EXECUTIVE SUMMARY

• Bitcoin declined by -50% due to emotional market reaction and forced liquidations of $1.3bn on BitMEX (largest derivatives exchange), which was temporarily shut down.
• Bitcoin caused a decline of the entire market capitalization of cryptocurrencies by -54% from $300bn to $140bn
• The Ethereum price decline of -60% caused liquidations on major lending platforms and revealed a design error in MakerDAO, causing a $4.5m loss.
• The market drop can be mainly attributed to fear and speculation, rather than to a change in fundamentals. In the current context, we see the following challenges and opportunities ahead:
• Market capitalization will be highly volatile in the short term, driven by market uncertainty, thinner order books and Bitcoin halving due in May 2020. Medium-term, liquidity will return when the fear of uncertainty settles and investors get comfortable with the economic outlook
• Trading volume will continue at current levels until the sentiment stabilizes, at around $100bn per day on spot market and $20bn per day on futures market. However, we expect options volume to increase, driven by volatility traders and broader willingness to hedge against further declines
• Financial services platforms have not collapsed due to market decline and are now implementing the learnings to ensure robustness; after 8% decline, the total value locked in those platforms is now stable and the platforms continue to offer ~5% interest rates. In the world of high volatility, we expect increased usage of lending and decentralized insurance platforms
• Transactions on blockchains have been growing at 44% CAGR, reaching 1bn transactions in 2019; due to recent utilization bottlenecks, we expect acceleration in releases of scalability solutions
• Lower valuations will allow investors to selectively find opportunities in projects with traction and with valuations that have been unfairly caught up in the recent market turmoil. We expect opportunities in trading (e.g. volatility traders, efficient market makers, derivatives exchanges) and in financial services (e.g. lending / borrowing platforms, decentralized insurance).

1. TRADITIONAL MARKETS DECLINED SINCE THEIR PEAK THIS YEAR DUE TO FEAR OF UNCERTAINTY: S&P500 BY -27% AND GOLD BY-11%, AS INVESTORS TOOK OUT CASH.

Protective measures against the coronavirus, such as quarantines and social distancing, are having a direct and indirect impact on the economy. Businesses experience shocks to both demand and supply globally. These side shocks from coronavirus protective measures coincide with a collapse in oil prices due to price war between Russia and Saudi Arabia, which results in downgrades and bankruptcies in the global oil industry. As the amount of corporate debt ballooned globally since 2008, a cascade of defaults across all industries is likely to ensue.

Citibank estimates a 30–40% earnings hit globally compared with 2019. Unemployment rate in the US is forecasted to increase by more than 5% (from the current 3.5%), which will further drive the drop in consumer spending. The crisis which started in the hospitality sector is now spreading into retail, manufacturing and capital formation. Banks are now accounting for 2 months of economic shutdown, then for 6–9 months for the economy to start functioning normally. The global GDP growth for 2020 is forecasted at 0.5% (recession starts below 2%) followed by a rebound in 2021 — but forecasts are revisited practically on a daily basis. This will likely not be a V-shaped recession.

The key factors to consider are how fast can the virus be contained and the ability to implement protective measures imposed by the government.

Due to this uncertainty, markets will continue to see increased volatility and negative market sentiment (i.e. mostly decline) at least for the next 3 months. Interest rates globally are now at or below 0%, with bond repurchases and other liquidity measures carried out by the Fed, ECB and other central banks accumulating daily, but so far failing to ease the market strain. Governments are pushing for a massive fiscal stimulus to both companies and the general public, but it is unclear how to get money quickly to the right places at the right time.

As a result, major stock indexes fell by 30% globally from their peak this year, as investors priced in increased risks and reduced future profits. Even gold, once considered a safe haven, dropped by 11% as investors liquidated their positions to get the much needed liquidity to cover margin calls and redemptions.

2. BITCOIN DECLINED BY -50% DUE TO AN EMOTIONAL MARKET REACTION AND FORCED LIQUIDATIONS OF $1.3BN ON BITMEX (LARGEST DERIVATIVES EXCHANGE).

Bitcoin price declined -50% from $10,000 on February 14 to $5,000 on March 17. Here is what happened:

Chart: Bitcoin price and volume (source: Coinmarketcap.com)

A — Bitcoin price started to decline from its peak of $10,000 USD by -10% near the end of February, in-line with the decline of other markets (S&P500), driven by fear from the impact of the coronavirus on the economy and by declining oil prices. Additional investor sell-out on March 8 and 9 caused another -10% decline in price and increase of funds inflow into safer assets (e.g. the USDT stablecoin). USDT trading volume reached $65bn per day on March 9, which is 8x higher than $8bn per day one year ago.

Chart: USDT volume (source: Tradingview)

B — On March 12 and 13, the continued sell-out of investors was accentuated by 3 strong shorts manipulating the price of Bitcoin on BitMEX. The decline caused liquidations of traders who entered the long squeeze territory. Solely on BitMEX, liquidations that followed the next 24h amounted to $1.3bn. BitMEX had to shut down the system in order to stop losing its insurance fund and causing a price difference with other exchanges. Let’s see exactly what happened, step-by-step:

Chart: Bitcoin futures price and volume on BitMEX (source: Tradingview)

B1 — UTC 12–03–2020 10:30: Drop started on BitMEX as high volume of sell orders (~$150m) was dropped on the market. This resulted in liquidation of $501m worth of positions within 1 hour and pushed the price down to $5,500. This was the highest amount of liquidations in the history of BitMEX.

Chart: BitMEX liquidations (source: Skew.com)

Because of the price movement of unexpected magnitude, liquidity on the BitMEX dried out multiplying the bid-ask spread by 20 times (i.e. bid spread from 0.15% to 2.96% for a $10m buy).

Chart: BitMEX spread on $10m order (source: Skew.com)

B2 — UTC 12–03–2020 23:22: The liquidity shortage, combined with another $100m short dropped on the market within 5 minutes caused the second wave of price decline resulting liquidations worth another $140m.

Chart: BitMEX liquidations (source: Skew.com)

UTC 13–03–2020 23:47: The price fell another 21% within 27 minutes, practically breaking the price peg between the spot price on Coinbase (grey) and BitMEX perpetual contract (blue).

Chart: Bitcoin price between price on Coinbase — grey line — and perpetual swap contract on BitMEX — blue line (source: Tradingview)

B3 — UTC 13–03–2020 01:50: The price stabilized at $4,500 range, when the 3rd sell arrived, resulting in another price decrease of 17% in 25 minutes. BitMEX was shut down when Bitcoin price reached $3,610. BitMEX announced that the reason for the shut down was a series of DDoS attacks (https://blog.bitmex.com/how-we-are-responding-to-last-weeks-ddos-attacks/).

Chart: Bitcoin price between price on Coinbase — grey line — and perpetual swap contract on BitMEX — blue line (source: Tradingview)

UTC 13–03–2020 02:40: BitMEX operations were restarted with real shortage of liquidity. Speculators lost interest in the broken product. The market started recovering.

Chart: Bitcoin price between price on Coinbase — gray line — and perpetual swap contract on BitMEX — blue line (source: Tradingview)

3. BITCOIN CAUSED A DECLINE IN PRICES OF OTHER CRYPTOCURRENCIES, SUCH AS ETHEREUM; THE ENTIRE MARKET DECLINED BY -54%.

Bitcoin represents ~60% of the market capitalization of all cryptocurrencies, with which it is highly correlated. The decline in Bitcoin brought down the entire market, which decreased -54% from $300bn on February 14 to $140bn on March 16.

Chart: Cryptocurrency market capitalization, YTD (source: Tradingview)

4. ETHEREUM PRICE DECLINE OF -60% CAUSED LIQUIDATIONS ON MAJOR PLATFORMS FOR DECENTRALIZED FINANCIAL SERVICES AND REVEALED A DESIGN ERROR IN MAKERDAO PLATFORM CAUSING $4.5M LOSS.

Ethereum is a platform that powers decentralized financial services, such as lending platforms (e.g. MakerDAO, Compound). But also, Ethereum is a platform that powers the USDT stablecoin. When the cryptocurrency market declined, USDT saw record inflow of capital and increased number transactions to the point of bottlenecking the Ethereum platform. On March 12 and 13 Ethereum network transaction fees increased 5x-9x compared to their daily average. In addition, Ethereum price declined -60% from $285 on February 14 to $110 on March 12.

Chart: Ethereum price — in black — and Ethereum transaction fee — in blue (source: Glassnode)

The rapidly declining Ethereum price on March 12 and 13 caused some loans on MakerDAO and Compound to become undercollateralized (price of collaterals denominated in Ethereum decreased below 150% of the face value of loans). When the collateral decreases its value, the collateral is liquidated, and the loan is paid back. On March 12, around $22m of collateral was liquidated across financial services platforms, which run on Ethereum network:

MakerDAO: $10,693,716Compound: $5,768,186DyDx: $4,487,834LendMe: $925,063DDEX: $498,156Aave: $215,451Nuo: $14,183Source: DeBank.com https://twitter.com/DeBankDeFi/status/1238166265627176961?s=20A bug on the MakerDAO platform caused a loss of $4.5m. The MakerDAO lending platform allows collateral to be liquidated via auctions. Due to the Ethereum network’s high transaction fees, there were no bidders in the auction except for one, who was able to bid 0$ and leave $4.5m of DAI uncollateralized (source: https://www.theblockcrypto.com/post/58606/in-a-first-makerdao-protocol-to-auction-mkr-tokens-to-cover-4m-bad-debt).

5. THE CRYPTO MARKET DROP CAN BE MAINLY ATTRIBUTED TO FEARS AND SPECULATION, RATHER THAN TO A CHANGE IN FUNDAMENTALS. IN THE CURRENT CONTEXT, WE SEE THE FOLLOWING CHALLENGES AND OPPORTUNITIES AHEAD:

Market capitalization: The drop removed ~$80bn from the market cap of Bitcoin. The drop was caused mainly by short-term investors, who held Bitcoin for 6 months (source: https://coinmetrics.substack.com/p/coin-metrics-state-of-the-network-30a). The investor sell-out, combined with the higher realized volatility than implied volatility caused market makers to pull back from the market. This decreased liquidity led open interests to decrease by 50% and spreads to widen 5x.

Chart: Spread on BitMEX (source: Skew.com)

In the short-term (e.g. next 3–6 months), we expect the price swings to continue, driven by the lack of liquidity, thin order book, uncertain economic outlook and the upcoming Bitcoin halving in May.

Mid-term, liquidity will return, when the fear from uncertainty settles and investors get comfortable with the economic outlook. With its supply limited to 21 million, Bitcoin has a chance to prove that it can fulfil the purpose for which it was invented: a hedge against inflationary monetary policy. Looking back 3 months, correlation with traditional assets is near 0, except with Gold, currently at 0.35. If the lack of correlation holds, investors will further drive up the demand to diversify their portfolios.

Chart: 3-months daily correlation with traditional assets (source: Rockaway Blockchain Fund internal research)

Trading volume: On the spot market, trading volume has been steadily growing 300% year over year since 2015 and is up 100% since the beginning of the year at $100bn per day (it reached ~$200bn during the crash last week).

Chart: Trading volume of all cryptocurrencies from Jan 1 to March 17 (source: tradingview.com)

In derivatives, the trading volume is $20bn per day on futures and $100m on options (source: skew.com). We expect trading volume to continue growing, driven by high volatility of this asset class.

Chart: Bitcoin volatility (source: btcvol.info)

Increased volatility on spot and derivatives markets results in higher revenues for exchanges and market makers. We expect the growth to continue especially in options, which are used by professional traders to trade volatility and by institutions to hedge their positions against further declines. Revenues of derivatives exchanges Deribit www.deribit.com and FTX www.ftx.com have been increasing.

Transactions: transactions on blockchains have been growing at 44% CAGR, reaching 1bn transactions in 2019. Nearly half of the transactions are executed on Bitcoin and Ethereum. The growth in transaction often resulted in congestion of the network, particularly on Ethereum (just like last week), which on average runs at 80% utilization rate. Many teams are currently working on scalability solutions for Ethereum, or on faster alternative chains such as Solana.com (disclaimer: Solana is a portfolio company of the Rockaway Blockchain Fund).

Chart: Transactions (source: blocknative.com)

Financial services: Despite the MakerDAO bug and the liquidations, the amount Eth locked in decentralized finance platforms declined by 8% from 3m to 2.75m, where it seems to have stabilized (as of this writing, it increased to 2.8m).

Chart: Ethereum locked in Financial services platforms (source: defipulse.com)

Last week’s market decline has stress-tested these platforms, which are now implementing their learnings to ensure robustness (e.g. scalability, automatic stop-loss or circuit breakers, reliable price feeds via oracles and simplified user interfaces). In the world of high volatility, we expect to see increased usage of lending platforms (e.g. by traders and by miners), and increased demand for decentralized insurance to prevent future collateral losses. Lending platforms continue to offer ~5% interest rates p.a. (e.g. Compound). Loanscan.io lists current yields across several lending platforms. If they continue to offer similar yields, we expect financial services to be the main driver of incoming capital into cryptoassets (to use MakerDAO or Compound, one has to buy the DAI stablecoin with fiat money). For some time, yields in the traditional world are likely to be significantly lower, driven by central banks’ monetary policy.

Lower valuations: Lower valuations create an opportunity to spot projects with traction and with valuations that have been unfairly caught up in the recent market turmoil. From the VC perspective, we see opportunities in trading (e.g. market makers, professional exchanges with fast response times) and in financial services (e.g. lending / borrowing platforms, decentralized insurance) where digital assets offer fundamentals of connecting participants worldwide, thus making markets more efficient.

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