Given the 100%+ recovery in ETH off the June lows ahead its much-anticipated Merge, we thought revisiting June’s Purge and July’s Surge were appropriate as these three events combined make for an historically unique opportunity for Digital Asset investors. .
Our theme pulls from Ethereum’s recent protocol roadmap cadence, dubbed: the Merge, Surge, Verge, Purge and Splurge – and outlined in Vitalik Buterin’s speech at the Ethereum Community Conference (ethCC) last month.
The Growing Utility of Ethereum
ETH’s recent gains should not be the primary draw to this protocol, rather, it is Ethereum’s clear and growing utility as a global settlement layer that draws our focus and underpins any investment thesis.
The graphic below captures 2021’s total value of transactions for three of the world’s largest value settlement networks. Ethereum took the number one spot last year at approximately $11.68 trillion USD in total value transacted, settling more than Visa at $10.40 trillion USD.
Unlike digital asset metrics, Visa’s total figure is reported once in their Annual Report, giving digital assets the edge in data transparency as these metrics can be rendered on a daily basis.
Normalizing the Transaction Data
The number of Bitcoin transactions have been adjusted (reduced) to account for the ledger metrics that often include several entries (change-related) for a single transaction. For example, a single BTC transaction between two parties can result in several unspent transactions (UTXOs) owing to the mechanics of how protocol bookkeeping addresses the partial transfer of BTC. Adjusting the BTC data is meant to provide an apples-to-apples comparison with Visa and Ethereum. See more details later in the bulletin regarding the nuances of on-chain transaction data and how it differs from traditional Visa transactions.
Market Context after a Historic Q2 2022
1. The Purge
Q2 market volatility rendered some Centralized Finance (CeFi) lenders insolvent as their asset liability mismatches and/or under or uncollateralized loans failed to perform under pressure. However, other decentralized finance (DeFi) and regulated players and protocols performed to expectation despite record price declines and heavy volume. This meets our definition of integrity, performing to expectation over time and regardless of circumstance. This proven distinction of the players with integrity is the MOST UNDER-REPORTED TAKEAWAY FROM THE Q2 PURGE.
Players and entities that exhibited such integrity under fire include;
2. The Surge
July’s spike in prices saw BTC rise 28% and ETH 72%. Be it short covering or other, we were not surprised as the sell-off was technical in nature – making the road to price normalization a volatile and potentially quick one.
Just as we discounted Q2’s sharp sell-off as a technicality, and therefore temporary, we are likewise NOT pointing to the price rebound in BTC or ETH as a validating point – quite the opposite. Our thesis for investment in both protocols is fundamental (Monetary Ratchet) with today’s price STILL offering a unique entry point (Baby’s out with the Bathwater).
The price graph below with the 200-week moving average underscores the unique entry point. BTC has traded below its 200W MA only 2.5% of the time since its existence.
In sum, we see the absence of forced selling by CeFi lenders combined with the potential for regulation, 2024’s Halvening (BTC) and 2022’s Merge (ETH), as making for advantageous entry points for both BTC and ETH.
3. Back to The Merge
Ethereum’s mainnet is tentatively set to merge with the Beacon Chain’s Proof-of-Stake (PoS) system sometime in September 2022. The consideration of a consensus change has been on Ethereum’s roadmap since pre-2016.
Dubbed “The Merge”, the upgrade will mark the end of the Proof-of-Work (PoW) based Ethereum and give birth to a leading, global asset settlement layer that will be based on a PoS consensus mechanism.
The merge to PoS intends to improve the energy efficiency, decentralization, security, and scalability of Ethereum. Instead of relying on physical miners which consume greater amounts of electrical energy, PoS relies on validators (virtual miners) and staked ether (ETH). In short, Ethereum intends to pivot from a hardware-dominant consensus mechanism to a system more software-dominant.
While the technological breakthroughs are commendable and worth reading more on, we approach it in this week’s bulletin from an investment perspective, therefore highlighting the impacts on ETH, the native token, rather than the Ethereum Virtual Machine (EVM) as a whole.
Impacts on ETH
Changes to the Ethereum network may shift supply and demand forces for ETH, the native token of the Ethereum network. See the following themes below:
1. (Cash Flow) ETH is transitioning from a commodity asset with no cash flow to a capital asset with cash flow.
Applicational-layer cash flows generated from DeFi yields differ from consensus-layer cash flow rewards received from staking. We note that yields are derived from fees related to on-chain business activity and will likely vary over time.
2. (Security) The price of ETH plays a direct role in network security under PoS consensus, which is unlike PoW mining profitability incentives which involve hardware capital expenditures. Instead of hardware-reliant miners providing security, ETH2 security is predicated on a growing and stable community of software-based stakers.
As the price of ETH goes up, the network becomes more secure as it becomes more expensive to acquire the ETH that is required to run a validator node. The inverse is also true if ETH price declines.
3. (Scarcity) The enabling of PoS consensus will reportedly drop new supply issuance of ETH by 90%, with some proponents claiming that the impact is equivalent to three Bitcoin halving events. ETH’s net issuance could remain under 1% and possibly go negative depending on network activity and fees generated.
Ethereum’s monetary policy is flexible, as the supply of ETH will vary resulting based on demand for blockspace. Below we list what would drive the three monetary policy states:
Deflationary (ETH burned > block issuance)
Disinflationary/Inflationary (ETH burned < block issuance)
4. (Consensus Access) Settlement time of acquiring ETH/validator keys is faster than acquiring and deploying PoW ASIC hardware, making it easier for participants to enter and exit the network consensus process. This increases breadth of inclusion.
5. (Scaling) L2s and scaling solutions pay fees to Ethereum – the more L2s there are, the better the value accrual to ETH. ETH acts as a reserve asset in this circular dynamic of demand. This is similar to how the dollar is used to settle all commodity transactions globally.
More on Ethereum and Bitcoin Transaction Volume (cont’d)
Comparing the on-chain transaction data to Visa is NOT an apples-to-apples comparison, but it does serve a purpose. While daily transparency is convenient, the nuances surrounding the types of on-chain data captured makes comparing these types of datasets tricky.
For example, some metrics include change-related unspent transaction outputs (UTXO) and internal transfers from within cryptocurrency exchanges, possibly inflating BTC’s total volume. This excerpt from Josh Stark & Bruno Lulinski from stark.mirror.xyz (source of the above graph) help clarify some of these nuances:
“In Bitcoin, addresses own discrete “Unspent Transaction Outputs” (UTXOs). Therefore, if you have 5 BTC, what you actually have might be a UTXO with 2 BTC, and a UTXO with 3 BTC, both controlled by your wallet. Anytime you transfer Bitcoin, you are “using up” one of those UTXOs. Imagine you want to send only 0.5 BTC to someone. Your wallet will “spend” the whole 2 BTC UTXO, sending 0.5 to your recipient (creating a new UTXO of 0.5 BTC), and sending 1.5 BTC back to you in a new UTXO containing 1.5 BTC” (source).
When looking at Ethereum data, volume isn’t only derived from ETH settlement, but also ERC-20 (token) settlement. The most popular ERC-20’s include stablecoins such as USDC, wrapped coins such as wBTC, and other DeFi-related tokens such as AAVE. These token metrics have been combined in the above graph, but only include those which settled at least $500 million USD last year, meaning that the total value settled on Ethereum is likely higher than what is reported in the above graph granted there are thousands of other smaller ERC-20 tokens which have not been taken into account.
The Digital Asset Universe
The total crypto market capitalization has remained above $1 trillion USD, with BTC dominance declining 1%, to 42% of total Digital Asset Capitalization and ETH dominance increasing 1%, to 19% since the publication of our previous bulletin.
Source: 3iQ Research. Data sourced from Coin.Dance, Etherscan, Messari as of August 3, 2022.
Source: 3iQ Research. Data sourced from Messari as of August 3, 2022. Figures expressed in USD unless otherwise stated. Past performance is not indicative of future results.
Source: 3iQ Research. Data sourced from Bloomberg as of July 31, 2022. Past performance is not indicative of future results.
Our major takeaway for July was the INCREASE in realized volatility for ETH on a 21D basis as prices rose. The significance is that in TradFi, higher volatility is often associated with equity price declines and credit spread widening among other behaviours that reflect risk aversion and result in loss. Similarly, volatility declines in TradFi often occur when equity prices rise, which is what we saw in July.
Where NASDAQ’ 21D volatility averaged 37% in June, it dropped to a 30% average in July after its 12% monthly gain, while ETH’s 21D volatility averaged 105% in June, rising to an 109% average in July after posting a 72% monthly gain. Extending the analysis, we see that ETH’s 21D volatility ended the month at 114%, slightly higher than June’s 112%. BTC’s 21D volatility declined modestly in July compared to June but its 63D volatility rose.
Capturing Upside Volatility: Plugging the Hole in your 60/40
The above analysis dovetails with our initial portfolio analysis where we substitute a modest, 1 to 5% BTC allocation into an otherwise standard 60% large cap U.S. equity and 40% fixed income portfolio.
Our initial findings reflect both enhanced nominal performance and risk-adjusted performance as measured by the Sortino ratio, where returns are adjusted for downside volatility.
Given ETH and BTC exhibit the return behaviour of an exponential grower, we are not surprised to see that their volatility profiles differ from Fiat trapped assets such as equities and bonds. For more detail, please contact our 3iQ team.
Source: 3iQ Research. Data sourced from Bloomberg as of July 31, 2022. You cannot invest directly in an index. Past performance is not indicative of future results
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About 3iQ Corp.
Founded in 2012, 3iQ is a Canadian digital asset investment fund manager with more than C$800 million in assets under management. 3iQ offers investors convenient and familiar investment products to gain exposure to digital assets. For more information about 3iQ and its digital asset investment funds, visit www.3iQ.ca or follow us on Twitter @3iQ_corp.
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Frederick T. Pye is the Chairman, Chief Executive Officer and Director of 3iQ Corp. He is also the Chairman and Director of 3iQ Digital Holdings Inc. Mr. Pye is recognized for creating and promoting creative and unique investment products for the investment industry.
Mr. Pye has managed private client portfolios with Landry Investment Management and various other investment dealers. Prior to this Mr. Pye was Founder, President & Chief Executive Officer of Argentum Management and Research Corporation, a company dedicated to managing and distributing quantitative investment portfolios including the first long-short mutual fund in Canada.
He was also Senior Vice-President and National Sales Manager of Fidelity Investments Canada and an integral part of the team that saw assets rise from $80 million to over $7.5 billion in assets under management during his tenure. He also held various positions with Guardian Trust Company, which listed the first Gold, Silver and Platinum Certificates on the Montreal Exchange.
Mr. Pye obtained a Masters in Business Administration from Concordia University.