The Devils You Meet on the Way Up
Upside risk management in 2024
The change in sentiment from one year ago is remarkable. And while there is a long road ahead, the sense that 2022 was a year best forgotten has been followed by a sense that 2023 was a year of recovery, rebuilding and a prelude to something big. I have written a lot about market structure because this has been part of the rebuilding: the market structure pre-FTX collapse was deeply flawed, and whether it’s off-exchange settlement mechanisms or expanded prime brokerage facilities or experiments in full ECN-style separation between the exchange and the custody and dealer functions there has been a lot of groundwork done to create trading infrastructure that institutional investors will recognize, not to mention work on foundational pieces of infrastructure like data, custody, execution and of course risk management.
Sadly, being crypto’s risk management company means we have some responsibility to be a bit of a downer and harangue everyone coming up to the party’s punch bowl.
Crypto outperformed in 2023 and the set up appears to be very favorable for a possible continuation into 2024, though in my personal view the drivers might prove surprising to everyone chanting that the institutions are coming. In the U.S. we are on the precipice of what Bloomberg estimates is a 90% probability of a Bitcoin ETF approval, and whether it’s sell-the-news or a sharp spike upward, in the longer term having multiple well-resourced institutions telling the Bitcoin and possibly Ethereum story to financial advisors across the country will surely help support the market even if inflows take longer to build. At the same time you have the psychologically significant Bitcoin halving; FTX and Celsius bankruptcy resolutions potentially unlocking stranded capital; and more jurisdictions likely to put in place rules offering clarity, even if the U.S. is slow to follow. It is a favorable environment to start the year.
Nevertheless, it pays to remember that you can have both downside and upside volatility. It’s why the Serenity conditional VaR model includes both value-at-risk (downside) and gain-at-risk (upside), and why our library of historical crypto scenarios includes both notable big crashes like the COVID crash and FTX bankruptcy and upside scenarios like DeFi Summer. It’s not just the direct exposure investors might face if they are short and cannot make a margin call: it’s the broader issue that upside volatility is still volatility, and while the downside is often dominated by healthy consolidation, the upside can conceal a lot of sins. Buffett’s famous maxim that it is only when the tide goes out you can see who is swimming naked has a corollary: the periods of hype and excitement are when people first decide to go skinny-dipping, believing that the calm, deep and liquid markets of such periods will keep them safe.
And here is where I would like to make some predictions to start the year, a few of them contrarian. This is not financial advice or any kind of solicitation; our mission here at Blockchain Confidential is educational, to help investors think about the complex risk landscape in digital assets. Still, part of that means outlining possible futures to consider when deciding how to allocate and hedge in 2024. And as in the preceding, I think the real risks that need to be considered here originate in that favorable setup and the excitement and hype that could come of it. Crypto does not have a great history when it comes to responsible management of upside volatility, and there are a lot of market participants out there seeking vindication and wanting to sell a story that shows they were right to stick it out since 2022.
Friction-free DeFi is explosive
In 2024 we could well see the start of the last bull market driven by retail and the crypto-native institutions.
But wait: aren’t the institutions coming?
Traditional financial institutions are very slow-moving: this won’t just apply to the reality of how long it might take for interest and assets to build in new Bitcoin spot ETF’s, this is about what happens after that. Institutional DeFi will certainly grow again, but it will be institutions the way they were defined in the last bull market: the wildcatter early innovators who embrace the challenge of a new asset class, with some true early adopters in the U.S. like Fidelity, Van Eck and Franklin Templeton — who really are in the, ahem, vanguard — or ones outside the U.S. like DBS or Brevan Howard. But the traditional participants here are mostly going to be focused on the most vanilla of use cases, and a year from now the number of active, fully-engaged participants is still going to be small. This is just the inertia of the industry: in the fall of 2023 I was at a conference that featured a plaintive cry from a panel moderator who works in tokenized assets: “if I get asked to do another proof-of-concept I will tear my hair out.” It will take time, and the slow pace in U.S. regulation, likely pegged to the political cycle, will not help the industry, although ex-U.S. it will go much faster.
But I believe something big is nevertheless afoot, a consequence of all that building done in the last two years, specifically in blockchain infrastructure and usability. In the summer of 2020, the first “DeFi Summer” the transaction costs on Ethereum were a big barrier to entry and network congestion overall created a lot of natural friction in this market. We are about to see what happens when you combine a rising market; a friction-free, high-throughput network; more capital efficient protocols; much easier-to-use tools with things like transparent Web2-to-Web3 wallet authentication; and another two years of stablecoin onboarding (see below). It’s not just that the market is set up favorably, it’s the technology as well.
Mix in FOMO and hype, and you could see a huge increase in activity. And the reality is it’s not going to be people setting up decentralized VPN or 5G nodes or mapping their neighborhoods: it will once again be DeFi, and it’s going to be driven by retail, with those same early crypto-native innovators diving in as the emerging traditional financial firms’ crypto involvement forces them up the risk curve to offer unique opportunities to the classic crypto allocators, who can now get their Bitcoin in their wealth management accounts.
It’s going to get wild & wacky.
Payments? Yes, payments
In 2024, stablecoin transaction volumes will exceed the amount processed on the Visa network; Nic Carter from Castle Island Ventures together with Coinmetrics makes the case. There are 10 million monthly active users of stablecoins around the world, and they are transacting in surprising ways: Tether on Tron, whatever you think about Tether or Justin Sun, is becoming a part of the emerging markets payment rails, and this has consequences: although Ethereum takes the lion’s share of L1 blockchain fee revenues at 57%, Tron follows with 31% according to recent research by Jamie Coutts. This is astonishing in light of the overhang of concerns about Huobi, Tron and most of all Tether. It would be like waking up one day and finding that the Eurodollar market had been cornered by a B movie actor running a trading system on a used Atari 2600, who custodies at his Dad’s pizzeria in Hoboken. I mean, it could happen, but would it be your first guess?
The flipside to this is that while many of us in crypto would just love to have real-world use cases to talk about at Thanksgiving in 2024, the reality is whether it’s the metaverse, NFT art markets, DePIN (storage, compute, 5G, GPU farms) or DeSoc (social media), the application layer is even more immature than the underlying infrastructure, and those propositions — much as I love them — might have a coltish awkwardness about them all year, with loads of volatility and very thin liquidity. Speculation might be more focused on the real-world use cases, which is good, but I think the strongest fundamentals will be in payments. On the other hand, this should finally settle the argument about crypto’s place in the financial firmament. Even if all we ever created was low-cost international settlement and financial security for citizens in countries with collapsing economies, we built something useful.
Bad actors love a party
You probably heard a lot of people wrapping up 2023 congratulating crypto for having swept the market clear of bad actors, with cases like SBF and CZ’s decision to plead guilty, actions against Do Kwan and the 3AC bros and more all serving as evidence that we have all learned our lessons, embraced regulation and moved on. Everyone who thinks crypto is the domain of fraudsters and good for nothing else is just out of date, failing to recognize that only 1% of transactions are dirty, or that traditional finance struggles with much the same.
This is rubbish.
The problem is both propositions can be true: the crash did reveal and sweep out a lot of bad actors, and a lot of work was put into strengthening the system, but fraudsters, hackers and other grubby sorts are also economically rational actors: they follow the opportunity, and there is so much more opportunity in a bull market than a bear market. They will return; they will continue to prey on retail and institutional traders; and if I am right that the friction-free environment will turbocharge the market, they may well have more scope for mischief than last time around.
The price of freedom from this bullshit is eternal vigilance, and so continuing to invest in security, audits, education and more is paramount. Caveat investor.
Liquidity risk is everything
At the end of the day, every risk is liquidity risk: the risk that you cannot trade at any price, whether it’s because your assets are frozen at a dodgy counterparty or were stolen, or more conventionally because there’s no bid or offer at the size you need to trade at a critical moment. This will not change in 2024: the additional depth that will come of institutional participants to the extent it shows up at all is going to show up in BTC and ETH, not in the altcoins. Continued work to source high-quality liquidity, diversification of counterparties and monitoring of accumulated exposures in illiquid names will be essential. This is not the U.S. equities market, and a year, even if another bull market takes off, is not going to change that.
The guardrails are still flimsy
The building cannot stop. Crypto is an immature market. Every single vendor or institution that said in 2023 that it was a bit of a relief not being on the insane treadmill of a bull market, allowing more focus on building: this is not the time to throw all your working capital into the next memecoin. This is a small and immature market competing with a traditional finance system that puts billions and billions of dollars every year into upgrading its infrastructure. This is not just a call to those investing in new systems, but to the market’s builders too: continuing to prioritize unsexy things like scalability, usability, testing, reporting, reconciliation and more is important. There is going to come a time when your choice is to support a sexy new Tron DeFi primitive or geo-redundancy for your data centers: choose wisely. At Cloudwall, we aim to continue with our mantra of “boring is the new sexy” and keep building the things needed to keep us all safe out there in 2024 and beyond.
Let’s go!