In summary, 2022’s crypto collapse is play in four acts with three down and one more to go:
Act 1: 2020–21 — Market Mania
Act 2: Q1 2022 — Leveraged Retail Wipeout
Act 3: Q2 2022 — Leveraged Insto Wipeout
Act 4: What’s next? Read on…
ACT 1 (done): Starting with DeFi summer in 2020, retail leverage and bull market mania drove TVL (Total $ Value Locked on the various blockchains) and token prices to unsustainable and unrealistic highs. Terra Luna, introduced in late 2020 with many virtues, epitomized the craziness; it rose in value from nothing at launch to over $40B in market capitalization in approximately 18 months, peaking in April 2022 before dropping to $0 just a few weeks later)
ACT 2 (done): More broadly than Terra, unsustainable inflationary native token rewards drove users to farm and then dump their earnings across all protocols and chains. The extremely high and temporary yields (sometimes in the 1000s of % APY), meant users chased yield and free token airdrops from one project to the next, levering up along the way. Once the rewards slowed or ceased, APYs became unrealizable and users fled.
This was the first leg down and it triggered widespread pain and further cascading selldowns in the first few months of 2022 (again, Terra Luna has become the poster child for this). Those with leverage were wiped out, driving liquidity down even further. The negative feedback loop saw lower demand from consumers across all projects driving lower and lower token prices. The reversal of price momentum lowered borrow demand from retail investors trading the wild rise in prices. Lower borrow demand meant lower lending APYs. All of these went round and round in a feedback loop driving prices, TVL & user #’s to plummet as the ponzi-esque upswing reversed itself.
ACT 3 (done): As consumers panic-sold, deleveraged and walked away from crypto en masse, TVL sank dramatically but then stabilized and even recovered some (as the Defillama.com chart above shows). But under the surface all was not well. By May and June this triggered highly leveraged and interlinked institutional funds like Voyager, Celsius, Three Arrows to collapse, causing another huge May-June selldown and flight of TVL (i.e. value shrinkage and funds leaving DeFi) as the Defillama.com chart shows.
ACT 4 (to come): The market now finds itself at a crossroads. EITHER the bottom is in and the 4th Act will be a return to stability / a new bull run; OR there remain further dangers lurking under the surface which will drive the market down even further. So far funds with no or low leverage have been able to hold so far. Yet with few exceptions their performance more or less tracks the overall market which is down 50–90%. The key question for Act 4 is will they capitulate and be forced to sell. They can avoid this if markets recover or resume a bull run but if token prices continue to fall they’ll be forced to cut losses or, facing massive redemptions from investors unhappy with their losses, they won’t have a choice. Or both. Like the first three “Acts”, this will create a new bottom, possibly another 50–80% down from the prior lows. Yikes!
What will drive the break, one way or another? And which way will it go? We think DOWN. The key drivers we’re tracking (and what we expect in the near term in parentheses) include:
- Growing Inflation (continues to stay high) means consumers purchasing power will shrink, especially for the large segments of the population on fixed income, and demand will fall;
- High Interest rates (more rate rises to come) means businesses, homeowners, credit card users or anyone who borrows will see their costs jump. A 4% rise in rates on a $1 million mortgage means an extra $40,000 per year in loan servicing costs;
- War in Ukraine/Russia sanctions (drags on) means food, energy, & key raw material disruptions for months more, not to mention the terrifying potential for widespread famine due to grain and fertilizer disruptions. The last time grain was similar disrupted (in 2010 Russia banned wheat exports due to drought shrinking output) prices doubled and we had the Arab Spring in the nations that relied so heavily on Russian grain.
- China Covid 0: (manufacturing disruptions and slow/negative growth to continue)
TLDR: We’re bearish and expect these trends to be expressed in declining consumer demand, shrinking earnings, lower investment activity and ultimately higher unemployment as the rest of the year unfolds. In a word: a recession, and one that will hit tech as well. Given the correlation of crypto with tech markets, we expect crypto to follow the market down.
One final note: there is a bifurcation between private and public that will likely persist: even as token prices and public tech company stock prices have tanked, VC-backed crypto companies have been somewhat shielded from the downdraft in prices. Anecdotally, quality projects continue to see very material valuation upticks, albeit perhaps not as much as last year. Why? VCs typically have a 8–12 year horizon and are cashed up with $10s of billions from some of the best years in fund raising ever so they (we) can take the long view. (No monthly or quarterly redemptions to drive selling).
The data tells the story. For example, YTD (as of July 2022), VC investments in crypto are >$18.3 billion, nearly triple the amount invested in 2020 and on pace to exceed 2021’s record haul of $32.4 billion (source; J.P. Morgan)
For the chartists, the past seem to suggest a fall as well. @MichaelMOTTCM has this chart which, with the white line, compares the S&P 500 in recent years mapped to similar boom to bust time periods for the S&P 500 (1994–1997, 1997–2001, and 2005–2008).
The rest of 2022 looks to be quite a difficult time. I sure hope we’re wrong!