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Tom Rodgers
Tom Rodgers Head of Research
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ETC Group Crypto Minutes Week #20

While markets are still parsing the shocking demise of algorithmic stablecoin Terra LUNA, institutions are buying Bitcoin in record amounts with prices at macro lows. And Ethereum just became Instagram’s NFT partner, setting the stage for a generational bet on the future infrastructure of the internet.

Terra LUNA ‘death spiral’: algo stablecoin fallout continues

This may go down in history as one of the worst recent periods to be a speculative crypto investor. It has certainly been chaotic and painful. Markets were stunned by the crash of the Terra LUNA project. In the course of a month, LUNA dropped from a $40bn market cap project to being effectively worthless.

The rapid rise of Terra had pulled in many thousands of speculators.

Terra's redemption mechanism allowed any holder to redeem one unit of its ‘algorithmic stablecoin' TerraUSD (UST) for $1 worth of LUNA. When the price of LUNA was rising, this system worked just fine. But when LUNA prices began to fall, the death spiral set in. UST lost its peg to the US dollar, and both confidence and liquidity evaporated overnight. Terra lost almost 100% of its value. As the supply of LUNA underwent hyperinflation, its price crashed to less than $0.00001.

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A group of backing investors called the Luna Foundation Guard (LFG) had only recently bought up 80,934 Bitcoin meant to act as backing for UST. The LFG was forced to sell all $3.2bn BTC at firesale prices in a bid to defend the $1 peg. It failed. Bargain-hunting investors stepped in to soak up the cheap Bitcoin hitting the market.

Post-crash, it was incredibly depressing to see national suicide hotline numbers appear as pinned posts atop the Reddit Terra forum. One man who allegedly broke into CEO Do Kwon's home in South Korea was an investor who lost $2m on LUNA, local media reported.

The lawyers and the class actions lawsuits began to circle. And so should they. The SEC is likely already investigating Terraform Labs, the company behind the failed stablecoin protocol. These arcane economic tricks to keep users flowing in started to look like a Ponzi scheme, some had warned. Kevin Zhou, head of crypto hedge fund Galois Capital had been short Terra for months. “ Don't put your money in boxes you don't understand ,” Zhou had urged. But many investors piled their life savings and more into LUNA.

DeFi and stablecoins are likely the first portion of the market that will be legislated on by both US and UK regulators. Both countries want to make their nation a ‘global cryptoasset hub'. That's generally bullish over all medium to long-term time frames.

The clear preferred move would be to regulate stablecoins issuers like banks, and hopefully to provider some kind of insurance over potential losses. US banks offer protection on deposits through the FDIC (Federal Deposit Insurance Corporation), and UK banks offer a similar backstop of up to £85,000 loss cover through the FSCS (Financial Services Compensation Scheme).

In August 2021 USDC collateralised stablecoin issuer Circle announced plans to become a national bank in the United States. If approved it would come under the oversight of the US central bank and various financial regulators. The company is also preparing to go public, with valuations mooted in the $9bn region.

One major issue the industry now faces is having their very different tech lumped in with Terra.

Algorithmic stablecoins like TerraUSD are not fully backed 1:1 by cash or crypto collateral. They rely on continuous and ever-increasing demand for linked tokens to function properly.

Collateralised stablecoins like USDT (Tether) and USD Coin (USDC) work in a fundamentally different way. They maintain their peg to the dollar by using reserves fully-backed by cash or cash equivalents. USDC publishes transparency reports each month to prove these reserves.

So was this crypto's Lehman Brothers moment, as some have suggested? The point at which contagion from one collapsing section of the market infects the rest? No. It may be a much-needed reset. It may be the point at which blind euphoria falls away and reality sets in. And that's a good thing.

More and clearer regulation, along with better investor protection, is always a net benefit to the industry at large.

Many crypto enterprises clearly have exploitable flaws. It's a Darwinian process as to which will survive. Its likely investors caught up in the glee of altcoins promising 20% APY yields without really questioning how the technology actually works, or trading on unregulated exchanges or betting with insanely risky leverage will lose out the most. This event may also push more investors who want crypto exposure towards regulated products like ETFs and ETPs which trade on recognised exchanges.

What crypto ETFs and ETPs really do is to put blockchain-based products into recognisable wrappers so that asset managers and individuals can trade in a way that they're used to doing with every other asset class. Issuers like ETC Group have certain legal responsibilities to their clients. No institutional investors or active trader has the headache of being their own bank or holding their own private keys, as ETC Group, for example, organises and manages all the custody requirements with regulated custodian BitGo Trust Company or Coinbase Custody. ETC Group's ETCs are also regulated by the German Federal Financial Supervisory Authority BaFin.

The hope now is that this event could dampen the kind of crazed euphoria that has sprung up around relatively unknown projects that claim the earth and deliver little.

Despite extreme uncertainty in the retail part of the market, traditional finance firms continue to bet vast amounts on crypto being a hefty money maker. In the last week, Citibank, BNY Mellon and Wells Fargo invested in crypto trading company Talos as part of a $105m funding round , while on 12 May 2022, a16z and Paradigm laid out a total of $175m to fund a Bitcoin-based startup led by ex-Meta payments chief David Marcus. Lightspark will focus on building out Bitcoin's payments potential through its Layer 2 add-on the Lightning Network.

Record $300m institutional inflows into oversold Bitcoin

Sharp falls in the crypto market have historically been an opportunity to buy the dip. That is, for those who strongly believe that cryptoassets will be an integral part of the future tech and internet landscape for decades to come.

In the seven days to 16 May 2022, institutions piled in to rack up almost $300m in BTC exchange-traded product buys, according to official data, suggesting that the LUNA crash and market sell-off was seen as a buying opportunity.

The week to 9 May 2022 saw similar institutional purchases, with net $45m flowing into BTC ETFs and ETPs.

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$300m of inflows into BTC represents by far the largest weekly amount in 2022. The next closest figure came six weeks ago on 1 April 2022, when institutions bought up $133m in BTC.

As has been made clear: the fallout from Terra will not be a long-term crash as some have suggested. What it will likely do is refocus investor attention away from the hot-money speculative chains, and back towards the major, secure cryptoassets like Bitcoin and Ethereum.

Traders and investors hunting for bargains in the face of crashing tech stocks, an underwhelming Q1 US earnings season and a wider ‘ everything rout ' in equities may be looking more closely at blue-chip cryptoassets now.

ETC Group analysis, as published on Medium on 10 May showed Bitcoin was widely oversold, with monthly RSI at its lowest point in over two years. Bitcoin's 2-year moving average (MA) multiplier, a widely-followed measurement of momentum, also dipped into the buy range for the first time since 2019.

Monthly RSI (Relative Strength Indicator) is a metric which tracks both the speed and severity of price momentum. There have only been five months in the past five years when monthly RSI was lower.

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Further analysis shows that Bitcoin's recent price action has been widely divorced from both growing adoption metrics and on-chain utility and momentum signals. Buying Bitcoin when the price drops below the two-year Moving Average (green line), and selling when the price shifts up above the red line (two year Moving Average x5) has historically generated outsize returns.

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Bitcoin's macro range low going back to early 2021 is in the region of $28k to $35k. Falling below this low point would have marked a more bearish outlook for crypto in 2022 than we see today.

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However, with markets soaking up the $3.2bn BTC from the LFG debacle noted above, Bitcoin bounced from the low end of this range and has recovered to just north of $30k.

There remains strong appetite for BTC in the early $30k region.

Certainly, with prices some 50-60% lower than they were six months ago, some of the speculative excess appears to have been purged, setting up Bitcoin and Ethereum for their next major macro move.

Meta debuts Ethereum NFTs on Instagram

One major adoption story buried in the avalanche of negative press around the Terra LUNA network crash could have far reaching implications.

On 9 May 2022 Instagram chief Adam Mosseri announced that the gigantic social network was trialling Ethereum-based NFTs with a select group of content creators. This brings crypto's biggest consumer-focused vertical to one of the world's largest social networks. Some 84% of US teenagers use Instagram.

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Meta's link up with Ethereum is a stark reminder that the original smart contracts blockchain remains an infrastructural play on the future scope of the internet.

In the last six months, Ethereum has pulled in more than $4.6bn in revenue, 30x more than its closest competitor Avalanche. This could also be one reason why the network's ETH token reversed course more quickly from macro price lows to recoup its gains. Smart contract blockchains Helium, Filecoin and Solana round out the top five by revenue.

Flow and Solana NFTs could follow on Instagram, said Mosseri. But the first experiment starts with Ethereum and its Layer 2 add-on Polygon (MATIC). Only NFTs minted on Ethereum and Polygon will be shareable on Instagram feeds, stories and in direct messages, Mosseri said.

Every time a smart contract that describes how NFTs are created is used, the Ethereum blockchain takes a cut in the form of transaction fees. The vast competition between app users, traders and NFT buyers and sellers to have their transactions included in the next Ethereum block is the reason why its fees are expensive. But by using add-on Layer 2 programmes like Polygon, users can see much more reasonable confirmation times and cheaper fees. Polygon has become an important part of helping Ethereum to scale up, because this complementary network makes Ethereum much cheaper and faster.

To use Polygon and take advantage of cheaper fees, users deposit ETH to a Polygon smart contract to create an equivalent amount of MATIC on the Polygon sidechain. When their transaction is complete, they can convert their MATIC tokens back to ETH.

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Source: PreethiKasireddy.com

There's a full explainer on the Polygon and Layer 2 technology here, for anyone who wants to find out more.

Ethereum doesn't work for free. Mosseri says Instagram users won't have to pay to display NFTs (unlike Twitter, where users pay $2.99) which suggests that Instagram will shoulder the costs for now. The subsidiary can certainly afford it.

Instagram is the fourth-most popular social network globally behind TikTok, Facebook and Youtube. As a proportion of total Meta revenue, Instagram has grown like wildfire. In 2015 it made up 3.6% of total company revenue. By 2020 that figure was 10 times larger at 33.9%. By 2023 it is slated to pull in more than 60% of Meta's US advertising revenue.

Over two thirds of Instagram users are aged 34 and under and four in ten are under 24, making the photo and video sharing platform especially attractive to advertisers and marketers. NFTs have already had a huge cultural impact and remain one of the first major use-cases of blockchains and smart contracts to break out and capture retail imagination. If you're reading this and you have children, their favourite rapper likely already has an NFT as a profile picture on their social media.

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From an infrastructural perspective, Ethereum is and will continue to be extremely important. Think about it this way: the creators of the baseline tech that underpins the internet, like TCP/IP protocols, did not get paid every single time their architecture was used.

By contrast, Ethereum gets paid (handsomely) every time its architecture is used.

And despite falling off from their all time highs, NFT sales remain one of the largest portions of the blockchain space. The OpenSea NFT market is still the biggest contributor to ETH ‘burn', a mechanism that removes a small amount of ETH from circulation every time a transaction is made. $715,000 in ETH is removed from supply every 24 hours, just from OpenSea NFT transactions. The most popular marketplaces or NFT collections using Ethereum see the largest volume of transactions, and hence ‘burn' the most ETH.

NFT markets or collections make up four of the top 10 ETH burners.

One final news story that may have slipped under the radar is that the German Federal Ministry of Finance announced a huge tax win for private investors. Gains from crypto-based exchange traded products will now be tax-free after a one-year holding period. This means German private investors will not have to pay taxes on profits from crypto-based exchange traded products, like ETC Group's Bitcoin ETP (BTCE), its Ethereum ETP (ZETH) or any of its 12 other crypto-linked investment products which trade on regulated exchanges.

The rule clarification means that the 100% physically-backed BTCE, ZETH and other similar popular products will be treated in the same way as physical gold ETCs, for example Xetra Gold or The Royal Mint Physical Gold, which are already tax-free.

The tax exemption comes with no cap, meaning investors can hold any amount.

Bradley Duke, Founder and Co-CEO of ETC Group said:

ETC Group was formed to provide robust, highly liquid and innovative cryptocurrency ETCs to investors in Germany and abroad. As part of the product development, our goal was to apply the best features of established physical gold ETCs to our crypto ETCs. This includes the possibility for end investors to have the underlying cryptocurrency physically delivered. The natural outcome of this feature is to achieve positive tax treatment for BTCE, ZETH and our other ETC products.

Markets

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Markets are still parsing the long-term fallout from Terra LUNA but have largely stabilised in the wake of a 30% slide over the past two weeks.

The reset of expectations and cleared-out leverage from the riskier portions of the market, are likely to set the stage for the next phase of pricing.

While no cryptoasset survived without losing some of its value, it is interesting to see which chains managed to hold on to the most. Stellar (XLM), Bitcoin (BTC), and Polkadot (DOT) fared the best, albeit with drops of 19.03%, 20.68% and 25.37% respectively.

With institutions clearly seeing Bitcoin's price crash as a buying opportunity, the sharp downside risk that characterised the past two weeks has been stemmed somewhat. But volatility is everywhere. More broadly, markets remain edgy following significant central bank rate hikes, decades-high inflation prints that appear far less transitory than governments would like, along with severe liquidity and collateral concerns.

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