Quarterly Commentary – Q4 2022

The Great Flood

“History teaches us that man learns nothing from history.” ― Georg Wilhelm Friedrich Hegel

Since 2008, the Federal Reserve has fomented loose financial conditions that can be summarized in one phrase: a flood of liquidity. If money is an ocean, then maybe digital assets are a vibrant, Darwinian island in the South Pacific. For DeFi protocols, liquidity is the source of life. Protocols have proven to be ultra-efficient at converting this liquidity to value for token holders.

Source: Dune Analytics, Dune Analytics

In March 2022 the Fed began tightening monetary conditions with cascading ripple effects through markets, particularly in digital assets. A falling tide sinks all boats, it seems.

Source: Yahoo Finance, MJL Capital

Market participants, hemming and hawing for relief, begging for each consensus surprise in economic data, are seemingly convinced that the flow of liquidity is finally ready to reverse course. Post the end of Q4, digital asset markets in particular have seen material strength on the back of encouraging economic data. All of a sudden, the same macroeconomic forces that provided headwinds for all of 2022 are reversing course and providing tailwinds. The reality is that the situation is fluid, and we do not know where the next shoe will drop. No one does - including and especially Mr. Powell. But right now, it seems the market is able to attain a higher level of certainty of the outcome for global economies moving forward, even if that future is value-destructive in nature.

Source: U.S. Bureau of Labor Statistics, Yahoo Finance

Digital assets have rallied hard on the back of easing economic data (the Fund has returned ~60% in January as a rough approximation). Our shorter-term outlook, an unnecessary evil of the current environment, rests on two likely pivot points, assuming key economic variables continue to trend in this direction:

1a. This rally in digital assets is short covering, we will return to an expected value plateau while we await clarity on monetary outlook. Expect spats of volatility and sideways chop.‍

1b. The buying is real. We may see a pullback followed by a test of range highs.‍

and then at some point...

2a. The Fed takes hawkish stance, talks down a pivot (“Higher for Longer”): We revisit lows. ‍

2b. The Fed takes dovish stance, communicates end of QT (“Buy Everything”): Secular bull market in digital assets.

Although I’d love to be the one to tell you that the dove will arrive punctually at eventide to welcome Mr. Powell to the Promised Land (i.e. that we will get 1b and/or 2b), I would objectively say those are not the likely outcomes. And that matters right now. On a probabilistic basis the expected value here is likely positive for the marginal dollar of allocation, but ignore the path function of volatility at your own peril. With the cost of 30 day money at approximately 4.5% and CPI at ~6.5%, one thing is for sure: Powell has more room to tighten if he wants. His current pace of tightening would imply approximately 4 years of current monetary regime to pull out COVID’s net addition to M2 ($100B/month versus $4 trillion printed), which tells me he also knows he can’t be too aggressive before something breaks. This issue is not nearly as resolved as the market seems to think.

Source: St. Louis Fed

What’s Happening in Crypto

Despite the lingering threat of contagion from the FTX collapse, we expect any further dominoes in 2023 will be footnotes compared to the magnitude of those already fallen. Currently, DCG, Genesis, and Binance are under intense scrutiny by market participants. DCG is facing the highest risk of bankruptcy following FTX's collapse, while Tether and Binance appear to be stable for the time being. Although we don't anticipate any major issues for Tether and Binance, they may still face challenges in 2023 due to Tether's history of aggressive reserve management and the increasing appeal of yield-bearing investments. Binance, known for its offshore operations, may also face heightened scrutiny from governments post-FTX given its market dominance.

As we discussed above, the bigger concern for the crypto market's direction is no longer endemic to digital assets but rather system-wide liquidity. The impact of changing monetary policies will continue to affect digital asset valuations, with select cohorts of particularly weak projects having yet to fully reflect reality (looking at you, Dogecoin, with a $12.5 billion market cap). Despite these challenges, the current environment presents a unique opportunity for building conviction and acquiring high-quality assets. The advantages of blockchain technology have never been clearer, and with lower valuations for the strongest projects, it's a favorable time to invest in top protocols trading at a discount. This is a once-in-a-generation opportunity for fundamental investors to acquire the next cycle of new dominant platforms.

“We see the obvious and visible consequences, not the invisible and less obvious ones. Yet those unseen consequences.., generally are more meaningful.” – Nassim Nicholas Taleb, The Black Swan

While the cryptoeconomy certainly faced its challenges in 2022, with collapses, bankruptcies, hacks, and scams that shook confidence in digital asset markets and brought the risk of reactionary regulation to the forefront. As we take a step back and reflect on the situation, it becomes clear that these events were actually a turning point for the industry.

What occurred in 2022 was nothing short of a tectonic shift in the digital asset markets. While many lament this as a “black eye” for the industry, we at MJL could not be any more encouraged by crypto’s cleansing. Let’s take a moment to remember what was lost at sea in crypto’s 2022:

1. Non-backed stablecoins
2. Unregulated centralized exchanges and lenders
3. Privacy mixers
4. Highly dilutive token models
5. Irresponsible leverage (frequently 10x or greater)
6. Financial businesses without financial risk management
7. Celebrities promoting scams

It was unsustainable - we all knew it at the time, we all know it now. Less dumb things for capital to flow into. Good.

Liars and frauds exposed and banished from the industry forever. Good.

$40 billion in leverage flushed out of the system. Good.

Source: Coinglass

The off-chain crypto economy was in desperate need of a reckoning, followed by a long look in the mirror...

Gone are (most of) the greedy, (most of) the reckless, and (most of) the fraudulent players, leaving behind a pressing need for policymakers to provide much-needed regulatory clarity, which will likely attract retail users and institutional investors alike. Most importantly, these developments present a significant opportunity for the digital assets to gain greater recognition and acceptance.

In the midst of the chaos, the on-chain economy proved to be more reliable and secure, with transparent, impartial code protecting users' rights, data, and assets. In contrast, the off-chain economy was plagued with principal-agent problems and centralized intermediaries with abhorrent risk management. These are issues as old as time and will likely repeat themselves in the absence of trustless, transparent systems. The contrast is clear: companies make promises, protocols make guarantees.

As the cryptoeconomy matures, it's likely that decentralized protocols will continue to take market share from their centralized counterparts, as users prioritize trust and transparency. The advantages of protocols over traditional legal systems are becoming increasingly evident, with lower transaction costs, accelerated innovation, and greater accessibility.

Of course these applications are still in their early days. Not only are many decentralized applications slow, clunky, and difficult to use, but many are also prone to hacks and unsustainably built. The latter attributes were heavily discounted in the bull market where deploying unaudited code and pumping usage through unsustainable incentives was en vogue. At a certain point during this period, the original design goals of this industry – to build reliable decentralized economic infrastructure – became an afterthought as bull market protocol architects sought returns.

As the industry sobers up following the collapse of Terra and similarly unsustainably designed protocols, we expect sustainable protocol design to once again command a premium. The coming years will be a much less forgiving environment than the past, and protocols that organically bootstrap demand and are designed thoughtfully to become critical infrastructure are positioned to win moving forward. We're betting on boring.

Emerging Trends

With that, MJL has witnessed a notable move away from centralized exchanges, largely to DeFi solutions, with popular DEXs in the spot and derivatives markets growing markedly QoQ. Although DeFi is still in its infancy, it is highly encouraging that market participants are waking up to the immutable, transparent nature of blockchain-native technologies and applications.

Over the next 6-18 months, leading blockchains are set to launch cutting-edge upgrades, scalability enhancements, and interoperability advancements. We expect the rollout of sufficiently secure, connected, and abundant block space to be a broadband moment for the industry that powers the next generation of applications.

Alongside the expansion of secure block space, we expect to see decentralized applications built on these underlying blockchains to become increasingly user-friendly. Major tech players such as Meta are pouring capital into metaverse research and development and integrating blockchain technology into their core products. Development has notably been focused on abstracting away the confusing machinations and terminology of Web3. Meanwhile Crypto wallet infrastructure is also undergoing a rapid evolution, particularly in the realm of mobile, with game-changing features such as multiparty computation, social key recovery, and direct fiat on-ramps becoming the norm.

Here is a non-exhaustive list of emerging trends that we are excited about (expect longer form thematic pieces on some of these over the coming months):

1. Account abstraction for Ethereum users
2. Traditional fintechs offering in-app access to on-chain protocols
3. Payments protocols are simplifying stablecoin transactions for merchants
4. Data providers are uncovering the valuable insights hidden within the cryptoeconomy
5. Decentralized social media protocols are gaining serious traction
6. RWA tokenization is becoming a major growth engine for DeFi

In short, blockchains are on the cusp of a major usability upgrade as retail and institutional infrastructure continue to mature at an unprecedented pace. With faster, scalable blockchains and user-friendly experiences, the influx of talent and capital that has flooded the industry in recent years finally has the foundation to develop applications well-suited for widespread adoption.

Source: Electric Capital

We're already witnessing the emergence of cutting-edge decentralized applications that are outpacing their centralized counterparts, as well as the tangible impact of scalability with Ethereum Layer-2s now processing more transactions than the Ethereum main chain. The stage is set for a massive onboarding of new users to the thriving cryptoeconomy, and the prospects have never looked brighter.

Onward and upward,

The MJL Team