NYDIG Research: Second Quarter 2022 in Review
by Greg Cipolaro, Global Head of Research and Ethan Kochav, Research Analyst
Second Quarter 2022 in Review
We look back at the second quarter of 2022 and the news that shaped it as well as important events in the future.
QUICK TAKEAWAYS
PERFORMANCE REVIEW
Bitcoin Falls Amidst Difficult Backdrop for Most Assets
The year continues to be difficult for most asset classes and bitcoin has been no exception. Persistently high inflation expectations have led central banks globally — especially in the United States — to implement tighter monetary policies. This aggressive tightening has been a drag on asset prices all year as liquidity has been leached from financial markets, but the impact seemed to accelerate in the second quarter. U.S. large cap stocks fell by 22.4% on the quarter, long-term treasuries by 12.1%, and bitcoin by 58.6%. Only commodities survived unscathed. Even the traditional inflation hedge, gold, did not perform well in the macro backdrop as it was down 6.7%.
One of Bitcoin’s Toughest Quarters in History
Bitcoin fell 58.6% in the quarter, its second-worst quarter of performance in history. Its worst quarter was the Q3 2011, in which the price of bitcoin fell 70.1%. This recent quarter was especially disappointing because the second calendar quarter has typically been strong for bitcoin from a price-performance standpoint. Bitcoin’s win rate in the second quarter, the percentage of periods in which it had exhibited positive performance, was 72.7% with a median return of 41.0% (exclusive of this quarter). Including this latest quarter, the win rate drops to 66.7% and the median return to 37.9%. Interestingly, bitcoin was weak in 2Q of last year as well, falling 40.7% in 2021.
EVENTS THAT SHAPED THE QUARTER
Fed Hikes Rates, Markets Fall
The Fed increasing interest rates to fight inflation has been the issue affecting markets since November, including stocks, bonds, and crypto. Rewinding to March 2020, the onset of the COVID-19 healthcare crisis quickly morphed into an economic crisis, which brought about substantial monetary and fiscal stimulus. The combination of these two stimuli created $2.5T worth of “excess” household savings in the US, the cumulative household savings above the long-term savings rate trend. These “excess” household savings likely went towards new homes, savings accounts, debt reduction, and of course, financial assets like crypto.
Since November, the Fed has signaled its pivot to deal with the after-effect of the pandemic and stimulus, namely inflation. Inflation has been driven both by strong demand due to the economic stimulus mentioned above and supply constraints. Lacking tools to improve supply conditions, though, the Fed’s only lever has been to crimp aggregate demand by increasing the cost of money and destroying the propensity for households and businesses to consume. The upper bound Federal Funds interest rate currently sits at 1.75%, well above the 0.50% where it started the quarter, and investors currently expect it to increase to 3.4% twelve months from now. This has had an adverse effect on financial asset prices. Moreover, as higher-than-desired inflation persists, the Fed feels forced to continue hiking.
Fed hikes alone can hardly be blamed for all the ills of the market. Other geopolitical and economic events, such as Russia’s invasion of Ukraine and coronavirus-related shutdowns in China, have also affected markets adversely.
What Historical Drawdowns Tell Us About the Present
With a crypto bear market fully underway, we can look at bitcoin’s previous price cycles for clues about the current drawdown. These price cycles, which peaked in 2011, 2013, 2017, and 2021, have occurred roughly every 4 years. A couple of observations come to mind when looking at the progression of these cycles. First, the return from the start of each cycle to its peak has declined with each successive cycle. This makes sense as the sheer market size of bitcoin prohibits prices from keeping up the same percentage returns from cycle to cycle. Second, even though these cycles have typically ended with drawdowns of over 80%, the magnitude of these drawdowns have lessened over time. While we do not have a crystal ball as to when this drawdown ends, there is reason to believe that the trend of shallower drawdowns may continue. One potential reason is the growing influence of institutional investors, who entered the space in the most recent cycle and largely remain invested.
Counterparty Risk Rears its Ugly Head in Crypto
A major theme of this crypto bear market has been counterparty risk. While the seminal example of counterparty risk was the 2014 bankruptcy of the Mt Gox exchange, which lost 650,000 bitcoins, worth $13B at current prices, that has morphed into risk with other centralized services, like lenders and crypto funds, and also the protocols themselves.
The first major collapse was that of the Terra (LUNA) platform and its associated algorithmic stablecoin, Terra USD (UST) in early May. The instability of the protocol's economic design, whose investors were incentivized by subsidized but uneconomic yields, resulted in the protocol’s catastrophic failure and the destruction of nearly $60B in wealth in just a few short days. While many had called this crypto’s “Lehman” moment, this fails to acknowledge that Lehman was near the tail-end of the Global Financial Crisis, whereas the LUNA/UST fallout seems to have kicked off the crisis in crypto. Crypto markets had already been ailing against the tough macro drop, but issues had mostly been with altcoins. while bitcoin had been bouncing about the mid to upper $30K range until the beginning of May. It was not until LUNA/UST blew a hole in crypto investors’ pocketbooks that bitcoin started to sink to previous cycle highs. Said another way, the macro conditions provided the kindling, and the LUNA/UST debacle provided the spark for the fire raging throughout crypto.
LUNA/UST’s collapse created knock-on effects through centralized platforms and decentralized protocols that we are still assessing. Many major crypto investors were exposed to the protocol and realized losses. Because of this, depositors began pulling funds from the ecosystem. With investors calling capital and liquidity draining from DeFi protocols, the more exposed crypto players found themselves unable to pay their debts.
If LUNA/UST was not necessarily a Lehman moment, perhaps the twin collapses of Celsius, a major crypto lender, and Three Arrows Capital (3AC), a crypto fund, provide more compelling parallels, though it is worth noting that the Bitcoin network itself continues to operate without issue. Celsius generated yield for its depositors — $11.8B worth as of May 17 — both by lending out their assets to hedge funds and market makers and by engaging in various principal market activities, such as participating in various DeFi activities. 3AC participated in many of the same activities, funding its operations through investor capital and significant borrowing from other players across the industry. Both were involved, to various extents, in the UST/LUNA crash. In mid-June, Celsius halted withdrawals from its platform, and several days later, 3AC founder Su Zhu cryptically alluded to financial difficulties at his firm, which was recently issued a notice of default for a loan worth $650M. The news of both institutions' insolvencies shocked the markets, moving prices significantly lower and leading credit markets to seize up. Several other firms, like Babel Finance, CoinFLEX, and Voyager, also reported financial difficulties in the wake of these events. As prices remain low and funding remains difficult to find, this list will likely grow. Despite these fireworks, the Bitcoin network continues to operate without issue. Individual firms may ultimately fail, but we do not view the recent crash as a referendum on Bitcoin technology. The ability to quickly transact value in a decentralized network will long outlast the current market volatility.
There Are Fewer Than Two Million Bitcoins Left
In early April, a lucky miner belonging to AntPool mined the 730,003rd block and received 6.25 of newly minted bitcoins, bringing the total circulating supply to just over 19 million. As of the end of June, there have been 19,081,800 bitcoins mined. With the maximum potential bitcoin supply set at 21 million, this means that there are fewer than 2 million bitcoins left to be mined. As a reminder, this supply cap is enforced through block subsidy halvings. Every 210,000 blocks — roughly every four years — the Bitcoin network halves the block subsidy it pays to miners for creating new blocks, the process by which miners process and timestamp transactions. This subsidy was initially 50 bitcoins when the network launched in 2009. Today, three halvings later, miners receive 6.25 bitcoins per block, with the next halving likely occurring in May 2024. Eventually, repeated halvings will programmatically reduce the block subsidy to zero around the year 2140. When the subsidy becomes zero, no new bitcoins will enter circulation.
This milestone is a helpful reminder of the bull case for bitcoin as an investment asset. The number of bitcoins left to mine is already a small fraction of the amount already outstanding. If demand continues to grow, then miners cannot increase their supply in response. Rather, for markets to clear, the price of bitcoin will need to increase.
New York Senate Passes a Mining Bill
In a last-minute flurry of activity to cap off its legislative session, the New York Senate passed a bill to establish a two-year moratorium on issuing air permits to fossil fuel-based electricity generation facilities that supply behind-the-meter energy to cryptocurrency mining. As we wrote when the bill was passed by the Assembly, the restrictions scoped out by the bill are highly targeted and do not constitute a wholesale ban on proof-of-work mining in New York. Nonetheless, the crypto industry has still spoken out vociferously against the bill, with some crypto advocates protesting because they misunderstand the substance of the bill and others raising concerns because they worry that it signals an unfriendly regulatory environment.
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The bill is not yet a law, as it still requires Governor Kathy Hochul’s signature. The likely deadline for her signature is the end of the year, though the legislature can demand a response sooner. She does not have to explicitly veto the bill to stop it from being enacted. If she does not sign the bill by the end of the year, then it is effectively vetoed (this is known as a “pocket veto”). Governor Hochul has not signaled her intention one way or the other and is still considering the facts. We will continue to track the bill’s progress.
Bitcoin Miners Face Headwinds
The second quarter of 2022 was difficult for miner economics. One measure that highlights the difficulty miners have faced is a statistic known as the hash price. Hash price measures the expected revenue of a miner per hash, defined as one guess at creating a valid block. Hash price decreases when bitcoin price decreases, since bitcoins issued for a successful block are worth less in dollar terms, and when network hash rate increases, since it is harder to mine a block. Since miner hash rate remains consistent from moment to moment, changes in hash price translate to instantaneous changes in expected miner revenue. This year has seen bitcoin prices fall and network hash rate increase as miners continue to plug in new machines. Thus, the hash price has cratered from $0.241 at the start of the year to $0.082 at the end of June, a fall of -66.2%. The drop is even more significant measured against its peak of $0.422 last fall.
Increased cost of capital (partially caused by reduced revenue expectations) has weighed further on the industry. Miners have historically been able to raise capital to fund their operations while holding onto their bitcoins. However, miner stocks have been decimated, with miners down 79.6% on average on the year. Credit markets have also dried up, with high yield spreads up 287bps on the year (according to the CDX High Yield Index). With loans hard to find and equity issuance highly dilutive, miners have needed to sell their accumulated bitcoins to generate cash. Looking at miner financial filings, public miners sold a net 4,411 bitcoins in May 2022, considerably more than the previous average of 1,115 bitcoins per month earlier in 2022. If bitcoin prices stay low, we may continue to see more bitcoin issuance circulated into the market. As of the end of May, those same miners held about 46,594 bitcoins according to public filings, or about $1.5B at prevailing prices at the time.
Public Crypto Companies Continue to Lag Bitcoin
Although bitcoin had a very difficult second quarter, the quarter was even worse for crypto-related equities. Miner stocks declined by 79.6% in the quarter (as mentioned in the section on miner economics above), while non-miner digital asset companies fell by 79.9% (both figures weighted by market cap). These stocks underperformed both bitcoin (-58.6%) and equity markets more broadly, as the S&P 500 was down only 20.0% and the Nasdaq Composite fell by 29.5% in Q2. In fact, of all 33 companies in our sample, only one outperformed bitcoin and none outperformed equities, illustrating the breadth of the declines. These dramatic losses have been driven by lower revenue expectations, the decreased value of digital assets and digital asset-related instruments (like loans) on balance sheets, and likely some amount of market panic. Time will tell whether the repricing was entirely justified across all companies.
For a full breakdown of individual equity and fund performance across the digital asset ecosystem, please click here.
LOOKING AHEAD TO 3Q22
Investors Try to Determine Fed Hiking Path
Fed Fund rate expectations 12 months out have increased dramatically on the year from 0.7% to 3.4%. By removing liquidity from the financial system, the Fed has slowed economic growth and reduced asset prices across the board, including bitcoin. Given these dynamics, investors are wondering when they might see an end to hawkishness at the Federal Reserve. Unfortunately, given current market conditions, the path to dovishness is getting increasingly narrow.
One reason that investors are predicting much higher rates is because of persistently high inflation. The latest CPI print showed an annual price growth of 8.6% overall and 6.0% for core, considerably higher than their averages of 2.4% and 2.2% respectively since 2000. And, based on the two-year stacks shown below, levels show little sign of slowing down.
The other factor driving expectations higher has been the Federal Reserve’s steadfast commitment to combat inflation at any economic cost. On Wednesday, at a central banker forum in Portugal, Federal Reserve Chairman Powell stated that failing to restore price stability represented a bigger economic risk than causing a recession. This ties with his comments last week in his Semiannual Monetary Policy Report to Congress last week that his commitment to curbing inflation was “unconditional” and that labor markets were unsustainably hot. Given these dynamics, it is unlikely that investors will be saved by weak economic numbers. The only way that investors will likely receive reprieve is if the Fed is able to slow inflation.
Bitcoin Prices Register as Cheap under Some Valuation Metrics
Market Cap to Realized Value (MVRV) has been one of the best valuation measures of cyclical highs and lows. MVRV represents the ratio of bitcoin’s current market cap to its “realized cap,” which values each coin at its price the last time it moved. In that sense, it is a measure of how much of a profit (or loss) holders are sitting on. If the MVRV is 2.0x, for example, then the current market cap of bitcoins is double the value at which holders obtained those bitcoins. MVRV has historically tended to trough under 1.0x, at which point the aggregate market is at a loss. MVRV is now sitting under 1.0x, with current levels at 0.89x.
MVRV is not the only metric that shows bitcoin may be trading at cheap levels. Another way we think about valuing bitcoin is through Metcalfe’s Law, which states that a network’s value is proportional to the square of the number of its users. Using the number of Bitcoin addresses as a proxy for users, this rule predicts a price at each point in time. This has done a reasonably good job of explaining the appreciation of bitcoin’s price historically. Notably, current prices are trading at a hefty 53.5% discount from the model price of $40,675.
Although both metrics indicate bitcoin may be trading at cheap levels compared to historical values, this does not mean that bitcoin cannot fall further in the near and medium-term. It simply implies that we may be approaching a bottom.
Excitement Around Lightning Grows
Adoption of the Lightning Network, a layer two protocol that makes Bitcoin payments fast and cheap, made significant strides in Q2 2022. The excitement began with an announcement by Lightning Labs, just before the Bitcoin 2022 Conference in early April, of a new technology named Taro. Building on Bitcoin’s Taproot update last year, Taro is able to introduce more complex asset types, like stablecoins and NFTs, that can be transferred on both the Bitcoin blockchain and the Lightning Network. This is a tantalizing idea, representing a potential new use case for the Lightning Network, though it still exists solely as a white paper and has yet to be developed.
Further use cases for the Lightning Network were highlighted at the Bitcoin 2022 Conference, at which several integrations and partnerships using Lightning were announced. Cash App, Bitpay, Kraken, and Robinhood announced integrations with the Lightning Network. Meanwhile, Strike, a Lightning-focused payments platform, announced partnerships with Shopify, payments firm Blackhawk, and NCR, the world’s largest point-of-sale supplier. Amid these announcements, usage of the Lightning Network appeared to increase. Lightning Network capacity, which measures the total amount of bitcoins locked in Lightning channels, increased from 3.6K bitcoins to 4.0K bitcoins over the quarter.
The Lightning Network shows significant promise in combatting one of the most common criticisms of Bitcoin: its scalability. If developers continue adding features and institutions continue to onboard it, then Lightning can continue to propel the adoption of bitcoin. If investors believe in Lightning, they should view this as a bull case for bitcoin.
The Market Awaits Reports Emanating from Executive Order
On March 10, 2022, the White House released its Executive Order (EO) on Ensuring Responsible Development of Digital Assets. The EO had been awaited with anxious anticipation by the crypto community, and its release led to sighs of relief as its terms were significantly less onerous than feared. Rather than dictating any new regulations, the order dictated the release of various reports across executive branch departments to help guide future policy. Only one of these reports has been released, a Department of Justice report on international cooperation on crypto law, which unsurprisingly had little to say on domestic regulation. Most of the reports are expected to come in the next quarter. Topics include central bank digital currencies (CBDCs), the environmental/energy impact of blockchain technology (likely focusing on Bitcoin and Ethereum mining), anti-money laundering and illicit financing, and building international frameworks for regulation. The tone of the EO seemed to imply a balanced approach to digital assets, but we will have to wait and see the reports to determine the White House’s ultimate approach. Below, we provide a timeline for the various reports that will be emerging in the coming months. As our recent analysis has shown, regulatory clarity is beneficial for bitcoin prices in the long run.
CLOSING THOUGHTS
The second quarter was challenging from a price-performance standpoint. Macroeconomic factors and counterparty risks with DeFi protocols and CeFi lenders and investment funds made it one of the most challenging quarters in Bitcoin's history. But investors should take solace in that we have been here before several times and that price cycles are a persistent feature for bitcoin and the digital asset class. The long-term secular growth in terms of adoption, usage, and technology building has not changed, despite recent market undulations. With that in mind and cyclical valuation measures that appear to be attractive, we urge investors to think about the long-term case for the asset, because to us, that has not changed.
Thanks for joining us for a review of quarterly performance and events. Please reach out with any questions or comments.
Sincerely,
The NYDIG Team