Happy new year! As the new year dawns, we find crypto mired in a torpor of extreme low volume and volatility, with very little movement to discuss. As a result, we’ll take the opportunity to reflect on the themes that emerged from the chaos of 2022, and look forward to what 2023 might have in store.
During Q1 and half of Q2, as BTC meandered between $35-45k, crypto traders were forced to trade global macro, with the Ukraine war, inflation and US interest rates the primary focus, leading to a strong correlation between equities and crypto, as both came lower after historic bull markets. That changed dramatically on the weekend of 7-8 May as the Terra stablecoin depegged, unleashing hyperinflation in Luna which duly imploded, wiping out around $50bn of crypto assets in a matter of days, while the majors dropped 15-20%, taking BTC and ETH down to $30k and $2,000 respectively.
While we all knew at the time that the destruction of this much capital in such a short time would create some contagion risk, it would have taken a true pessimist to predict that by the end of the year, this event would have triggered the bankruptcy and/or zombification of many of the largest crypto lenders / traders / funds, and also taken down one the world’s largest crypto exchanges.
After a month of range bound trading around $30k, on 10th June US CPI came out much stronger than expected, and crypto fell hard alongside equities, trading down through $25k on the Monday, and finally below $18k the following weekend. Given that futures basis failed to blow out to the downside, it looked as if the selling was physical, and of course we now know that this was correct: the move was fuelled by the liquidation of loan collaterals.
More big bankruptcies followed, but thereafter the market settled into a low volume summer, with BTC grinding higher to test resistance at $25k in August, as traders celebrated a change of tone from the FOMC, who had stated that, going forward, further rate rises would be data dependent. That rally turned out to be a fake-out though, and unravelled quickly as the Fed re-confirmed their hawkishness, and as unconfirmed rumours of fresh bankruptcies circulated.
In September we had another relief rally, as the market looked forward with optimism to the ETH Merge, but ETH peaked around $1,775 on 12 September, a few days before the Merge, and by the end of the week was trading below $1,300, despite a successful implementation.
Amongst all the doom and gloom of the year, it is easy to forget that in late October and early November we had a period of crypto strength; idiosyncratic rallies in alts driven by optimism about real world applications. DOGE fans dreamed about when Musk finally went through with the Twitter deal, Matic announced a tie-up with Meta, Solana with Google Cloud, and Litecoin with Moneygram.
Alas, all of this would quickly pale into insignificance: on the weekend of 5-6 November, a copy of an Alameda Research balance sheet was circulated on Twitter, showing that they held an awful lot of FTT, which was being used as loan collateral. Within a few days, FTT had effectively become worthless, as had the entire FTX ecosystem, including billions of dollars of customer assets, and of course Alameda itself, whose troubles had begun back in May with a long position in a certain cryptocurrency called Luna.
A clear theme to emerge after the FTX collapse was wholesale removal of assets from centralised exchanges, with a consequent drop in exchange traded volumes, as the market prioritised credit risk management over trading opportunities. Consequently, cross-exchange arbitrage opportunities opened up wider than we have seen for a few years. In late November, December futures for BTC and ETH on CME were trading at annualised discounts to spot of around 20% and 25% respectively, while trading around 8% discount on Deribit, and only 5% discount on Binance.
The near-death experience that was 2022 for so many players will cast a long shadow deep into 2023. Low valuations and damaged balance sheets will mean the continued prioritisation of credit risk over market opportunity. And as a result, the market will demand a safer alternative to the current stock of unregulated offshore exchanges performing dual functions of custody and matching.
Although existing market players may continue to trade on existing exchanges, one is inclined to believe that real growth in crypto still requires new entrants to the market - read Trad-Fi players - and those parties still plan to trade crypto. But having watched 2022 from the sidelines, many have put those plans on the back-burner, pending a safer environment. Consequently the ability to trade without custodying assets on unregulated offshore exchanges may now be a prerequisite for future growth driven by new entrants to the market.
If that statement turns out to be correct, we expect volumes to move into either OTC trading (FX model) or into better regulated exchanges which operate together with a clearing house or central counterparty (equity model). The development of prime brokers and/or central counterparties may therefore be a theme to watch in 2023, as it would likely be perceived as long-term positive for market growth.
The bubble that burst in 2022 had been inflated using leverage to feed a long-only business model within opaque, privately-held institutions during the largest ever bull-cycle in crypto; and the reflexive nature of markets probably ensured that crypto was driven to heights it would never naturally have attained without such leverage. The reaction to this should be an urge to build more sustainable business models which can survive in sideways and bear markets. Lower leverage is a given, due to the higher standards of credit risk management already being employed in the OTC lending market; but we may also see tools developed which allow easier separation of credit risk from interest rate risk. Better price risk management will probably involve a greater use of options for balance sheet management, and the ability to make money in sideways or bear markets will require the use of options as well. It may be that growth in the use of derivatives - both in terms of volume and complexity - may also be a theme for 2023.
Unlike 2022, crypto enters 2023 without upward momentum. Token investors who survived last year will therefore probably be looking for real-time, real-world applicability, as opposed to betting on the hope of some future potential use-cases. One would expect the winners of 2023 to be those tokens which can demonstrate immediate cash-generative use cases in the real world, which do not depend on future crypto market growth and uptrends.
While idiosyncratic crypto stories should be key to finding the winners in mid-cap alts, most crypto traders will still feel they need to keep an eye on global macro, which will continue to influence sentiment and overall market direction. Key here is whether inflation has peaked: if it has, then traders will start to focus more on growth metrics, and whether we can avoid recessions in developed markets. If not, then with the Fed still in a combative mood, we could see more downside in equities. And if equities do remain weak this year, it might be worth keeping an eye on private market valuations, which still appear to be defying gravity, and could therefore be a trigger for downside volatility.
That said, we have to hope that the worst is now behind us, and that most players have now insured themselves sufficiently against further downside, such that if crypto was to go lower again in 2023, chances are it would be a grind rather than a collapse. Perhaps the surprise this year will be to the topside, but if I were a betting man, I would wager that would come in the second half of the year, and in the meantime, that the majors spend few more months trading in quite narrow ranges, where the best strategy could be to sell volatility on vol rallies, and fade moves in either direction.
Either way, surely it can't be any worse than 2022…? Happy trading!
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