desk

The derivatives side was just as busy, as our desk traded the second-highest weekly volumes of the year. Last Wednesday, May 11 was the largest bitcoin options volume trading day of the year, with nearly $2B worth of options traded. Trading was primarily focused on put selling, new call overwriting positions, and rolling down strikes given the spot moves.

This increase in option selling was driven by an increase in option prices. Option-implied volatility (IV) of bitcoin catapulted higher on the spot drawdown over the past week and a half. One-month at-the-money (ATM) IV moved from 54% on Tuesday, May 3 (before the FOMC rate decision) to as high as 102% last Thursday, May 12. It has since settled at 78% as of May 16, still an elevated level versus the 64% average seen this year. Shorter-dated options have become more expensive than longer-dated options, which tends to occur when volatility spikes higher.

With the rise in IV, 25-delta options skew, the measure of the price of puts versus the price of calls (more formally, 25-delta put IV – 25-delta call IV)/ATM IV) has increased to reflect the fearfulness in the market. The put/call ratio has reached a one-year high of 0.72. Put prices increase relative to call prices when markets are more fearful; as a result, there is more demand for downside hedging. This has occurred for both shorter- and longer-dated options. To take advantage of this dynamic, our trading desk favors selling puts into a higher implied volatility environment.

Stablecoin Supply Declines as Crypto is Converted to Cash

As bitcoin prices have fallen, we have also seen withdrawals from stablecoins. The most notable example was the fall of algorithmic stablecoin Terra USD (UST), but traditional reserve-backed stablecoins have also seen outflows. Stablecoins are frequently used as trading tools in both centralized and decentralized exchanges, so these outflows may reflect waning interest in the asset class. While significant in dollar terms (~$5.5B), though, the withdrawal since the end of April only represents about 3.5% of the total stablecoin assets. This move was accompanied by a rotation from Tether (USDT), the most popular stablecoin, to USD Coin (USDC), the second most popular one. USDT has long caused consternation in markets over a lack of transparency surrounding its reverses, so this rotation likely reflected a flight to safety, especially in light of the UST’s unraveling. The culmination of these market forces led to a brief de-pegging of USDT, though prices quickly recovered as Tether was able to process redemption requests at par.

It is important to understand that, although the collapse of LUNA/UST resulted in the tragic loss of wealth for its multitudes of holders, UST was not systemically important in the way that Tether is. Tether is a quote currency heavily used on many offshore exchanges, chiefly Binance. Unlike offshore exchanges, onshore exchanges such as Coinbase or Gemini tend to have stable banking relationships and thus favor trading in USD terms. In addition, Tether is heavily integrated within DeFi, whether for trading, providing liquidity, or lending and borrowing. So far, Tether appears to have processed $9B of cash redemptions, over 11% of its capital base, without a noticeable hitch, but as it is a structurally important asset, we continue to monitor it. Notably, there are other stablecoin replacements that have gained significant adoption, notably USD Coin, and access to fiat rails is more broadly available today for exchanges versus when Tether first began trading.

Defi Sees Collateral Base Swoon

Another area we continue to monitor is DeFi. A common measure of usage of the DeFi ecosystem is Total Value Locked (TVL). Much of DeFi activity — borrowing/lending, exchange trading, staking — relies on users posting collateral in one form or another. Lenders need to post coins to be borrowed against, for example, and automated market makers need coins to place bids and offers. By locking up their coins, investors can generally receive a yield. An increase in the value of TVL represents an increase in investors chasing this yield and vice versa. After massive growth in TVL over the past several years, it has nosedived this year. Looking at the top 5 protocols, TVL has decreased by 47% year to date. Some of this is just a reduction in the value of coins, but the rest is coins being taken off applications.

Looking at On-Chain Behavior

New Holders Realize Losses while Long-Term Holders Stay Put

Looking at spent transaction volume by age, a measure of how long coins that are moving on the network have been held, most of the coins that have moved were only recently acquired. Less than 2% of the daily on-chain transaction volume represents coins that have been held for more than 12 months. Because the price of bitcoin is down over the past 12 months, this is leading to some of the largest realized on-chain losses in Bitcoin’s history. Not since the market correction a year ago have we seen anything resembling such a magnitude of on-chain realized losses.

In that vein, the percentage of bitcoins that have stayed put for over a year is increasing. This number, which last troughed in spring 2021, tends to increase in bear markets as shorter-term investors exit the market.

What do Flows Say?

Exchange flows were significantly positive in the last few weeks, though this was caused by a single whale. In attempting to defend the Terra peg, the Luna Foundation Guard (LFG) moved about 80,000 of its reserve bitcoins onto an exchange to sell on the open market. Apart from the impact from the LFG, exchange balances have generally declined this year. Lower exchange balances are generally viewed as bullish since investors tend to move their coins off exchange when they are not in a hurry to sell them.

Final Thoughts

Digital asset markets have had a bumpy ride the past few weeks, largely driven by an outgrowth of volatility stemming from traditional financial markets. On the positive side, leverage does not seem to be a factor driving markets, long-term holders appear to be intact, and more bitcoins continue to be held away for longer. On the flip side, the decline in stablecoin supply indicates capital being withdrawn from the digital asset ecosystem while traders position themselves defensively. Given the high correlations with financial markets, it is unlikely this episode of elevated volatility in digital asset markets ends until there is stability in traditional markets. Despite the ups and downs of the market in the short-term, for investors focused on the long term, we still believe that the secular case for bitcoin, its growing long-term adoption and usage, remains unchanged.

Please reach out with any questions or comments.

Sincerely,
The NYDIG Team

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Disclosures

This communication has been prepared solely for informational purposes and does not represent investment advice or provide an opinion regarding the fairness of any transaction to any and all parties nor does it constitute an offer, solicitation or a recommendation to buy or sell any particular security or instrument or to adopt any investment strategy. Charts and graphs provided herein are for illustrative purposes only. This communication is not research and should not be treated as research. This communication does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of New York Digital Investment Group LLC or its affiliates (collectively, “NYDIG”).

It should not be assumed that NYDIG will make investment recommendations in the future that are consistent with the views expressed herein or use any or all of the techniques or methods of analysis described herein in managing client accounts. NYDIG and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this communication.

There can be no assurance that any investment strategy or technique will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment, which may differ materially, and should not be relied upon as such. The investment strategies, techniques or philosophies discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation.

The information provided herein is valid only for the purpose stated herein and as of the date hereof (or such other date as may be indicated herein) and no undertaking has been made to update the information, which may be superseded by subsequent market events or for other reasons. The information in this communication, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.

Information furnished by others, upon which all or portions of this communication are based, are from sources believed to be reliable. However, NYDIG makes no representation as to the accuracy, adequacy or completeness of such information and has accepted the information without further verification. No warranty is given as to the accuracy, adequacy or completeness of such information. No responsibility is taken for changes in market conditions or laws or regulations and no obligation is assumed to revise this communication to reflect changes, events or conditions that occur subsequent to the date hereof.

The derivative strategies described in this communication may be effected through transactions with NYDIG Derivatives Trading LLC (“NYDIG Derivatives”) or by NYDIG Asset Advisory LLC (the “Advisor”) acting in its capacity as a commodity pool operator or commodity trading advisor, depending on the structure and definitive agreements that you enter into, if any.

NYDIG Derivatives is registered as a money services business with FinCEN. NYDIG Derivatives is not licensed by the SEC, CFTC, or NYDFS and is not registered with any self-regulatory body such as the NFA or FINRA. You understand and agree that NYDIG Derivatives is not acting as a commodity pool operator, commodity trading adviser, introducing broker, or futures commission merchant. In addition, you acknowledge that NYDIG Derivatives is not licensed as a swap dealer. Because of this, you will not have the protections under state money transmission, securities, or commodities laws and rules that you would otherwise had if NYDIG Derivatives were so licensed or registered.

Alternatively, the strategies in this communication may be effected through the Advisor. The Advisor is registered under the CEA as a commodity pool operator and as a commodity trading advisor. Although the Advisor is registered as an investment adviser under the Advisers Act, the Advisor will not be acting in such capacity with respect to the strategy, and the Advisor’s provision of services to the strategies will not be governed by the Advisers Act.

THE ADVISOR IS A MEMBER OF THE NFA AND IS SUBJECT TO NFA'S REGULATORY OVERSIGHT AND EXAMINATIONS. THE ADVISOR HAS ENGAGED OR MAY ENGAGE IN UNDERLYING OR SPOT VIRTUAL CURRENCY TRANSACTIONS IN THE STRATEGY. ALTHOUGH NFA HAS JURISDICTION OVER THE ADVISOR, YOU SHOULD BE AWARE THAT NFA DOES NOT HAVE REGULATORY OVERSIGHT AUTHORITY FOR UNDERLYING OR SPOT MARKET VIRTUAL CURRENCY PRODUCTS OR TRANSACTIONS OR VIRTUAL CURRENCY EXCHANGES, CUSTODIANS OR MARKETS. YOU SHOULD ALSO BE AWARE THAT GIVEN CERTAIN MATERIAL CHARACTERISTICS OF THESE PRODUCTS, INCLUDING LACK OF A CENTRALIZED PRICING SOURCE AND THE OPAQUE NATURE OF THE VIRTUAL CURRENCY MARKET, THERE CURRENTLY IS NO SOUND OR ACCEPTABLE PRACTICE FOR NFA TO ADEQUATELY VERIFY THE OWNERSHIP AND CONTROL OF A VIRTUAL CURRENCY OR THE VALUATION ATTRIBUTED TO A VIRTUAL CURRENCY BY THE ADVISOR.

Risks Related to Strategies

Risks Related to the Investment Strategy

The investment strategy is newly developed and therefore there is no meaningful performance data on which potential investors may evaluate the strategy. Bitcoin and bitcoin derivatives are a relatively new asset class and are subject to unique and substantial risks. There can be no assurance that your investment objectives will be achieved, that there will be profits or that losses will be avoided. Due to the limited history of digital assets and the rapidly evolving nature of the digital asset market, it is not possible to know all the risks involved in making an investment in digital assets, and new risks may emerge at any time. Currently, there is relatively limited use of any digital asset in the retail and commercial marketplace in comparison to relatively extensive use as a store of value, thus contributing to price volatility that could adversely affect the investment strategy. Digital asset transactions are irrevocable and stolen or incorrectly transferred digital assets may be irretrievable. As a result, any incorrectly executed digital asset transactions could adversely affect your investment. Some purportedly decentralized digital assets may be more centralized than widely believed, or may become more centralized over time, increasing the risk that an adverse event impacting an individual personality or entity could result in a reduction in the price of digital assets and adversely affect the investment strategy. A failure to properly monitor and upgrade network protocol could damage the digital asset networks.

The investment strategy will involve investments in derivatives, including OTC derivatives contracts. The use of derivatives involves risks that are in addition to, and potentially greater than, the risks of investing directly in digital assets, securities and other more traditional assets. It is intended that options will be written to seek to generate income for the investment strategy from premiums, and investments also may be made in derivatives for investment purposes and for hedging and risk management purposes. Certain derivative positions used in the investment strategy involve the risk that, if the volatility of the underlying asset is greater than expected, the investment strategy will bear losses to the extent of the obligations under the relevant derivative contracts, which may not be outweighed by the amount of any premiums received under the investment strategy for the sale of such derivative instruments.

The investment strategy is subject to various increased market risks, including volatility risk and valuation risk, based on the strategy’s use of bitcoin and bitcoin derivatives. Bitcoin and other digital assets have generally exhibited tremendous price volatility relative to more traditional asset classes. In addition, certain market factors make valuing bitcoin and bitcoin derivatives more complex and errors may occur.

Specific risks involved in the use of certain types of derivatives in which the investment strategy may invest include options risk, call option risk, position limit risk, clearing risk, counterparty risk, and illiquidity risk. Certain of these risks may be greater for investments in bitcoin and other digital asset derivatives as compared to more traditional asset derivatives.

The investment strategy intends to hold bitcoin and invest in derivatives related to bitcoin and may incur greater losses as a result of non-diversification.

Trading prices for bitcoin have historically been highly volatile. The value of the bitcoin held under the investment strategy could decline rapidly, including to zero.

The bitcoin held under the investment strategy may be subject to loss, theft or restriction on access, each of which could result in the halting of the investment strategy’s operations or a loss of the assets. Such losses could result in a reduction in the value of your investment. The custodian of the assets has adopted security procedures intended to protect the assets held under the investment strategy, but there can be no assurance that those procedures will be successful in preventing such loss, theft or restriction on access. You should not invest unless you understand the risk that the possession or control of assets held under the investment strategy may be lost.

The ability of the Advisor, its custodians and security vendors to adopt technology in response to changing security needs or trends poses a challenge to the safekeeping of the bitcoin held under the investment strategy.

There could be unforeseen difficulties in operating and maintaining the investment strategy’s security procedures or other key elements of its technical infrastructure.

Fees and expenses will be charged regardless of profitability and may result in the depletion of the assets held under the investment strategy. The value of your investment could decrease if unanticipated operational or trading problems arise. The bitcoin held under the investment strategy is not subject to FDIC or SIPC protections. Service providers, including custodians and security vendors, owe no fiduciary duties to you, are not required to act in your best interest and could resign or be removed by the Advisor.

Risks Related to Tax

The United States tax rules applicable to your investment and the investment strategy are uncertain in many respects and tax consequences could differ from expectations.

The tax treatment of bitcoin could have negative tax consequences.

Your investment in bitcoin or other appreciated property may lead to a recognizable gain as a result of such investment. Although the Advisor intends to operate the strategy to avoid triggering Unrelated Business Taxable Income (“UBTI”), you could nonetheless be subject to UBTI as a result of the investment strategy.

Risks Related to Regulation

Regulatory changes or actions may alter the nature of your investment or restrict the use of digital assets or the operation of digital asset networks or exchanges in a manner that adversely affects the investment strategy. If regulatory changes or interpretations require the regulation of one or more digital assets under the CEA by CFTC and/or under the Securities Act of 1933, as amended, the Exchange Act of 1934, as amended, the Advisers Act or the Investment Company Act of 1940 by the SEC, compliance with these requirements could result in additional expenses or significantly limit the ability to pursue the investment strategy or may adversely affect your investment. It may be or become illegal to acquire, own, hold, sell or use digital assets in one or more countries.

Other Possible Risks

There is no assurance that the above list is complete or that there are no other risks that may exist now or may arise in the future.

Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Legal advice can only be provided by legal counsel. Before deciding to proceed with any investment, investors should review all relevant investment considerations and consult with their own advisors. Any decision to invest should be made solely in reliance upon the definitive offering documents for the investment. NYDIG shall have no liability to any third party in respect of this communication or any actions taken or decisions made as a consequence of the information set forth herein. By accepting this communication, the recipient acknowledges its understanding and acceptance of the foregoing terms.

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