Most significant Banking Failure Since the GFC
Our clients know the rationale behind our bullish perspective on crypto this year. Consumer prices are broadly trending lower, peak-tightening occurred last year (on a rate-of-change basis), and global liquidity conditions have been more favorable than many anticipated. We also felt comfortable that most of the “forced selling” from market participants exiting the ecosystem was behind us.
Unfortunately, over the past few weeks, economic data became hotter than expected, and Fed Chair Powell was more hawkish in his discourse. As a result, rates did not abate nearly as fast as we had anticipated. In fact, the US 2Y hit its highest level in over 15 years, and the futures market repriced the expected hike at the March FOMC meeting from 25 bps to 50 bps (note: this chart is as of premarket hours on Wednesday, and the futures market has since reversed course a bit).
Further, the liquidity injections from the PBOC and BOJ were paused.
Even while this was occurring, our view was that the path of least resistance for rates was lower in the near term. This would result in bond volatility falling, financial conditions easing, and capital potentially being drawn from the RRP to participate in the private markets. Not to mention, risk assets had held up quite well in the face of these persistently tightening conditions (until yesterday).
Below we can see the inverse relationship between risk in the bond market and bitcoin. The correlation is relatively strong, especially if we remove the FTX-driven drawdown from the picture.
Unfortunately, what flew under our radar were the duration mismatch issues plaguing our traditional banking institutions.
Silicon Valley Bank ($SIVB) is a commercial bank that provides financial services to the technology, life science, and venture capital sectors. The bank’s core expertise lies in working with startup companies. It has played a pivotal role in facilitating the growth of the technology industry in Silicon Valley and other global innovation hubs.
SVB is (was) also the 16th largest FDIC-insured bank in the US.
Without getting too deep in the weeds on bank balance sheets and capital requirements, SVB essentially realized a loss on their securities available for sale. They had purchased too many low-yielding, long-dated bonds for their liquid portfolio and needed to roll their book into higher-yielding assets.
After realizing a $1.8 billion loss following the sale of their $21 bn debt portfolio, they announced a proposed $2.25bn equity capital raise from investors which would dilute the shareholders significantly. The cratering stock price, coupled with the realized losses, shined a light on its balance sheet and the unrealized losses that it (legally) carries on its securities earmarked to be held to maturity. Following this, an old-fashioned bank run ensued.
The market was pulled down under fears of systemic banking failures. While we are certainly far from a Lehman moment, the chart below suggests that concerns regarding our banking institutions’ health are warranted and that the Fed’s aggressive hiking was something that our financial institutions were unable to keep up with.
According to the data, our banks are sitting on $600 billion in unrealized losses, mainly because the low-yielding debt securities acquired by banks last year to cover deposits are now significantly underwater on a fair value basis.
The bad news is pretty straight forward – the market (crypto and equities) is on uneasy footing, and many are wondering if there will be another bank to fall in the coming days via bank run.
However, the upside of all of this is that rates have started to roll over, likely under the assumption that these structural risks have tightened financial conditions significantly and will make the environment for spending and credit creation even more challenging.
Further, the “worst-case scenario” here is that the liquidity issues continue to surface due to underwater bond portfolios, resulting in the continued degradation of the commercial banking system. There is the possibility that this will thwart the ongoing QT efforts and, therefore, will be quite the tailwind for risk assets.
In summary:
- We have not discussed it at length, but Silvergate failed due to a similar inability to make depositors whole without incurring significant losses on the sale of assets. However, they were small, having deposits of just north of $2 billion.
- A similar issue plagued SVB, which has over $200 billion in deposits, 100x the size of Silvergate. The downfall of Silvergate likely contributed to the bank run that transpired with SVB. Run risk operates like a flywheel – once it starts, it is tough to stop.
- The market for equities and crypto likely needs to shake out a bit more before benefitting from any constructive data or pullback in rates. However, as we will discuss below, we think the outlook for cryptoassets is constructive in the near term, particularly for larger-cap assets.
Core Strategy
How do we think about risk in the current environment? While things seem uneasy, and one’s intuition is screaming to run to stables, we are unsure that now is the time to sell.
Rates are starting to fall off a cliff. This is likely due to banking stresses on the treasury market and the sense that a 50 bps hike might actually bring the banking system down entirely.
If the banking contagion continues, and we see runs on other mid-sized banking institutions, it is unlikely that the federal government will let the bleed continue indefinitely. We likely see a Bear Stearns-style absorption of customer deposits (we acknowledge huge differences between both crises – our main point is that the government will appease the rioters to reduce panic). And while the same risks will remain, we have the precedent of risk assets rallying after a government attempts to minimize panic while that systemic risk persists. See below for the $QQQ rally between the fall of Bear Stearns and the collapse of Lehman.
Further, we have seen many cryptoassets find support at critical technical levels. Most importantly, BTC is bouncing off its 200-day moving average.
Additionally, the incremental leverage in the system added since the start of the year was effectively wiped out yesterday.
Any additional drawdowns are likely to emanate from the spot market. While this is entirely possible, it mitigates the risk of long liquidations driving us lower.
Removing ATOM
The app chain thesis is the idea that the future of blockchain technology will involve multiple specialized blockchains (or “app chains”) that can communicate and interact with each other. These app chains will be tailored to specific use cases or applications and will be designed to be highly efficient and scalable.
Cosmos, whose native token is ATOM, is a project that aims to facilitate this vision by creating an ecosystem of interconnected blockchains. Its goal is to enable different app chains to communicate and exchange value with each other, creating a decentralized and interoperable network of blockchains. Cosmos uses the Inter-Blockchain Communication (IBC) protocol to achieve this, allowing different app chains to transfer tokens and other data securely and efficiently.
Our thesis behind including ATOM is that Cosmos developers have been and will continue working on developing better tokenomics around the ATOM token to increase network adoption and entice more apps to migrate to their ecosystem. While we still believe in Cosmos developers’ ability to do this successfully, it is unclear whether they will lead the charge on app chains. Recent developments within the Optimism ecosystem and their “super chain,” as well as the developments surrounding app-specific rollups, present an interesting challenge to Cosmos.
While we will continue to monitor progress within the Cosmos ecosystem and update our views accordingly, strategically, we should remove ATOM from our Core Strategy and allocate elsewhere.
Surprisingly, ATOM outperformed BTC quite well over the past week. It is possible that its lack of fundamental adoption and preference among crypto traders spared it from a similar demise. This advantageous price action is worth taking advantage of and selling for other assets that can perform more strongly to the upside in the intermediate term.
Increase Concentration in the Majors
From a risk/reward perspective, with Shanghai FUD seemingly priced in and bitcoin approaching its critical levels of resistance, increasing allocation to the majors (BTC, ETH) is appropriate in this rebalance.
To summarize
The risk asymmetry in 1H is to the upside, and the ongoing calamity in the US banking system will be resolved via orderly intervention. Rates rolling over will help to boost conditions for risk assets, and we expect the overarching disinflationary trend to continue with next week’s CPI. While we know that idiosyncratic contagion risks from the banking fallout remain present, we feel that the risk/reward here still favors being long but with increased relative exposure to the majors.
Parting Thoughts on Banking, Sovereign Debt, and Crypto
Satoshi Nakamoto, the pseudonymous creator(s) of Bitcoin, inscribed the following message on the Genesis block, which is the first block in the Bitcoin blockchain:
” The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”
This message is a reference to a headline from The Times, a UK newspaper, on January 3, 2009, which suggests that the UK government was considering a bailout for banks in the wake of the global financial crisis. The inclusion of this message is seen as a commentary on the flaws of the traditional financial system and a nod to the fact that Bitcoin was created as an alternative to centralized banking systems.
This was in the middle of the Great Financial Crisis and was the dawn of a new era of QE, falling rates, and an expanding everything bubble. Satoshi recognized the inherent fragility of this liability-based system and produced software that would be free from government interference and allow peers to hold their wealth in the form of digital bearer assets, unencumbered by counterparty risk.
Asset prices surged following the GFC, banks became more regulated, and many in western society forgot about the risks embedded in the banking industry and how the constant issuance of low-interest sovereign debt was making everything more fragile.
Well, a cohort of tech-forward SMBs and numerous individuals were left banging on the door of their bank on Friday, asking the federally-backed banking institution for their hard-earned capital. What transpired with SVB (and Silvergate) was tragic, and we hope those affected can recover their funds expeditiously. However, the knock-on effects will be significant.
While we want to be sensitive to the situation at hand, we also need to be cognizant of how significant of a tailwind this could be for digital assets, particularly bitcoin. There is the legitimate potential that this cohort of people is forced to re-think counterparty risk. There is a reason that individuals in developing nations hold cash and gold bars under their mattresses – it is because the counterparty risk in their local banking institutions is massive.
We are not going to pretend that the banking sector now carries the same risk as those in Lebanon or Sri Lanka, but that risk is clearly non-zero. And if to mitigate this risk, people start to realize that there are decentralized rails in which they can store a portion of their capital without being beholden to the risk of bank losses, then this could be a positive long-term catalyst for the industry. While many will point out that, at present, one would mitigate counterparty risk in exchange for increasing purchasing power risk, this is how risk management works. Not to mention, increased adoption would intuitively reduce purchasing power risk over time.
This is less of an actionable trade idea and more of an occasional reminder of the “so what” behind crypto. The modern financial system in the US is comparatively sound, but it is not ideal. Where it falls short, crypto excels.