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Prepare to Advance

On January 22nd of this year I published the first piece on this blog titled "Survive and Advance". The basic premise is that crypto markets are simply about surviving the bust cycles so you can advance to the next bubble cycle where you can play fast and loose. It looks at a very simple momentum/trend following model that represents the strategic incarnation of that core belief we hold paramount at Starkiller, that liquid crypto markets are basically a series of bubble and bust cycles, that this isn't likely to end until the growth in the asset class slows considerably, and investments in this space must be managed as such. For the past six months we have been in survival mode. Later on in this piece I'll explain why now is the time to shift your thinking towards advancing, and how to strategically step back into the market. But before we get there, I want to review some of what's happened over the past 6-12 months and how we got here.

For those of you too lazy to click that link, here is the basic thesis from that piece:

Investing in crypto markets successfully is about one main thing, survive and advance. Because the asset class is growing so quickly (roughly 200% CAGR since 2016), it also has an associated massive amount of vol. And that vol isn't choppy, it's extremely smooth. Crypto markets are basically a series of bubble and bust cycles where we grow an order of magnitude each time, in both price and most of the underlying metrics. Huge assumptions of massive future global growth are pulled forward into prices within a short period of time, and then poof, the liquidity is gone, there are no new users, no new money, and we get 80-90% drawdowns. This action is COMPLETELY rational given the above variables. And because of that, if you consider what produces optimal aggregate returns over a long horizon (7-10 years), it's simply being able to limit drawdowns so you can survive and advance to the next adoption cycle when you can basically throw darts and be up 500%.

I was surprised in February and March when talking to both friends and institutional allocators about this thesis in general, how sure so many of them were that we would never see another 70-80% drawdown in BTC or ETH again. These weren't even what you would deem the "true believers", these were markets people. They felt the asset class had been institutionalized and the vol would come down, not all the way down, but they felt another massive drawdown would be a huge left tail event. I pushed back on that thesis pretty hard, which left some of them puzzled how I could be so long term bullish on something and at the same time so sure a large swath of the asset class could go to zero and the two biggest assets could draw down 80%+ again. Crypto believers aren't really known for their nuance, that's for sure, so this threw some people off kilt, forcing them to try and hold two pretty competing ideas in their mind at once, often a difficult thing when it comes to markets.

Well, here we are, BTC and ETH have drawn down 74% and 82% respectively.

The simplistic trend following model I laid out in Survive and Advance (5/50 EMA crossover) got whipped around on one entry and exit between mid March and late April but came out no worse for wear and has kept you in cash since through this most recent puke. In fact, looking back through the model's history this is actually the smallest drawdown peak to trough it has experienced during a 70% drawdown in BTC and ETH. Another way to put this is, this bear market has been the most "trendy" of them all. One of the questions I get asked a lot by allocators is whether or not we expect regime change at some point which will break these models, and how will we know it when it happens. I can often sense a good portion of that question is rhetorical, meaning they think it already has. Well, as you can see, definitely not. There will be a day when this market is priced more on metrics of some intrinsic value, when these assets are more mature and there isn't so much convexity, when they aren't all basically hero or zero venture bets. The growth rate at that point will slow, likely correlated with saturation of user adoption, the vol will come down and these models won't work quite as well (note they still work in many lower growth markets). We're a long way off from that, I would still expect another 2-3 bubble/bust cycles from here.

I bring up the idea that these people believed another 80% drawdown was a massive left tail event because of the conversation around the deleveraging and liquidations taking place in the crypto market today. Specifically I'm talking about Three Arrows Capital (3AC). Look, I don't mean to pile on here, in fact the point I want to make is that while 3AC was reckless or worse in a lot of different ways, it's obvious that they very much weren't alone in believing that their VaR was a lot lower than it turned out to be. Or maybe they just didn't care and it was all a YOLO trade. I don't have any insight there except to say an 80% drawdown shouldn't be a 1929 or 2008 event for your models, it should still be the base case assumption for a bear market in crypto. Anyone who was running a strategy counter to that simply wasn't paying attention. Add all the leverage they and others took on top of that and it's not a surprise they got liquidated.

I also find it interesting that many crypto market participants believed that we wouldn't see the kind of liquidity cascade selling we've seen in previous cycles. This happens when on-chain loans that become undercollateralized get auto-liquidated by DeFi protocols sending huge blocks of supply onto the market all at once. What makes crypto leverage so dangerous is that it's often collateralized by the same beta assets the traders are looking to lever up, and that's mostly BTC and ETH. We had been having a pretty vigorous internal debate at Starkiller over the last 5-6 months over whether there wasn't as much of this type of leverage in the system as previous cycles because the drawdown from last summer had washed out a lot of retail traders already. What even we failed to realize/see was that leverage which had previously been pretty visible, was replaced by institutional leverage being taken by 3AC and others via shadow banks like Celsius, BlockFi and Voyager off-chain and outside of the perpetual swaps. Not only that, but this time the leverage wasn't even collateralized in many cases, which is insane. And as we've seen over the past month or so, when that leverage went bad it resulted in the same outcome.

I want to say one more thing before getting to the important point of this post. Without getting deep into the regulatory weeds, because that's a whole huge can of worms, I just have to remark how absolutely insane it is that these shadow banks were/are still allowed to exist. And especially the ones that were/are basically selling an unregulated yield swap product to retail. Look none of us has perfect foresight in markets, and god knows I have gotten so many calls wrong about how crypto markets would develop over the years even in getting the macro picture right. But this one was soooooo obvious. Step one, shadow bank promises 8% yield to retail investor for deposits of both beta assets and stablecoins. Step two, shadow bank turns around and attempts to generate more than 8% yield by lending said assets, some in DeFi, some to firms like 3AC. Step three, bull market ends, DeFi yield dries up, CeFi lending bets go bad. Step four, shadow bank can no longer cover promised yield, investors sniff it out, a run on the bank takes place, they freeze depositor assets, they are insolvent. Ummmmm, where have we seen this before? Oh I don't know, maybe the 1920s when the EXACT SAME THING HAPPENED (minus the DeFi piece) and led to almost all of our current banking regulations. I have been screaming for several years that CeFi should not be selling yield swaps. Full stop, end of conversation. Don't sell yield swaps. DeFi protocols can facilitate yield swaps, retail users can interact with DeFi directly to attain yield, but CeFi should not centralized that risk, no matter what, end of story. And of course the inevitable happens, a bunch of tech bros who started these companies and didn't know anything about managing risk in DeFi (got blown up in Terra) or care to do any actual diligence on their direct lending (3AC) blew shit up. How could we possibly have predicted that! The SEC should have shut these down immediately, no questions asked, the second they had one onshore account (this still would not have prevented all of the offshore customers but that's not the SECs job). But Gensler didn't, he let this go on, then slowly tried to crack down a little bit, he even let the states go at them first. A big piece of me believes that Gensler being as smart as he is, wanted to see this happen (and knew it would) because it would somehow prove his point that the SEC needed full regulatory authority over crypto because it's just another capital market and the same stupid behavior will be exhibited as it has in all others historically. He's not wrong, that's exactly what happened, I just disagree with the his end goals, which are not to protect investors, they are to prevent DeFi from happening because it inherently makes it difficult for the government to regulate at all (which is true) and he wants to be Treasury Secretary. Guess who is the gatekeeper for that post, Liz Warren, who is also smart enough to know that DeFi solves a lot of the problems she and others on the left care so much about, but her desire to see the government control the financial system overrides that (for now). Capital markets are going to be on-chain and they are going to be global and permissionlessly accessible and that is a scary thing for governments. But until the UX for DeFi is better there are going to be people who try and centralized risk by taking a spread for getting you that yield in an easier dumb way. Don't be one of those people on either side of that trade, please.

Ok, moving on. So more importantly, where are we now after this mess.

I'm not going to give the sermon on why you should believe in the long term value of the crypto market, or why more specifically you should want risk managed beta exposure. Bear markets like this one, regardless of the specifics, will test that belief in just about all of us, I get it. But let's move past that and assume you're with me here in that long term bet. There are a list of things that happen at or close to the bottom of a bear market.

  1. Major institutions become insolvent or get liquidated. Yup, check. 3AC, Celsius, and a whole bunch of others are either on their way out or getting bailed out by the central bank of SBF.

  2. A major financial product breaks. Well yea I think we can say $80B in value from Terra/Luna suffices. We definitely have our poster child for poorly designed thing that lost a wide swath of people a ton of money this cycle. There's always a WebVan or no down payment adjustable rate mortgage.

  3. Liquidity cascades take place as margin calls (manual or automatic) force supply onto the market in quantities market makers can't handle. Yea we definitely started to see that a few weekends ago. There was a $150M on chain liquidation of ETH via Uniswap that printed around $900 when ETH was at $1,100. The market obviously then went down to test that level, where eventually it bounced. Certainly that could have been the beginning of much higher vol and not the end, we'll see.

  4. Liquidity dries up. For sure there is a lot less liquidity in this market, especially in the long tail of coins. Retail is gone, market makers have withdrawn risk, especially from DeFi, check that off for sure.

  5. Mainstream media declares it's over for good, that it was all garbage, and you should have known better. Yea we're definitely there. I'm even seeing a good portion of the open minded ones question whether Web3 has or will ever have real world value/use cases at all.

  6. Major layoffs happen. Yea all the brokerages (except FTX which is very lean and Binance which seems to have unlimited capital) have already fired 20% of their staffs, that will likely go to 50-60% by the time this is over but we're definitely in the "casino is closed" phase here and they know it. Robinhood might get taken out by SBF, we'll see.

  7. Calls for increased regulation, regulators need scalps. We're getting there, though to be fair the real scalp chasing happens after the bottom because regulators are always late. I guarantee you someone is going to jail though, someone always goes to jail.

  8. Funding rates go extremely negative. We haven't quite seen this yet. It got a bit bearish there a few weeks ago, especially in the long tail of coins, but BTC and ETH funding rates haven't really approached the kind of levels we've seen at other bottoms. It still feels like whales are trying to hang on to long term accumulations acquired between $30,000 and $40,000. This too will likely end in a washout.

  9. Spreads get super loose. Well, we kinda maybe started to see a little of this a few weeks ago but it definitely didn't look like last summer or previous cycles where spreads blew out to literally percentage points wide and there were massive cross exchange arbs in price. We just haven't seen it yet, but it feels like it's coming. Maybe there are enough market makers now vs before to prevent this, but I doubt it.

  10. And finally, apathy sets in. We're not here yet. And this doesn't necessarily have to take place. Bear markets can end in one of two ways, a final run of capitulatory selling (think '08 equities), or in the apathy stage where things just get really boring, people forget about the asset class, and we just run out of sellers one day (tech circa 2002). I'm of two minds here. On one hand I think there's too much institutional money that's been raised to invest in the early stage of crypto for apathy to set in this time. This doesn't feel like 2019 where we went into a deep winter and people just forgot crypto existed. On the other hand, if the macro economic background doesn't change, a lot of people may just keep their powder dry, unless there's a major catalyst which would have to be product adoption driven. I personally don't believe we're in for a huge long term macro economic regime change to higher inflation and higher rates. We're already starting to see demand destruction in the price of commodities like copper, the real estate market is freezing like Han Solo into carbonite, consumers are pulling back, etc. Putin's war in Ukraine may extend this regime with one more big spike in the price of oil (demand destruction in economic expansions often start with oil spiking) but I trust Powell when he says they are prepared to destroy risk assets and get you fired from your job (my words not his) to bring down inflation (I'm passing no judgement on whether this is good policy or not, but you better believe he'll do it). So, I wouldn't bet on a 30 year treasury at 6%, Powell will have done his job way before that happens and we'll go back to the long term structurally deflationary environment we came from. So maybe we get the apathy stage, maybe we don't, but it wouldn't be my base case scenario.

So reflecting on the above, we may not be there yet, but given the magnitude of the drawdowns we're not far off, most of the pieces are in place. Our focus now really shifts to identifying a reentry to holding beta exposed assets and away from exclusively stablecoin yield farming.

Which brings up the question, what is the optimal way to step back in.

As a simple exercise I had our diligent quantitative research intern run a quick analysis for the relative performance of using the above mentioned 5,50 EMA cross trend following strategy vs a simple two week dollar cost average into BTC and ETH at different drawdown levels (50%, 60%, 70%) with a six and twelve month look forward. Why two weeks on the DCA, I don't know, it's arbitrary, but that was kind of the point, two weeks seems like a reasonable DCA strategy in this case.

Since 2012 there are 15 total observations of 50%+ drawdowns, 9 for BTC and 6 for ETH. BTC has 4 distinct cycles and ETH has 3. Obviously we are not counting the current cycle which fulfills the full 70% drawdown threshold for both assets as we don't have the 6 and 12 month forward returns yet.

The table below shows each observation for both the 6 and 12 month lookahead.

There are some pretty obvious lessons to be drawn here, most notably, regardless the drawdown level crypto assets can always go lower. There are 9 observations in which the 6 or 12 month return for the DCA strategy is negative! In 4 of those observations you lost another 50%+!!! There are zero negative observations for the EMA cross model. The average 6 and 12 month returns for the EMA cross model are 152% and 220% respectively, and 66% and 108% for the DCA model. We don't show the statistics here but maybe even more importantly the max drawdown levels for the two strategies aren't even close. The EMA cross model is at the end of the day designed to manage risk, which is why we use it.

Will crypto markets go through another bullish cycle as they have in the past after these massive drawdowns, we don't know for sure, but IMO it would be foolish to bet against it. What is obvious here is that patience is incredibly important, as exhibited by the 5,50 EMA cross model. But it's also hard to lose over these timeframes if you're willing to reallocate into the blood.

In reality we use a mix of trend following and shorter term mean reversion models to buy back in. There may be a capitulatory event coming when all of the things I mentioned above such as a blow out in spreads and liquidity cascades take place where we step in to buy serious blood, then use stops to protect gains even though we're nowhere near having our trend models trigger. The point here is to treat all rallies until that happens as suspect and strictly protect gains.

The hardest part about bear markets is having the patience to sit on your hands. The old saying, "if they don't scare you out they'll wear you out" is so true. Even those of us who run more quantitatively driven somewhat systematic strategies need to preserve emotional capital so that when the time comes to go back in, we don't freeze up. Getting chopped up too many times in a bear market will absolutely do that to you.

We're entering a period of extreme opportunity where the expected forward return for the crypto market has improved immensely relative to six months ago. Keep your head on straight and the rewards are obvious.


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