Quarterly Commentary – Q3 2022

A Coiled Spring 

While Q2 2022 was all about “Crypto Winter”, Q3 showed the first signs of Crypto Spring. The digital asset space has begun to show green shoots, with correlation to the overall markets moving markedly lower.

Q3 showed signs of stability and presented an abundance of fundamental opportunities - a stark contrast to the highly-correlated decline we witnessed in Q2. Since we discussed the ETH 2.0 merge and our related event-driven strategies in our last letter, we have seen a number of new investable opportunities present themselves. From partnership announcements to software upgrades and corporate restructurings, the market has consistently rewarded investors that are paying attention to impending catalysts with opportunities for positive idiosyncratic returns. Our strength in navigating crypto-specific market structure and our ability to draw from experience to analyze and quantify this broad range of event types has led to strong outperformance. While the mainstream media remains fickle in deciding whether we are in a “bull” or “bear” market, the MJL team has been hard at work finding pockets of investable opportunities amidst the uncertainty.

Despite a continued flow of bad headlines across global markets and politics, the realized volatility of bitcoin and other major cryptocurrencies has declined substantially; historically, this almost always precedes a sharp move in either direction. For now, the crypto market seems to be rearing its head for a big move and as of this writing it has been to the upside.

Institutional Adoption Continues

We have witnessed increased adoption by some of the largest technology and financial enterprises in the world, which we believe to be a key driver to the next major leg up. Any one of these institutions is capable of onboarding a critical mass of new users to certain blockchains and applications over a relatively short period of time. This is an encouraging sign of continued organic growth in addition to  more constructive and healthy market dynamics. Here are a few developments we saw in Q3:

In January of this year, Twitter enabled ownership-verified NFT profile pictures and in Q3 other tech companies began following suit. 

Meta (formerly Facebook) announced that its NFT collectibles support would be available to all Facebook and Instagram users within the United States. Meta first began enabling NFT support on its platforms in May with Instagram, and then added Facebook support in June. In both cases, the firm started with a limited number of users, but has gradually expanded the pool over time. In August, the company announced a cross-posting feature that lets users show off NFT collectibles across their Facebook and Instagram accounts. According to Meta, the feature showcased the “interoperability” of NFT assets that can plug into various platforms.

Coffee giant Starbucks announced the launch of its own blockchain-based loyalty platform and NFT community, Starbucks Odyssey. While the company hasn’t fully detailed what the platform will look like, the original press release stated that the “New Starbucks Odyssey experience will offer members the ability to earn and buy digital collectible stamps (NFTs) that will unlock access to new, immersive coffee experiences,” adding “as one of the first companies to integrate NFTs with an industry-leading loyalty program at scale, Starbucks will create an accessible Web3 community that will enable new ways to engage with members and partners (employees).”

Social network Reddit launched a collectible avatar marketplace – allowing users to store and manage blockchain-based profile pictures – as the first step towards a wider push for integrating blockchain technology into their platform. In-line with their continued efforts to abstract away potentially confusing terminology from their blockchain-based feature rollout, Reddit did not refer to the avatars as NFTs in its post. The firm, however, added that blockchain technology remained a part of its long-term plans: “We see blockchain as one way to bring more empowerment and independence to communities on Reddit.” Reddit’s NFT marketplace has seen impressive traction and growth in the first 60 days since launch:

• 3,000,000 Polygon wallets created
• 86,000 NFTs minted
• $100mn in market capitalization created for users
• $235,000 in daily trading volume
• 4% trading fee * $235,000 * 365 days = approximately $10 million in annualized revenue for NFT exchanges (in this case OpenSea)

Macro

Despite the continued adoption of blockchain solutions, we remain cautious on the market as a whole in the short term as the macroeconomic and geopolitical landscape remains highly uncertain. As each new datapoint and Fed speech comes to surface, it has become increasingly difficult to understand their implications on the price of assets. One thing is certain: the market is searching for any and every reason why the Fed may be forced to change course. Note the word “force”. The Fed has been abundantly clear that this will not be the case and that rates will remain in an elevated state until “the job is done”. Given the stickiness of inflation and the time it takes for policy enactment to filter through to the broader economy, it stands to reason that “higher for longer” should be the base case scenario for every investor. We remain laser-focused on finding assets that are inherently valuable, issued by projects that are solving real problems using blockchain technology. We remain “micro-convicted” on the digital asset class despite short-term headwinds, as digital networks have continued to grow along their exponential long-term trajectory despite a linear drawdown in valuations. More on this later.

We recommend reading this thread from macro strategist, Jim Bianco, on the current state of crypto and stock markets and why they may be diverging.

Regulatory Developments

Q3 saw significant regulatory and legislative headlines from the White House, Congress, and the SEC alike. TL/DR: Progress on regulation is slow. In our view, legislation will initially center around stablecoins and lenders given it is the lowest hanging fruit for politicians at this point and is a somewhat bi-partisan issue.

1. In Q3, The White House issued its first-ever “comprehensive framework for the responsible development of crypto assets”. The release was painted in broad strokes, but depicted reasonable balance, juxtaposing investor protections with industry-friendly provisions.
2. The SEC asserted its claim to be the lead regulator in crypto again in Q3, threatening enforcement against trading venues (such as Coinbase). Chairman Gary Gensler reiterated in a speech that he believes crypto assets to be synonymous with securities and therefore their trading venues must be registered as broker-dealers.
3. Congress emerged as an advocate of regulatory clarity, with bipartisan bills that included significant pro-crypto doctrines. Congress has been taking a progressive stance toward the sector as market observers and participants believe new legislation will be necessary to properly regulate the asset. 

What’s Happening in Crypto?

We left off our last letter with a brief discussion of the Ethereum 2.0 Merge, which we saw as a major development for crypto assets. Since then, Ethereum has successfully migrated to its Proof of Stake consensus mechanism without a hitch. As we predicted, we have witnessed a material decrease in ETH inflation, with ETH actually printing deflationary blocks at periods of high network activity.

For background, this Ethereum Improvement Proposal (EIP) 1559 changed the fee model drastically. As of its recent implementation prior to the Merge, each transaction includes a variable base fee that adjusts according to the current demand for block space. This base fee is burned, or permanently removed from circulation, lowering the supply of Ether into perpetuity. This has an acute market impact as the inherent selling pressure from validators is completely offset. 

Given the “bear market” dynamics playing out across the blockchain economy, this is highly encouraging and we are constructive on the Ethereum ecosystem if and when user activity begins to show renewed strength. Please see below for a quick rundown of how the migration to a Proof of Stake consensus mechanism has impacted the fundamentals of the Ethereum network. For stakers, Ethereum is effectively trading at a 17.2x Price/Earnings multiple, which we find to be remarkably low given the pace of network growth and level of innovation.

The Opportunity Set Today

In addition to finding success in the opportunistic/event-driven section of the portfolio, we have also been confidently adding to long-term fundamental positions, albeit with a conservative investment focus. Specifically, that would be:

1. Monopolies or near-monopolies in a given market sub-subsector
2. Entities with little to no chance of going bankrupt or running out of runway
3. Assets without supply-side pressure from VC unlocks or programmed inflation (unless growth and profitability substantiates the model - which is rare)
4. Tokens with a high degree of operating leverage to a resurgence in activity

Zooming out to the bigger picture, we have seen the ETH/BTC ratio remain resilient in the 3rd quarter, a major indicator of market health for our portfolio. In June, our overriding “crypto macro” thesis was that Bitcoin would continue to see selling pressure from miners, macro funds, and tie-ins to traditional financial entities, while the Ethereum network’s ever-expanding set of use cases (many of which we own) and major upgrades would continue to generate value for holders.

Portfolio Attribution

The Fund saw a number of wins in the Third Quarter despite a relatively choppy market. Here are a few notable highlights, all of which were notably driven by real fundamental progress and quantifiable value creation. We touched on some of the Fund’s greatest winners in our last letter, but we will restate them below with each asset’s contribution to the overall portfolio return:

• LDO (+4.55%) - controls approximately 90% of the Ethereum liquid staking market and directly benefited from the Merge.
• ETH (+4.31%) - underwent the Merge (discussed above).
• wCFG (+4.12%) - a central player in the blockchain securitization market, migrating to its own purpose-built blockchain.
• GMX (+2.21%) - a newcomer in the derivatives exchange space which experienced a surge in trading volume and fees due to its unique and highly efficient liquidity model.

Here are the largest detractors from the Fund in Q3:

• FXS (-0.74%) - no negative fundamental developments. A number of funds including Mechanism Capital, Paradigm, and Arca were forced to liquidate this position and we have added to our position. The name is current trading below 2x this year’s earnings, offers a healthy yield, and is rapidly expanding its ecosystem of products.
• SILO (-1.18%) - a number of funds were forced to liquidate this name, which was already very thinly traded (and a small position in the Fund). This position has naturally sized down as our Assets under Management have grown.
• AURA (-1.17%) - no negative fundamental development - for context this token is up 475% YTD. We have added to our position and are happy to discuss our thesis and model.

Sector Performance

When observing the sector attribution across digital asset markets in the third quarter, it is somewhat clear that the pro-cyclical names (Exchanges, Derivatives, and Lending) have caught the strongest bid, while VC favorites and more speculative narratives (gaming, IoT, NFTs) have experienced weakness. This rotation has typically preceded periods of positive price performance, but we would also like to point out that there has been quite a bit of short-covering in the back half of the quarter.