Q1 Market Update
April 14th, 2023
Greetings from Perceptive Capital. We hope this message finds you well and in good health. We welcome the opportunity to share some of our team’s latest perspectives and market insights as we exit yet another busy quarter in crypto and financial markets broadly.
Before we begin, an important note regarding investor statements: You may have noticed that since November we’ve provided investors with two monthly statements. This is the result of a bifurcation of fund assets into a liquid investment account and an illiquid “Side Pocket” account, denoted as “SP” on the statement. The Side Pocket account includes frozen FTX assets as well as two private investments that are vesting. As the vesting positions are paid out, they are moved from the Side Pocket account to the liquid investment account. This activity is shown as a Redemption from your Side Pocket account, with a corresponding Addition to your general account. The fund’s assets that were frozen on FTX exchanges are now part of the official bankruptcy proceedings. We initially took the most conservative accounting approach and marked all FTX assets down to $0.00 in November. The value of the fund’s FTX claim will be repriced/revalued once we either (1) receive an official recovery as part of the bankruptcy resolution, or (2) sell our claim in the secondary market. In the immediate aftermath of the bankruptcy, FTX claims traded in the secondary market to bankruptcy specialists between $0.01-$0.05 of claim value (1-5%). Today secondary market claims trade markedly higher, above $0.20+ (20%+). And as of April 13th the liquidators have recovered $7.3b in assets and are now even considering restarting the exchange according to Bloomberg. As the situation continues to unfold, we’ll assess the range of possible exit opportunities. It’s important to note, however, that the FTX assets maintain a value of $0.00 in the fund’s Side Pocket account, despite our perceived likelihood of a positive recovery. As such, the value of your Side Pocket statement is likely to be understated. Additionally, as the value of the FTX claim is marked at $0.00, our investors do not pay any management fees on these assets.
Market Overview
Exiting a dramatic 2022, all top ten cryptocurrencies by market capitalization (BTC, ETH, BNB, XRP, DOGE, ADA, MATIC, DOT, OKB, and LTC) experienced negative price returns as low as -81%. Meanwhile, 2023 has thus far shown a substantial rebound in 2023 with an average YTD return of 48.5% for the same top ten cohort.
By now, the banking crisis has been discussed ad nauseam, and most correctly understand the crisis to have stemmed from the banks’ losses on long-duration bond portfolios, which were negatively impacted by the Fed’s rapid rate increases. The banking casualties have thus far included Silvergate Bank, Silicon Valley Bank and Signature Bank here in the US, and Credit Suisse abroad. Some speculators believe that the timing and circumstances surrounding the forced liquidation of Signature Bank by the FDIC amount to a targeted attack on the Crypto industry, as Signature Bank was one of the industry’s primary banking partners and provided an important blockchain infrastructure service (Signet) used by crypto market participants for 24/7/365 USD settlement. The only other bank to provide such a service was Silvergate Bank (with their SEN platform), which collapsed days earlier. Chiefly among these speculators is Signature board member and former Congressman Barney Frank (of the Dodd-Frank banking reform act) who immediately commented that there was foul play involved by the FDIC and federal government. This suspicion was further validated when the FDIC’s subsequent sale of Signature Bank to Flagstar Bank excluded crypto client deposits and the Signet technology. Crypto markets experienced volatility as participants digested the possibility of an emerging anti-crypto agenda in the US. Nevertheless, a lack of confidence in global financial systems and a flight to quality continue to provide support for BTC with dips well bid and implied volatility as firm as we've seen since 2022.
The banking crisis has led to unusual volatility surrounding the market’s expectations for Fed hikes. As it currently stands, the market largely predicts (83%) a 25bp hike at the next meeting on May 3rd, with cuts in late 2023 and 2024. While this week’s 5% CPI print might suggest that consumer inflation is easing, many market pundits see inflation as high enough to warrant further hikes or tightening measures. Further, OPEC’s recent surprise announcement of oil production cuts has led to increased oil prices which is likely to counteract any recent disinflationary gains. Aside from inflation concerns, persistent tightness in the labor market is also likely to keep the Fed fearful of a potential wage-price spiral, and strengthens the case for continued Fed tightening. The macro picture remains as clear as mud, with data points to support narratives to hike, pause, or cut rates, but we at Perceptive believe it’s unlikely that the Fed reverses course without stronger evidence that inflation is truly abating and a wage-price spiral can be avoided. This has inspired our portfolio positioning to remain somewhat cautious, despite the recent run-up in equity markets. That said, Bitcoin has markedly outperformed the broader markets lately, encountering renewed optimism as a potential banking system alternative. Similarly, Ether completed its latest network upgrade this week (Shanghai/Capella or “Shapella”) and is up approximately 10% following the successful network deployment.
Ethereum’s Latest Upgrade: Shanghai/Capella
Ethereum’s Shanghai/Capella (Shapella) upgrade, which unlocks staked ETH rewards for validators, took place on April 12. Recall that in September 2022, another network upgrade, “The Merge”, was implemented to transition the Ethereum network from Proof of Work (PoW) to Proof of Stake (PoS) consensus. Now, Ethereum’s next major technical improvement is the Shanghai upgrade, which allows users to withdraw their staked ETH from the Beacon Chain. Fundamentally, this upgrade closes “the loop on staking liquidity” and helps Ethereum become a more sustainable and secure chain. In order for the Shanghai upgrade to be implemented, the Capella upgrade – a simultaneous upgrade – must also occur on the Beacon Chain. ConsenSys explains that Capella allows “locked” ETH on Ethereum’s consensus layer (CL) to be withdrawn, which is then applied to an execution layer (EL) level address. The entire upgrade is commonly referred to as Shapella since it’s the first upgrade that involves developments to both Ethereum’s execution layer and consensus layer. Further, the upgrade is expected to introduce some technical improvements to the Ethereum Virtual Machine (EVM) as well.
Ethereum Foundation details around staking and withdrawals
Video explaining Withdrawals: How Do Ethereum Withdrawals Work? All You Need To Know
Crypto Regulation - One Senator’s Anti-Crypto Army and CBDCs vs. Stablecoins
“Washington’s misguided crackdown will only push risks into the shadows, leaving regulators to play whack-a-mole as the risks continuously pop up in unexpected places.…Here’s the reality: Internet-native money exists, and it won’t be uninvented. Today, U.S. dollars can move across the internet without banks and without permission, settling as fast as the speed of light and at a fraction of the cost of incumbent payment sy2Q2AQAstems. This technology will steadily disintermediate traditional banks. Anyone with an internet connection can run the code and use U.S. dollars without banks. Despite the recent attacks, I remain optimistic regulators will come to realize that antidotes exist to the crypto scams seeping into the system…”
- Caitlin Long, Founder/CEO, Custodia Bank. Shame on Washington, an open letter to DC lawmakers.
There are crypto advocates on both sides of the aisle who seek a balanced and informed approach to regulation to ensure that crypto can be used safely and responsibly, while also promoting innovation and growth in the industry. However, amidst a never-sleepy regulatory landscape, Elizabeth Warren (D-Mass.) has announced a new anti-crypto re-election campaign. Warren, who is on the Senate Banking Committee that oversees the U.S. Securities and Exchange Commission (SEC), has been at the vanguard of a slew of anti-bitcoin and crypto bills that have been introduced over the last year. Ironically, the Senator, who has often been seen as anti Wall St., is now winning support from many banking industry groups that feel threatened by the transformative crypto industry, and align with her recent anti-crypto stance. Warren is driving a hard line, which appears to be drawing significant anger from many of her former supporters on the left:
In July 2021, Warren called for greater regulation of the cryptocurrency industry and introduced a bill that would require companies to disclose more information about their crypto holdings and activities. She has also called for the creation of a government-run digital currency, also known as a Central Bank Digital Currency (CBDC) which she argues would provide a safer and more stable alternative to cryptocurrencies.
Importantly, CBDCs are different from Stablecoins. CBDCs are digital versions of fiat currencies that are issued and backed by central banks, such as the Federal Reserve, whereas stablecoins are private-market solutions designed to maintain a stable value relative to a specific fiat currency, such as the US dollar. While CBDCs have the potential to offer many benefits, such as faster and more secure payments, there are also concerns about the potential risks associated with their implementation. The primary concerns surround the potential for increased government surveillance, a loss of privacy, and censorship. One can imagine the authoritarian appeal to monitoring, tracking and restricting any user, merchant, or industry that might fall out of favor of the prevailing leadership. Alex Gladstein, chief strategy officer at the Human Rights Foundation, has recognized the danger to financial freedom and privacy inherent in central bank digital currencies (CBDC), especially in repressive regimes. According to Gladstein, “The end of cash and the insta‐analysis of financial transactions enable surveillance, state control, and, eventually, social engineering on a scale never thought possible.” He points to China’s social credit system, in conjunction with a digital yuan, as paving the way toward “financial omniscience.” Thus,
When the government can take financial privileges away for posting the wrong word on social media, saying the wrong thing in a call to parents, or sending the wrong photo to relatives, individuals self‐censor and exercise extreme caution. In this way, control over money can create a social chilling effect.
Some politicians in the US have recognized these potential threats, as Senator Ted Cruz, and Florida Governor Ron DeSantis each recently announced legislation attempting to prohibit or restrict the use or development of a Federal Reserve CBDC, citing concerns around financial surveillance.
Meanwhile, US dollar stablecoins present the potential to expand the reach and utility of the US dollar in the digital age without the same risks to surveillance or state-control. They offer a fast, efficient, and low-cost way to transfer value across borders, which make the US dollar more attractive as a means of exchange and a store of value. In addition, they help to increase financial inclusion by providing access to US dollar-based financial services to individuals and businesses in countries where traditional banking is limited or expensive.
If the US does not support the development and adoption of US dollar stablecoins, it could cede ground to other countries that are more forward-thinking in this area. For example, if China’s digital Yuan gains widespread adoption it could undermine the US dollar’s position as the dominant global reserve currency.
Bitcoin Halving
Bitcoin Block Reward Halving Countdown
One of the biggest catalysts on the horizon is the Bitcoin halving of 2024. Currently 6.25 Bitcoin are released into circulation with every new Bitcoin block mined (roughly every ~10 minutes). Every four years this block reward, given to Bitcoin miners for processing transactions on the \ blockchain, is cut in half. In April, 2024 the daily issuance of Bitcoin will drop from 900 to 450, reducing the inflation rate on the network to below 1%. This supply shock has historically corresponded with increased investor interest, media coverage and positive price action. Bitcoin typically leads a rally associated with the halving event followed closely by Ether and other alt coins. We have positioned our portfolio to take advantage of the cyclicality of this event.
Real World Assets (RWA), Blockchain’s Next Killer Use Case
Citigroup released a report asserting that the blockchain-based tokenization of real-world assets (RWAs) could become the next “killer use case” in crypto, forecasting the RWA market to reach between $4 trillion to $5 trillion by 2030. (Citigroup article: full report). Of the up to $5 trillion tokenized, the bank estimates $1.9 trillion will come in the form of debt, $1.5 trillion from real estate, $0.7 trillion from private equity and venture capital and between $0.5-1 trillion from securities
Stablecoins, partially discussed earlier, are a prime, existing example of how blockchain technology can be put to great use. The volume of stablecoin transactions now exceeds that of certain global credit card transactions. In 2022, the on-chain settlement volume for stablecoins (excluding exchange activity) surpassed 7 trillion, which is significantly higher than the volumes of Mastercard, Amex, Discover, and close to that of Visa, making it possible for anyone around the world to transact and save in dollars. The next growth metric to eclipse is to surpass wholesale money movement networks such as ACH and Fedwire, which have volumes of approximately $70 trillion and $1 quadrillion per year, respectively.
While stablecoins are leading the way for on-chain Real World Assets, we expect to see further integration of blockchain technology into traditional payment and banking systems. Backed-Fi, for example, uses fully backed ETFs and yield products as ERC-20 tokens, making them compatible with DeFi. Companies like Centrifuge, which recently surpassed a Total Value Locked of $100 million, continue to bridge the gap between the old world of finance (with a focus on structured finance) and the new world of blockchain.
NFTs and Culture
Consumer brands, such as Starbucks, Tiffany's, and Nike, continue to embrace blockchain technology and web3. Starbucks, for instance, has established a program on the Polygon Blockchain, an Ethereum sidechain, which offers new Starbucks rewards programs and experiences to its customers using web3 technology. Similarly, Instagram is building an NFT brand on the same platform. These companies are recognizing the importance of meeting their customers where they are, given that Gen-Z and Gen-Alpha are digital natives. As the purchasing power of these younger generations increases, companies expect them to continue to make more digitally native purchases and interactions.
As always, the investment landscape is ever-changing, and we remain committed to providing you with updates and analysis. Please do not hesitate to reach out should you have any questions. We thank you for your continued trust and support.
Your Team at Perceptive
