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The Revolution That’s Been Building for 12 Years

Jeff Dorman, CFA
Feb 1, 2021
What happened this week in the Digital Assets markets?
Week-over-Week Price Changes (as of Sunday, 1/31/21)
 
 
WoW
YTD
Bitcoin
+2.7%
+14%
Bloomberg Galaxy Crypto Index
-4.1%
+38%
S&P 500
-3.3%
-1.1%
Gold (XAU)
+0.7%
-2.3%
Oil (Brent)
-0.2%
+7.5%
Source: TradingView, CNBC, Bloomberg
 
At this point, no one needs another recap outlining the absurdity that ensued last week from Reddit to Wall Street. The events were well covered.  Yet at the same time, I could write 100 pages explaining my views on the events, while refuting many of the misguided takes currently circulating.  In the interest of time, we’ll focus on just a few topics that seem most relevant and differentiated:

  1. Few, if any, truly understands the financial system
  2. Market manipulation is not new
  3. What’s different is simply who was manipulated and why 
  4. Social unrest has been a driving force for 12 years -- only this time, they brought their wallets
The Hypocrisy of “Investing in What You Understand”
One of my favorite excuses for why an investor won’t invest in a new asset class like digital assets is “I only invest in what I understand”.  Really?  Because based on what happened last week, there wouldn’t be a single investor in the world who bought stocks or bonds issued by banks, brokerages, or asset management firms.  The Robinhood saga and subsequent inaccurate responses from business leaders and politicians serve as a public reminder that repo, sec lending, margin calls, and regulatory capital requirements are confusing, murky, and wildly misunderstood.  Fortunately, here comes Congress riding in on their high horse with a solution to a problem that has existed since the 1800s.  In fact, the etymology of the term “Cornering the Market” came from the mid-1800s, when speculators would buy all of the sugar that was available for trade and stand on a literal street corner to control and artificially inflate the price by squeezing short sellers.  Unless Congress and the SEC have a time machine and can go back to 1850 to stop J.P. Morgan, and then back to 2007 to stop Ben Bernanke, I fail to see how they are going to stop market manipulation or rampant risk-taking (The SEC vs Big Ben Bernanke -- coming to an AMC theatre near you!).
 
Bottom line:  Last week’s events were not new; market manipulation happens all the time.  
 
There is a reason “Big Boy Letters” and “ISDA Master Agreements” exist.  In layman’s terms, it means “someone is about to get their face ripped off, just don’t cry about it when it happens because we’re all willing participants in the manipulated game”.  Just about every single rule and regulation built on Wall Street has been a reaction to some form of past market manipulation or tomfoolery. These events, however, usually only happen to the pros, behind closed doors -- and no one really polices pro-on-pro crime.  Only in rare cases do these trades make it to the public.  The only difference between last week’s events, and the events of the last 150 years, is WHO it happened to, and HOW it unfolded, as these events almost never involve Joes beating Pros.
 
The reason this current attack on Wall Street and a completely dysfunctional capital markets system took place is more important than the attack itself, and the anger that caused it has been brewing for 12 years. 
 
“Occupy Wall Street” is Back … Only This Time, They Brought Their Wallets To The Fight
We’ve been writing about wealth inequality, social unrest, and what it means for society and financial markets since we started Arca in 2018.  Below are just a few snippets from prior write ups that ring more true today:
 
Following the repo unwinds of November 2019:
 
“Unlike Occupy Wall Street, which was a flawed movement against massive, well-capitalized institutions, the OK Boomer movement is pinning people (young adults) against people (baby boomers).  And this is not going to end quietly. The general sense is that the older generation, willingly or unknowingly, has stolen from future generations.  This is clearly evident when it comes to debt accumulation, and maybe less clearly evident when it comes to things like climate change.  But it is creating a cultural divide in society, no longer just “rich vs poor”, but now “young vs old”.
Following the massive Government bailouts in March 2020:
 
“The government is selling our future to bail out companies that may or may not continue to employ their workers. The backlash around bailing out Wall Street at the expense of Main Street will only intensify from here.  Occupy Wall Street is making a comeback, only this time, the solution may be a peaceful protest via owning Bitcoin.”
Following the Black Lives Matter movement building up to Presidential election in August 2020:
 
“Wealth inequality is one of the “Big Factors” that is shaping our world, now and in the future. Everything from politics, to Brexit and Occupy Wall Street, to the recent global riots are fueled by people who are essentially saying, “I don’t care how bad the alternative is, we want something new.” Monetary inflation explains a substantial portion of the wealth gap, as does capital formation solely rewarding equity holders over customers. Sound money like Bitcoin may fix the inflation problem, by restoring fiscal and monetary discipline and ultimately rebuilding the middle class. Meanwhile, democratized capital formation via digital assets that reward community and network users instead of equity owners may fix the equity-holder problem.”
This overwhelming mistrust, inequality, and anger are the real reason why Bitcoin, DeFi and other digital assets are booming while stock investors are questioning everything they once knew.  Bitcoin was born in 2009 due to mistrust of central banks, governments and financial institutions. Since the inception of Bitcoin, banks have made using and investing in digital assets extremely difficult. As a result, these two worlds have coexisted, evolving in parallel, but separately and distinctly.  But when brokerages start restricting what assets people can and can’t trade, and make sweeping decisions with regard to where you can send your money, and how you can spend your money, it rekindles the narrative for why decentralization is so important in the first place. Rules and regulations are fine; arbitrary restrictions and dictatorships are not.  Decentralized trading, decentralized lending, decentralized insurance, decentralized everything starts to make a lot more sense in light of what is happening today in the traditional financial system. This is less about Bitcoin and more about societal rights, only for the first time, the solution is here --- it was being quietly built over the past 5 years and is now ready for prime time.  Occupy Wall Street failed not because the idea was wrong, but because there wasn’t a better solution.  You can complain about banks and brokerages and “Too big to fail” all you want… but if there is no solution, nothing can or will change.  We now have a solution in the form of decentralized money and decentralized finance and decentralized quasi-equity ownership of companies via tokens. “Virtual Occupy Wall Street” is back, and now the whole country can participate with free money from the government without physically being anywhere. 
 
The Rise of DeFi and Decentralized Exchanges (DEX’s)
Cash has been rendered worthless.
Government/Sovereign bonds offer negative real yields. 
Corporate bonds offer asymmetric downside. 
Commercial real estate might be in a death spiral. 
And last week’s events turned equities into a laughing stock.  
 
No matter where you look, it’s all telling the same story -- too much cash, a desperate desire to invest that cash, and not a lot of traditional ways to deploy that cash.  From doubling IPOs, to hundreds of SPACs, to baseball cards setting records, to digital art, to Reddit-induced short squeezes -- all of the market’s frothiness can be traced back to this single “get out of cash” conundrum.
 
The rise in digital assets is offering investors a new arena, and both retail and institutional investors are noticing.  Anecdotally, the Arca team collectively has fielded well over 100 calls/texts this week alone about digital assets from friends and family - most of them getting off zero. The mess has turned digital assets into a beacon of hope.  On top of that, a certain sub-sector of digital assets (Decentralized Finance or DeFi) has directly benefited from this past week’s failures of traditional finance.  As our friend Paul Kremsky at Cumberland said, “Decentralized Exchanges (DEX’s) are essentially the opposite of “my broker just said I can’t buy any more”, and the question right now is whether that message will break through or remain isolated to those already in digital assets”
 
The market is answering that question for him.   Last week, Bitcoin rose just 3%, and smart contract platforms were flat, but DeFi tokens, in general, rose +37%, while DEX’s more specifically rose +46%.  The market leader in DEX’s, Uniswap, saw its UNI token jump +82% This compares to tokens of Centralized Exchanges (CEXs), which broadly rose just +12%.  The digital assets market is clearly differentiating, and picking winners out of last week’s equity dumpster fire. As Arca's own David Nage pointed out, the Robinhood, TD Ameritrade, and other brokerage fiascos were direct advertisements for Decentralized trading. 
 
unnamed (48)
Source: Messari
 
Equally important, as we’ve noted before, this is not a case where only the richest, earliest shareholders benefit.  The customers that are driving decentralized exchange growth are also the ones making all of the money. 
 
unnamed (49)
Source: Twitter / @santiagoroel
 

unnamed (50)

Source: The Block
 
Noelle Acheson of Coindesk had an interesting take.  While GameStop’s stock price may not reflect reality today, perhaps the market is telling you what they think about the future -- a future where a product that you use is more important than the earnings it generates.  She writes, “The new-found power of retail investors has shown that sentiment not only trumps earnings forecasts, it can impact them. The very same investors piling into the stock are the same demographic that GameStop’s future business will target.”
 
Exactly.  GameStop’s retail bonanza might actually create the demand it desperately needs, as shareholders turn into customers.  When your shareholders and your customers morph into one homogenous group, your company can grow by leaps and bounds.  And this is exactly what digital assets do -- they combine the utility of using a product with the financial prospects of owning that product.  
 
“I don’t invest in digital assets because I don’t understand them”... it’s time to understand them, as this link between user and investor is only going to grow stronger in the future.
 
Risk Management, the Great Leveraged Unwind, and What Comes Next
Before we conclude, it would be remiss of me not to mention the fallen hedge funds who suffered at the virtual hands of Reddit, and the risks that they took.  As Oaktree’s Howard Marks once said (paraphrasing), “I’d never want to be in the Top 5% of all hedge funds, because the same risks that it takes to get in the Top 5% are those that can put you in the bottom 5%”.   
 
It takes only a few months to learn how to trade, but it takes many decades to learn how to manage risk.  Melvin Capital, Mapleland Capital and D1 Capital are not innocent. Every investor on the planet will tell you that 3 strategies consistently get fund managers in trouble:
 
1)  Shorting
2) Leverage
3) Illiquid positions
 
Risk management matters. I learned this the hard way, and so did every successful fund manager that I know.  But for the past 12 years, moral hazard has changed the way investors think about (or don’t think about) risk.
 
unnamed (51)
 
With that in mind, Bank of America recently asked fund managers for the last 20 years whether they consider themselves to be taking risks right now in the market. This number has never been higher:
 
unnamed (52)
 
As my friend Ken Luskin wrote, “There are various explanations for this, which aren’t uniformly negative. Fund managers didn't think they were taking much risk in 2007 and 2008, and that was precisely the problem. At this point, many feel viscerally uncomfortable to be positioned in stocks, but that low returns on bonds and cash leave them no choice.”
 
So the difference between today and past periods of excess is that investors are aware of the risks, and therefore may be quicker on the trigger if the risk elevates.
 
On the one hand, as Edward Jones points out, the risks are isolated:  “We'd characterize what's playing out in certain individual stocks, like GameStop and AMC, as pockets of froth and speculation. We've seen what we would consider similar pockets in other areas in recent years as well (though not with the level of attention or scrutiny as is occurring presently). This means that what's occurring now is not necessarily a harbinger of more severe trouble ahead for the economy or market. Last July, shares of Eastman Kodak rose 1,481% in three days amid speculative buying. In 2018, amid the craze over cannabis stocks, the stock of cannabis producer Tilray Inc. spiked 1,159% in less than two months. Bitcoin prices rose more than 700% from last March to earlier this month.  The S&P 500 is up 66% over the past 10 months. The takeaway is that narrow targets of speculation, in our view, pose different implications for investors than market-wide euphoria.”
 
On the other hand, last week may have triggered a quick release of risk across the board.  The VIX spiked +60% on Wednesday alone, and remains comfortably above its historical average.  Further, according to Goldman Sachs’ “Weekly Kickstart”, last week showed the largest hedge fund position de-grossing since February 2009, and even after shorts and longs covered, hedge fund exposures still remain close to record highs indicating more risk of positioning-driven sell-offs could happen in the future.  This deleveraging isn’t unique to equities.  In the digital assets world, we’re seeing a collapse of leverage as well. The Grayscale premiums to NAV are approaching zero (and GBTC even went briefly negative), the rolling spot/futures basis is narrowing, and open interest on futures is falling.   
 
If anyone was planning on taking this week off… I’d reconsider.  Buckle up your chin straps!
 
What’s Driving Token Prices?
As noted above, this really was quite the week for a bevy of assets, digital or otherwise: GME, AMC, DOGE, XRP, and XAG all screamed higher, captivating participants of all asset classes. Rather than get into what was driving those prices, we focus on two projects with concrete fundamental news:
 
  • Alpha Finance (ALPHA) announced their v2 upgrade, offering four new pools for yield farmers to gain leverage. Whereas in Alpha Homora v1 a user could only take out a loan in ETH, the option has now opened up to include USDT, USDC, and DAI. The team noted that as they continue to add more leveraged pools, more assets will be made available to both lend and borrow. This launch was highly anticipated, with the token (+88%) reflecting the sentiment of the market.
  • Axie Infinity (AXS) announced that their Ethereum sidechain (Ronin) went live on mainnet, which aims to reduce network congestion and allow for higher throughput at lower costs for users. The mainnet comes with a migration, which will be rolled out in phases. Separately, the team announced that DappRadar has joined as a network validator for Ronin. The token surged ahead of the release, peaking at +63% before
What We’re Reading this Week
 
 
 
 
 
 
 

And That’s Our Two Satoshis! 
Thanks for reading everyone!   
Questions or comments, just let us know.  

The Arca Portfolio Management Team
Jeff Dorman, CFA - Chief Investment Officer
Katie Talati - Head of Research
Hassan Bassiri, CFA - PM / Analyst
Sasha Fleyshman -  Trader  
Wes Hansen -  Head of Trading & Operations
Alex Woodward- Analyst
  
To learn more or talk to us about investing in digital assets and cryptocurrency
call us now at (424) 289-8068.
 

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