Bullish Unlocks

Shapella Arrives

We are now less than a week away from staking withdrawals being enabled on the Ethereum network. We have been discussing this topic frequently throughout our research, but to reiterate, we maintain that the market is overly pessimistic about the supply-side effects of this event. To reiterate the key points behind our rationale:

1. Liquidity Access for Most Stakers: Approximately 60% of the staked ETH is through liquid staking providers or centralized exchanges (CEX), which already provide liquidity access without waiting for the upgrade. Thus, when questioning the magnitude of the supply overhang, we should consider the maximum sell pressure to be 40% of the total 18 million ETH currently locked on the beacon chain.
2. Withdrawal Queue Post-Shanghai Upgrade: There are limitations on the number of validators permitted to exit the Ethereum Beacon Chain and restrictions on the withdrawal process. These restrictions help minimize the amount of ETH entering the market in a short timeframe, reducing the risk of a sudden supply overhang. Moreover, a significant factor in the supply overhang equation is when an ETH holder sells their ETH. A withdrawal from the beacon chain does not necessarily necessitate an immediate market sell.
3. Market De-Risking Prior to Shanghai Upgrade: The ETH/BTC ratio indicates that holders have de-risked in anticipation of the upgrade. The ratio has dropped to new year-to-date lows following the successful deployment of Shanghai on the Goerli testnet, reflecting ETH holders preemptively accounting for potential negative supply-driven impacts on price.

Market Positioning

To support our view that the market is positioned cautiously ahead of this event compared to the rest of the crypto market, we can examine the options market. Below, we compare the ETH put/call ratio leading up to the Merge last September to the current upward trajectory of this ratio. 

As the ratio currently trends upward, it indicates that the market is taking a more cautious stance ahead of the staking withdrawals event. This cautious positioning could potentially limit the downside risk in the market, as many participants may have already accounted for the potential negative supply-driven impacts on price.

We also notice that the gap between the ETH put/call ratio and the BTC put/call ratio has converged over the past 12 months. This implies that the level of risk-aversion in the ETH options market is not just a reflection of the overall sentiment across the entire crypto market. Instead, it is likely a direct response to the anticipation of staking withdrawals.

Staking Ratio Likely to Increase Over Time

As illustrated below, the current percentage of circulating ETH staked is significantly lower compared to other competing layer 1 smart contract platforms. It is likely that the Shapella upgrade will result in an increase in the percentage of ETH staked. This potential increase could offset any concerns regarding negative supply-side effects on price, further reinforcing the notion that the market may be overly pessimistic about the implications of the upcoming event.

We believe that a significant part of the gap in the percentage of supply staked can be attributed to illiquidity risk. Over the past 12 months, we’ve seen that black swan events in the crypto space tend to come in flocks. As a result, for many investors, it’s challenging to justify staking a substantial portion of their holdings without the ability to unstake at any given moment. This notion also highlights the growing popularity of liquid staking.

Comparing the inflation-adjusted annualized staking rewards on various competing PoS chains, we find that ETH currently offers an attractive yield on staked supply. Once the illiquidity risk is addressed post-Shapella, this inflation-adjusted yield is likely to entice many ETH holders to consider staking. Additionally, given the more mature futures market for ETH compared to other competing L1s, it’s plausible that funds will become increasingly interested in capturing this yield in a delta-neutral manner during times of increased uncertainty.

Finally, it’s worth noting the relatively consistent growth in new ETH staked. Apart from last summer, when ETH prices hit a low point and the market was still grappling with multiple upheavals, the amount of new ETH staked per month has remained fairly stable. Surprisingly, since Shapella’s tentative announcement in January, new ETH staked has continued to increase. This is contrary to the prevailing narrative that Shapella should lead to an exodus of stakers. Instead, we are observing a continued draw of investors to staking, likely because Shapella is seen as a significant de-risking event and a formal conclusion to Ethereum’s transition to proof-of-stake.

Climbing Mt. Gox

Another Supply Overhang Issue

Mt. Gox was a Tokyo-based Bitcoin exchange, founded by Jed McCaleb in 2010. It rapidly became a significant player, handling around 70% of all Bitcoin transactions globally at its peak. Unfortunately, due to security breaches, thefts, and mismanagement, Mt. Gox collapsed in 2014, losing approximately 850,000 BTC (valued at $450 million then) and filing for bankruptcy protection. This event had a profound impact on the crypto market and is still considered one of the largest exchange hacks in history. Mark Karpeles, the exchange’s CEO, faced legal charges, and creditors have since been engaged in a complex, protracted legal battle to recover their lost funds.

After nearly a decade, the distribution of claims from the bankrupt exchange is finally approaching. As of 2019, the recovered assets include: 

1. 142,000 bitcoin ($4.0 billion)
2. 43,000 bitcoin cash ($5.4 million)
3. 69 billion Yen ($525 million)

These assets are anticipated to be distributed to creditors during the repayment process. In light of the ongoing theme of supply overhangs, many investors are wondering whether this distribution will negatively affect market prices. Similar to our view on the Shapella upgrade, we believe that the risk of Mt. Gox supply impacting asset prices will be minimal.

The Process

Creditors had until today to let the Mt. Gox trustees know which option for repayment they chose:

1. Cash Option: If a creditor elects to be paid out in cash, the trustee is responsible for selling the corresponding cryptocurrencies to generate the necessary funds. Once the coins are sold, the cash amount will be transferred to the claimant through bank remittance or a fund transfer service provider.

2. Crypto Option: If a creditor chooses to receive their repayment in crypto, they will receive a distribution equal to the total yen-denominated value of their claim proportioned to the total basket of yen, bitcoin cash, and bitcoin on the Mt. Gox balance sheet. The trustee will transfer the respective asset to a trusted custodian, such as Kraken or BitGo. These custodians are then responsible for distributing the assets to the claimants according to their individual claims.

The Risk

Understanding this high-level process there are two potential sources of sell pressure:

1. Sell pressure from the trustee converting cryptoassets to cash to pay out creditors in accordance with payout option 1 above.
2. Sell pressure from following the distribution of cryptoassets to those who select payout option 2 above.

Addressing the first risk is relatively simple and necessitates understanding the current makeup of Mt. Gox creditors. At the time of Mt. Gox’s prominence, there wasn’t a fat tail of bitcoin traders. Whales were the dominant market force. Consequently, it is reasonable to assume that the distribution of claims skews toward a few larger balances. Moreover, considering the nature of the assets underlying these claims, a market among crypto-focused funds emerged to acquire any unwanted Mt. Gox claims for pennies on the dollar. For those wanting to bypass the cumbersome bankruptcy process in Japanese courts, this presented an excellent opportunity to achieve liquidity. It also allowed the market to transfer these claims from those who might be inclined to sell their bitcoin to those with a long-term investment thesis in the asset. 

These funds, which possess a deep understanding of bitcoin’s long-term potential, are more likely to opt for repayments in crypto. To substantiate this with anecdotal evidence, our team has had discussions with the top two creditors regarding their payout methods, and both have signaled to us that they will be opting for the crypto option. Thus, we think that the incremental sell pressure from the claims trustee is negligible.

To address the second risk, which deals more in the realm of incremental supply overhang, we should remember that funds are well-equipped to manage risks using derivatives and other financial instruments and may be more inclined to hold or invest in the recovered bitcoin rather than sell them immediately. The timing of the repayment process also plays a role. With the next Bitcoin halving about a year away, these funds might anticipate a potential increase in Bitcoin’s value and choose to hold onto their assets, expecting a potential market upswing.

BTC Claims vs. Daily Volumes

To anchor expectations, it is worth considering the worst-case scenario – the trustee market sells 100% of the bitcoin in its possession all at once. To be clear, this is not going to happen (see commentary above). However, it puts the amount of supply coming to market in perspective. 

Below we map the hypothetical selling pressure from claims relative to daily BTC volumes assuming three scenarios:

1. 25% of BTC creditors opt for cash
2. 50% of BTC creditors opt for cash
3. 100% of BTC creditors opt for cash

Assuming the worst-case scenario, where 100% of BTC creditors opt for cash, the daily sell pressure would represent roughly 10-20% of daily volume. While this is a substantial percentage, it is important to reiterate that this scenario is highly unlikely (as previously discussed).

In a more realistic scenario, we could expect that less than 5% of BTC creditors would opt for cash payment, which would equate to 0.5% – 1.0% of daily BTC volume. In this case, the daily sell pressure would be significantly lower, posing a minimal impact on daily BTC volumes.

By evaluating these hypothetical situations, it becomes clear that the potential influence of the Mt. Gox repayment process on daily BTC volumes is likely to be limited, especially when considering the preferences of the creditors and their propensity to choose crypto repayments over cash.

A Quick Word on Market Liquidity

Last week we discussed the interplay between bond market volatility, the RRP, and U.S. net liquidity. Over the past few weeks, the ongoing banking crisis, the Fed’s language shift, and easing monetary policies from major central banks have contributed to increased net liquidity in the U.S. and higher global USD liquidity. 

One risk to these absolute liquidity levels is the potential negation by the Fed’s reverse repo facility (RRP). When liquidity flows into the RRP, it is theoretically being drained from the private market. Recent bond market volatility, as represented by the MOVE index, may have exacerbated the increase in RRP utilization. Investors are less likely to park their cash in short-term treasuries if they are subject to high volatility and are not willing to venture further on the debt risk curve if “risk-free” treasuries are behaving erratically. Many are also moving away from banks as the industry awaits to see if run risks have been mitigated.

We discussed last week how, as the bond market starts to normalize, it is expected that some capital will be pulled out of the RRP and back into the private market. This would be beneficial for liquidity-sensitive assets. However, if bond market volatility remains high and the recent liquidity injection by the Fed begins to be repaid, the liquidity absorption by the RRP might pose a risk to both liquidity-sensitive assets.

To the benefit of asset prices, this past week, we saw a substantial drain from the RRP, likely in response to a normalizing rate environment and a steadying of withdrawals from bank accounts.

Consequently, we can see that US net liquidity levels remain elevated, indicating an environment that should continue to be supportive of cryptoassets. 

Core Strategy

After an impressive quarter for bitcoin and the wider crypto industry, it is certainly tempting to look for recent tailwinds to turn to headwinds. However, we think the risk asymmetry in 1H remains to the upside, as liquidity conditions for risk assets should remain favorable, buoyed by global liquidity increasing. Key risks to this perspective would include sustained bond market volatility, a hawkish shift from global central banks, or a debt ceiling resolution, which would result in a glut of new treasuries coming to market.