The Breakdown - What One Crypto VC Is Focusing on During the Bear Market

Episode Date: October 3, 2022

This episode is sponsored by Nexo.io, Circle and FTX US.   On this edition of “Long Reads Sunday,” NLW reads threads from MacroAlf on the problems of pensions, degentrading on why currency concerns should spook investors and Meltem Demirors on what she’s thinking about during the bear market. - Nexo Pro allows you to trade on the spot and futures markets with a 50% discount on fees. You always get the best possible prices from all the available liquidity sources and can earn interest or borrow funds as you wait for your next trade. Get started today on pro.nexo.io. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - I.D.E.A.S. 2022 by CoinDesk facilitates capital flow and market growth by connecting the digital economy with traditional finance through the presenter’s mainstage, capital allocation meeting rooms and sponsor expo floor. Use code BREAKDOWN20 for 20% off the General Pass. Learn more and register at coindesk.com/ideas. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is “The Now” by Aaron Sprinkle and “The Life We Had” by Moments. Image credit: Nuthawut Somsuk/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.  

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexo.io, Circle, and FtX, and produced and distributed by CoinDesk. What's going on, guys? It is Sunday, October 2nd, and that means it's time for Long Read Sunday. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if If you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also a disclosure, as always, in addition to them being a sponsor of the show, I also work with FTX.

All right, folks, welcome back to Long Reads Sunday. And this week again, I think that we are going to focus on threads from Twitter. I mentioned this before, but the original Longreed Sunday, when I first started using that name to describe content, was a thread of threads on Twitter. I started it in early 2018 more than four years ago, and really what I noticed is that there were so many great threads on Twitter that had everyone chatting about them and talking about them for a day or even some number of hours, but then were pushed down by the relentless pressure of new content on the feed. Threads were really powerful because you got more of people's thoughts. There was room for more

analysis than you'd get from a single tweet, but they were much less imposing and difficult to compose and easier to start than writing a full essay. Now, eventually that morphed into a newsletter and eventually that morphed into this podcast, but I still think there's value in capturing threads that might otherwise get lost to the pages of Twitter. I've also found that the more that markets go down, the more that people thread. Part of that is that there's just lots and lots of room for interpretation, and part of that is that people just have more time. So today we're going to look at three threads, one that's more macro-focused, one that kind of combines macro and crypto and crypto, and one that's very focused on the crypto industry itself.

We start, and I'll let you guess which of the three this is, with Twitter user MacroAlth. He's the writer of the Macro Compass newsletter, host of the Macro Trading Floor podcast, and you hear me reference his tweets quite a bit on this show. He writes, Something very important is going on in the pension fund industry. Why was the Bank of England forced to intervene as the lender of last resort? Is something going seriously wrong? A thread. First, some context. The size of the global pension fund industry is estimated to be in the 35 to 40 trillion area. It's a very large and systematically important industry, not only because of its size, but also because of its social impact. When it comes to countries, the share of pension

fund assets as a percentage of GDP can be vastly different, as some countries choose to accumulate retirement savings in other vehicles. Conservatively speaking, the UK pension fund industry has 4 trillion in assets or roughly 125% of GDP. It's very large. Pension funds liabilities are a promise to pay a stream of retirement cash flows in the far future, 30 years plus. This organically exposes pension funds to 30-year plus interest rate risk, which needs to be hedged, at least to a certain extent. Pension funds must also generate returns. To hedge interest rate risks, swaps are a very convenient instrument. A receiver, interest rate swap, is nothing else other than an agreement to receive cash flows at a fixed rate against the obligation to pay cash flows at the prevailing floating

rate over time. The trick is, swaps don't require any principal investment up front. The beauty of a swap is that there is no principal investment up front. The cash that would have been invested in a long-dated safe bond has now been deployed in other higher-yielding assets. Bear this in mind. To avoid bilateral counter-party risks, today's swaps are mostly cleared by a clearinghouse. An initial margin, often paid by posting bonds as collateral and variation margins, as interest rates move during the lifetime of the swap, mostly paid in cash, are required. So, short recap. UK pension funds are huge. They're sitting on a very large amount of 30-year receiver swaps betting on lower interest rates to hedge long-dated liabilities. This requires very little upfront cash payment,

hence cash is invested in stocks, emerging markets, credits, etc. Then this happens. And at this point, Alf shows a chart of UK bonds this week. 30-year swap rates explode higher like never, literally never, before. It's margin call time. Wait a second, though. Most of the pension fund cash is tied in riskier assets that the clearinghouse doesn't accept as collateral. Well, we'll go to the Bank of England and post this collateral there and get some cash in repo from them. Ah, but pension funds don't have direct access to the BOE.

Okay, let's ask banks. Yeah, sure. Banks were smelling this from far away. and actually contributed to the massive move higher in rates. If I know my client's risk of insolvency will move higher as rates move viciously higher, as a bank, I am likely to hedge some of my risk and position for that. I can buy some OTM options, payer swapsions, and as rates move up, I will exacerbate the problem and make money, margin calls squared.

The only way out is to liquidate assets, bonds, stocks, all, and meet margin calls to try and avoid insolvency. But these assets are dumped into market makers with limited risk warehousing ability, post-GFC regulation. And hence, it's fire sale time. The Bank of England was forced to step in and intervene by effectively limiting the margin call vicious circle and very likely slaughterhouse in the domestic pension fund industry. By mechanically forcing 30-year yields down, they stop the bleeding. Is this only a UK issue? The UK pension fund industry as a percentage of GDP is very large, but it's not the only one. If you run the numbers on some European and Nordic pension funds,

you'll quickly realize that a 200 basis point move in 30-year euro rates could seriously cause troubles. The most relevant aspect here is that the pension fund industry dynamics could easily force central bank's hands at the very moment when credibility is the most at stake. The BEO didn't pivot. They simply had to step in to temporarily stop the bleeding in a systematically important sector. By doing so, they lower real interest rates and actively fight bond vigilantes demanding higher yields to fund external deficits and their very own credibility in fighting inflation. All right, guys, back to NLW. So obviously this is super dense.

It's the type of thing that you have to read or maybe even listen to a couple of times. And of course, as always, I'll have links to all of this in the show notes. But I think that the relevant thing to hone in on is actually a question of how many of these other sort of house of card style economic setups are there out there, where the entire structure of the system is predicated on conditions that no longer remain true and might not be coming back anytime soon, if at all. Want to keep more profits when trading? Get the best possible prices and trade with 50% lower fees on NXO Pro. The new spot and futures trading platform uses aggregated liquidity of over 3,000 order books collected from multiple sources. Utilizing the complete NXO Suite allows you to earn interest and borrow funds as you wait for the next trade setup.

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Next up, a shall we say slightly different type of thread. This is from at Hoddle Cryptonite or DGen Trading, whose bio reads, Retired Sloth actually. Hope is not a trading strategy, but I am a bultard. They write, What happened in TradFi pre-March 2020 and the parallels between now? TLDR, panic, and prepare. Before Sloth went to work at Mokas,

sloth had a side gig trading for one of the top inventors. investment banks in the world. Unfortunately, Sloth had to trade through March 2020, which gave him a few weeks of neck pain. During the initial signs of the crisis, think January 2020, COVID was widely assumed to be just a nasty Asian flu. Stocks were still floating around just fine. However, a nasty signal started flashing in the asset class that Sloth happened to trade. Currencies, especially Asian emergent market currencies were blowing up left and right. KRW, SGD, CNH, INR, IDR. On a side note, as a bank trader, your primary duty is to make markets. Not really as a punter, for real for real. When markets blow up, it makes your job hard

because you become the source of liquidity, and your clients are usually smarter than you. Now, WTF is liquidity. In its purest form, it is the frictional cost of transaction. In slots speak, it is the amount of dumb money floating around sloshing and greasing the gears of finance. When liquidity diminishes, it makes getting in and out of positions harder, which inevitably makes volatility higher, simply because bid-ask spreads are wider. Markets and prices then tend to jump more. When volatility gets higher, funds everywhere, especially those who target VAR, have to degross their positions, which makes markets more liquid and kickstart to grab for cash. When volatility in one asset class spikes, it also tends to lead to spikes in the peripheral

asset classes, whether because of confounding factors or as a direct consequence. FX vol and interest rate vol then funnel into credit stress. Equity markets are the last to be affected. The joke was that equity market guys are usually the dumbest. If crypto is an asset class, then I guess crypto might give stonk market guys a fight for that title. So anyways, back to March 2020. By Feb, the world in equity markets had started to notice. Across the span of one month, stress within the system became a fissure. Debt markets entirely dried up, affects fall off the charts, stocks limit down. Crypto was sailing along, not really affected until March 2020 when we had a nasty correlation one event when there was an entire run on cash. So why the fuck should I care now?

Simply because over last Friday, the GbP flash crashed. GbP is a major currency. It's not an emergency. It's market currency. The last time a major currency flash crashed? AUD pre-March 2020. Currency, especially developed market currency markets, are assumed to be almost perfect markets. They have the deepest mode of liquidity. The fact that a DM currency is experiencing flash crashes tells you that there is a grab for liquidity. Retail mostly look at stonks. And if stress spreads to the equity markets, I can tell you we're just at the start of a crisis and panic is not even here yet. Macro TBH is dog shit right now. Japan is blowing up. Europe is blowing up. China is not going to reinflate to save the world. Every country has to raise their interest rates

and suck out liquidity from the system. We have, in my opinion, a correlation one event coming, and crypto will probably get crushed. If I estimate, we will have terrible macro conditions in the confluence of Mount Gawks' unlock overhang looking at us. The prospect of a billion Bitcoin being unlocked for sale when there is no bid on any assets is terrifying. Bitcoin to what? 12K, 6K, 3K? Honestly, in a correlation one event, you don't know where is the low, particularly in crypto where infrastructure is not fully battle tested, and instantaneous liquidation. At least in TradFi, you get a weekend to work shit out. However, that is probably the best thing to happen for young people. You have the chance to buy a liquidation event and make it.

Anyways, good luck. I'm Gigi, back to my holiday. Now, this thread got a ton of attention, and most people, I think, focused on the larger macro story that they were trying to articulate. There are a lot of folks out there who are very skeptical about the effect that this Mount Gawks unlock is going to have. Scott Johnson, for example, in the comment says, Meh, Mount Gawks creditors have basically had open offers to buy their claims from hedge funds like Fortress for nearly a decade now, and Fortress aren't buying those claims unhedged. So anyone that needed to liquidate the claims don't need to wait for them to be actually

delivered. I personally tend to think that Mount Gawks unlock concerns are overblown, but at the same time, I think the point that DGEN trade is making is that that might change in the context of one of these correlation one events. Finally, let's end with a quick brain dump, as she puts it, from Meltem to Mirrors. This, I think, is a good reflection to see what one successful investor in the crypto space is paying attention to, as this bare market hums merrily along. Meltem writes, stuff I'm thinking about right now, hence quiet and mostly off social.

Web 3 infrastructure business models vary analogous to Web 2, hence business metrics end up converging over time. Limited examples of scalable token-driven models that work, most successful companies are Web 2 slash centralized models. Next, most profitable businesses in crypto outside of interchange is selling services to venture-funded crypto coes. Hosting in Web3 infrastructure will be a huge category, but custom SaaS growing rapidly, especially in cybersecurity, compliance, and legal tech. AWS dominates startup spend by giving credible early-stage companies 150K in credits and building strong lock-in. Whoever

spends their way to this strategy and crypto infrastructure will dominate. Microsoft and IBM tried in 2017, Google is about to unleash their multi-product strat. Next, lending pools were helpful for liquidity aggregation, but don't make sense long term. In current environment, P-to-P lending platforms that enable aggregation of customized loans into loan portfolios, built using custom risk parameters, will dominate. Customization over aggregation. Next, crypto products need better bundling. Constructing your own crypto ops and backend stack is brutal and cost-heavy right now. Unsure if it will be M&A or channel partnerships, but too much is unbundled from a price perspective and cognitive overload perspective. Next, very few companies have invested in building effective sales and marketing teams that have technical

competence, seeing high churn and poor NPS from companies who enjoyed free media during the bull market, but now have to acquire and retain users and customers. Next, NFT projects will launch their own marketplaces, their own front-end products and platforms, and if they can, their own chains. Once you run out of stuff to sell or your audience runs out of cash, you need cash flow. As a follow-on, NFT market microstructure is still being formed, but will be an even bigger category than defy as the universe of assets represented as NFTs grows. Liquidity aggregation will be key to winning.

Next, Bitcoin is still exciting despite the narrative cycle on crypto-Twitter and in mainstream media. Vocal minority of Bitcoin MLM people, podcasters and paid content shills aren't relevant. Builders are focused on global gig economy, payments via lightning network, new privacy tools, etc. Slow and steady progress. Next, Dow's in current form are really not useful for solving the social and economic coordination problems they're trying to solve. More doubt tooling doesn't change this. It's a behavioral economics and transaction cost problem, re-coasis theorem. Should be used sparingly, in my opinion. Next, all reliable, secure compute will require energy. Energy is a universal constant for all

comms and compute, solving for energy sources and more efficient hardware just as important as inventing new consensus mechanisms. Physics for the win. Huge opportunity if you are patient. Next. After eight years of cryptoVC and equity plus tokens, tokens still the fastest path to liquidity by dragging future expected value into the present moment. But, rife with moral hazard and difficult to monetize without bigger whales to buy your bags. Next, three to five years need material exits on overpriced equity. Next, critical inflection point for industry as a whole on censorship resistance and decentralization. Washington, D.C. is busy, compromises being negotiated behind closed doors. not a criticism, just a reality. This makes Bitcoin more important in my humble opinion because fewer

big players to attack. Next, still early for blockspace slash secure financial compute as an asset narrative, but digital commodities markets are coming. Enron was super early. A few companies tried in 2013 with cloud compute futures. Will be a big narrative cycle in 2023. Next and last, Twitter bots are absolutely unbearable. The level of spam and crypto junk email is insane. I don't want your newsletter or podcast or NFT-gated Dow. Crypto is still one of the most exciting and high-growth categories in my humble opinion, just more landmines and dumb money now. Back to NLW here, and look, I apologize if that's a little hard to follow. I think what's interesting is when people who are actively investing in a space give you a type of preview into how they're thinking about things,

there's a lot to be gleaned from that. This idea of a critical inflection point for the industry around censorship resistance and decentralization is certainly something that comes up a lot right now. And I think a lot of the rest of Meltem's interests just reflect what a different environment it is now, where we have time to actually think about what the industry needs to move forward. So anyways, guys, like I said, this is a classic LRS hearkening back to the beginning of that name, and I hope you enjoyed it. For now, I want to say thanks again to my sponsors, nexo.io, circle and FTX. And thanks to you guys for listening.

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