Just Crypto #1: 2021 Review & 2022 Outlook

Summary

• 2021 Year-In-Review
• 2022 Macro Outlook
• 2022 Crypto Outlook
• 2022 Themes & Trades

2021 Year-in-Review: QCP

In spite of another year of Covid restrictions, we’ve managed to expand our global footprint. (Here are some of the events you might have seen us)

2021 has been a year of tremendous growth for us, especially in options:

1. Our options book increased exponentially with almost $22 billion in notional traded, including some of the largest trades the market has ever seen.

2. In addition to BTC, ETH and BCH, we’ve created sizeable option markets in many Altcoins this year. (with ROSE, CEL, MKR, BIT, SUSHI, SPELL, TRX, AXS, SAND and many others to follow)

3. Expansion of options trading into Defi, largely via DeFi Options Vaults (DOVs).

2021 has also been a profitable year for the desk:

1. Being long gamma and long the wings paid off during the hard sell-offs in May and November.

Source: skewAnalytics

2. While short vega performed extremely well the entire 2nd half of 2021.

Source: skewAnalytics

3. The strategy faced some difficulty in August, when implied volatility squeezed
higher, while realised volatility declined.

This was caused by some short covering in vols ahead of the BTC ETF approvals. However, implied volatility has trended lower since, dipping sharply into year-end.

2021 Year-in-Review: Crypto Markets

2021 took off like a rocket with massive inflows in Q1 sending crypto prices to new highs and
derivative markets into a record-breaking frenzy. 3-month futures basis traded up to a record 50% annualized and perpetual funding rates touched 300% annualized.

This frenzy in crypto came to an abrupt halt as prices crashed in May led by the double-whammy of a record high US CPI print and Elon’s tweet over Tesla’s BTC ESG concerns. BTC eventually traded below 30,000, a whopping 55% drawdown from the highs in just over a month.

However in July, crypto prices recovered just as decisively on the back of institutions warming up to BTC again. BTC eventually traded to a new high of 69,000 in November.

As the hype over the BTC ETFs fizzled, the market turned soft and has remained capped by inflationary and central bank tightening fears and the emergence of new Covid-19 strains.

Nonetheless, as crypto enters the mainstream, the term ‘Unicorn’ has become a misnomer, with an unprecedented number of crypto companies/projects achieving multi-billion dollar valuations in 2021.

The DeFi/NFT boom earlier in the year initially drove ETH network congestion to unsustainable levels. In 2H21, the second leg of growth was spread across other Layer 1s, leading to a more balanced and robust multi-chain ecosystem.

2021 has seen the rapid expansion and proliferation of Defi as a viable source of investment
income.

However, questions have been raised about the sustainability of Defi returns when token incentives become the primary source of yield. Dependency on token distribution and price inflation leads to the problem of diminishing returns as token rewards fall. Many Defi protocols also face the issue of liquidity musical chairs – where non-loyal liquidity exits the protocol, once rewards end in lieu of the next new reward-paying protocol.

DeFi Options Vaults (DOVs) is one possible avenue for sustainable Defi returns in the long-run. DOVs effectively monetise the volatility of the underlying asset to provide a high base yield. Token incentives and staking rewards on the collateral are added bonuses, not a primary source of return. This could be a reason for the critical adoption of DOVs in the second half of 2021. We expect this to continue in 2022.

2022 Macro Outlook

In our present macro environment, we see possible parallels to two periods in history:

1. Roaring 1920s (bullish) – A full decade of economic prosperity and asset price growth before
   the crash of 1929
2. Stagflation 1970s (bearish) – High double-digit inflation leading to Fed tightening and
   capping asset prices for the entire decade

1. Parallels to the Roaring 20s – Post-crisis Boom

2. Parallels to the 1970s – Radical monetary experiment

1971: End of Gold standard → Start of debasement of Money
2020: Exponential Money printing: Cumulative money supply (M1) is now 5x more than it was in all of history

While there are similarities to both periods, we reckon the present state of the economy is closer to the 1970s – for the very reason we flagged in May that inflation wasn’t transitory and in July that Q4 2021 will be the Fed’s wake-up call.

As the 1970s marked the start of history’s exponential inflation (Fiat debasement), we now face the highest level of CPI deviation in history today.

The Fed has finally woken up to this inflation risk, and this will compel them and other global central banks to tighten faster, harder and most importantly with resolve.

Since the advent of Fiat and the debasement of money, normal business cycles have been replaced by central bank liquidity cycles. The major difference this round is that liquidity tightening comes on the back of high inflation. And if this leads to a real GDP decline similar to the 1970s, all asset prices will be impacted.

Since 2020, BTC has been trading like a macro risk asset. Risk assets are directly impacted by real GDP (a good proxy is the steepness of the US 2y10y rates curve – the best market indicator of real GDP). So generally speaking since last year:
Steepening = Higher BTC
Flattening = Lower BTC

BTC’s other macro driver has traditionally been the USD. But we expect a global hiking cycle in 2022, so the efficacy of the USD correlation is less clear to us.

Our 50-year USD timecycle since Fiat currencies began, also implies that 2022 will be another sideways to down year for the USD

2022 Macro Takeaways

1. We expect the Fed to wind up asset purchases in March and 3 interest rate hikes thereafter to 0.75% by year-end.
2. Inflation will keep rising and peak in Q2 at 7% Y/Y but only on base effects rolling off.
3. High inflation and a tightening Fed would drag on real GDP.
4. However it is nowhere near a stagflation scenario, as real GDP will still be positive for the year.
5. Nonetheless this will lead to a further bear flattening of the 2y10y rates curve (currently at 80bp), although we don’t expect it to
   invert anytime in 2022.
6. This flattening will begin to cap asset prices including BTC, especially in the 2nd half of 2022.
7. The USD typically strengthens in Fed tightening cycles, but next year will be a coordinated tightening among all central banks
   who are dealing with overly high inflation, and therefore the USD’s path will be mixed.
8. In late-2023 we expect the Fed funds rate to reach 2%, leading to a flat real GDP and an inversion of 2y10y

2022 Crypto Outlook

1. Institutional Participation in Crypto and the Compression of Vols
2. GBTC Activism as a Potential Price Dampener?
3. DeFi/NFT Boom/Bust/Consolidation?

In 2022, the first thing we expect to see is a major flippening of crypto ownership from primarily retail to institutional players, with institutions having a much larger participation.

As institutions build up their coin holdings, a natural next step would be to seek yield on their treasury.

The lending market seems like an attractive starting point, until one considers the oversupply of BTC in the lending market and the resultant low yield for coin.

The next step would be partnering with major TradFi institutions to create a BTC-collateral money market, that could extend into BTC-backed bonds or even mortgages – a positive development, but one still far away on a commercial scale.

Which would naturally lead the more sophisticated institutions to the active BTC/ETH options market – a space major investment banks are now keenly eyeing.

Institutional participation typically compresses volatility. We see this in traditional macro assets where implied volatility consistently trades below realised volatility.

The 2nd thing we’re looking out for in 2022 is the first form of crypto activism – where activists investors eyeing the GBTC discount lobby for a conversion to a physical ETF, to profit off the arbitrage worth 20% now.

As we wrote in July, there’s currently no par-correcting mechanism due to the suspension of redemptions but that’s also what’s been extremely supportive for BTC.

GBTC is the single largest institutional holder of physical BTC in the world (655k BTC worth $33bn). A big surprise in 2022 could be an unexpected approval for the GBTC ETF. The normalising of the GBTC discount to par could put some pressure on BTC spot price.

The 3rd thing we expect in 2022 is a last burst of proliferation of DeFi protocols before an eventual large-scale consolidation thereafter (similar to the path we saw in the Dot-com bubble – DeFi total market cap (2017 – 2021) vs NASDAQ (1995-2001) below).

2022 Themes & Trades

Themes for 2022

Views

1. Near-term short squeeze but significant resistance around all-time highs for BTC.
2. BTC underperformance versus other Layer 1s.
3. Volatility compression and curve flattening.

Longer-term trends

1. 2020s will be known as the decade of financial market reinvention and disintermediation primarily through DeFi and NFTs. This is after a widespread consolidation in these sectors weed out 90% of copycat projects and funnels capital to the standout ones.
2. Metaverse and VR igniting the wearables tech space as the iPhone did in 2007 for the current smartphone revolution.

A high short-base has built up with perpetual futures funding remaining negative for
the past 2 months – this will lead to low impetus for downside follow-through until
the shorts clear out, while topside remains vulnerable to a short-squeeze.

For BTC, we think there will be significant resistance around the 69,000 all-time high. Our two possible Elliott Wave count scenarios:

• Already completed the 5 waves since 2017 ending with the 69,000 high in Nov.
• Since then the move from the highs to 42,000 lows in Dec marked the A correction wave
• We’re now in Wave B and expect to find resistance around the 60-70k region before a final Wave C lower

2nd Scenario:

1. We’re still in the final Wave 5 higher since 2017, with fresh all-time highs still to come
2. The 69,000 Nov high only marked Wave i within the larger Wave 5, with the drawdown to 42,000 being Wave ii of 5
3. A powerful Wave iii of 5 will subsequently follow which breaks 69,000, before a corrective Wave iv lower and eventually Wave v of 5 marking the top

The decline of BTC dominance in 2021 will continue next year, and fuel a relative value play in 2022, versus other Layer 1s who will gain market share.

Volatility curves to compress and flatten on the back of increasing institutional participation in the options space.

Trades for 2022

Spot Ref 51500 BTCUSD, 27 Dec

1. Hedging long BTC:
a. Buy zero-cost Jun-22 Risk reversals (Jun 41k P vs. Jun 80k C)
b. Buy zero-cost Sep-22 Risk reversals (Sep 37k P vs. Sep 100k C)

2. Earn yield on long BTC:
a. 2 month 80k covered call for 11% annualized
b. 100k Jun 22 covered call for 11.4% annualized
c. 120k Sep 22 covered call for 9% annualized

3. Carry play:

• Short Feb Iron Condor (30/40k Put Spread & 70/80k Call Spread) for 25% annualized

4. Diversification out of BTC: Long Laggard Layer 1 basket