The crypto markets have crashed... I hope this doesn't come as a surprise to anyone reading this. But, there are a ton of risks with crypto being unregulated – liquidity risks, smart contract risks, and of course macroeconomic risks. I've pointed these all out previously, though admittedly I couldn't see how fast or when this would all unravel. But, those risks should always be factored in your allocation. All that being said, I am still bullish on crypto. And, I'm actually excited for the "crypto winter" which is likely ahead. This will be a time to actually focus on the technological opportunities, and building more long-term positions. Again, because we are STILL so early, I would consider that in my personal allocation of not more than 5-10% exposure (and that number may be different for you).
WTF is happening?
A quick summary to get you up to speed, in case your not.
Terra LUNA and UST collapse
If you don't know about this, then consider yourself lucky that you had no exposure. The Anchor protocol on Luna was offering 20% yield on the UST algorithmic stablecoin. The stablecoin USD-peg, however, was purely dependent on LUNA demand. At the end, there was death spiral which crashed both LUNA and UST. About $40bn was lost.
Celsius freezes withdrawals
This is the most recent one causing investor panic. The last number I was able to find was that they have about $30bn in AUM and 1.7million users. They're basically a centralized platform which promised users a higher yield than traditional savings account, for storing their crypto... who, in turn, took advantage of DeFi opportunities and pocketed the difference. It's kind of like a bank... except for crypto... except not regulated.
Clearly they took on too much liquidity risk. They had some exposure to the LUNA collapse, which based on on-chain research is in the couple millions – which doesn't seem like enough to trigger this pause, but it's worth noting.
What everyone is really worried about is the stETH-ETH de-peg situation. Celsius pays depositors up to 7.8% APY for their ETH. Most of those deposits, are likely locked up in staked ETH on the PoS Beacon chain. The reason it's locked up, is because the Merge (which I'll go into further) hasn't taken place yet, upon which the locked tokens will release slowly. stETH is a derivative asset created by the Lido protocol, creating liquidity for staked ETH until the merge takes place. There is about $5bn of TVL on the protocol, whereas total staked ETH on the Beacon chain is is $26bn (just for perspective). Celsius apparently holds about $400m of stETH in its wallets, which it would have to return to customers at a loss for redemption now – thus the need to freeze.
There's also the issue of a $300m leverage taken on what was $400m of BTC leveraged in Maker protocol, which faced liquidation at $22.5k/BTC. Thankfully they added more collateral, and the liquidation price is now at $17k.
There's a lot to fear now in crypto...
Tether de-peg fears
Bank runs, can happen to... uhh, banks. Real ones. But, of course, they are regulated, so crypto will get more heat now because of these issues. When regulation does come however, we'll likely be seeing a lot more capital pour in. So, that smells like an opportunity to me... sniff sniif
Buy stETH at discount?
First of all, the de-peg scenario of stETH is very different from the one at Anchor protocol (though we have yet to recover from those scars). stETH would be the TradFi equivalent of a liquid asset trading below NAV – like a REIT. By that definition, Grayscale's Bitcoin Trust (GBTC) has also "de-pegged" and every major traded crypto trust. So, it's not as big of an issue, imo. The issue is that Celsius can't didn't maintain enough liquidity and/or took on too much risk.
If you buy stETH, you're buying ETH... and you own the keys. So, this is a unique opportunity to buy some at a "discount" if you believe in Ethereum and the Merge eventually taking place.
What is the Merge?
The Merge, at a high-level, is where Ethereum will migrate to a proof-of-stake (PoS) consensus. As you probably know, this will result in more energy efficiency, and mitigate most ESG concerns, unlike Bitcoin.
Because miners will no longer be issued ETH for validating transactions on the network (instead it will be stakers), there will be less ETH issued daily. So, for additional context, right now there is about 13k ETH issued daily; whereas post-Merge, assuming 15m ETH staked (currently 13m), there will be about 1.8k ETH issued daily. This is a significant reduction to supply, which will have a positive impact on price. There's currently 121m tokens in circulation, which takes the 4% annual dilution rate down to 0.5%. But, when considering EIP-1559, which was recently implemented to burn transaction fees (in ETH) Ethereum, depending on demand, will be net deflationary. Think of this as a 1-2% annual buyback yield, on a stock.
Staking Yield & DCF Valuation
As a reminder, all valuation sheets are available to premium members of The Hawk Letter and Discord. I highly recommend you join, to make your own assumptions and investment thesis :)
ETH post-Merge will be earning staking rewards for those tokens locked. This would be akin to a dividend yield on a stock. So, we can technically value what this would be and even perform a DCF valuation on it.
Unfortunately, there are a lot of assumptions you'd have to make for a valuation. So, there will a high degree of uncertainty. But, we assume the most conservative scenarios to set a buy price on ETH.
I took a look at several models available online:
- Ethereum Price Models
- DCF Valuation of Ethereum v3 - Ryan Allis of Coinstack
- ETH projections (updated 23 April 2022)
- ETH Model
After considering the thought process of people who are probably smarter than me, I was able to determine my own conservative pricing model. The major questions, which I didn't find an answer to is, "why are assuming the price of ETH to calculate fees generated, to determine the fair value/price of ETH?" It's a circular reference and will not work in poor market conditions. Which is why I believe these projections in the range of $5,000-15,000 don't make sense to me.
Being the conservative person I am, I look at ETH fees and transactions over its limited history, and chose the bottom of the market in 2019 – when no one is talking about crypto. The networks was generating about $2M per month, down from its 2017 peak of about $60M... in other words, a 97% decline. I then looked at this in ETH denomination, since that would be a better input, and assumed an 80% drop from this cycle's peak of 400M ETH fees/mo. to about 80M ETH in fees as a baseline. Based on historic data about 85% of the base fee is burned (since EIP-1559), leaving about 15% in tips for validator – which will form part of our revenue.
The remaining revenues will come from MEV (miner extractable value), which is another form of revenue from prioritizing transactions in blocks. I can't go over it in detail, but have linked it here for your reference.
Finally we have block rewards, which are passed directly to validators, based on the number of stakers – which I've assumed to about 15M.
Taking these three revenue sources in to account, I've assumed growth rates and different variables for the conservative, base, and optimistic cases. You can get a better idea of this on the YouTube video linked above, since it's easier explained.
You'd really have to play with the assumptions yourself, but I can see a range of $8,000-12,000 per ETH. The real question is how long will it take us to get there – because that matters, and eventually drives the IRR.
I believe crypto is a risky asset class. Yes, it has in times been correlated to high beta equities, which also makes sense to me. By investing in crypto, you're taking a bet on the future. This is assuming you're not trading or gambling, which is unfortunately what drives the prices right now.
To make the assumptions that I've made in this analysis, you'd have to get an understanding of Layer 1 technology that is implemented in Ethereum, and compare it to others and form your opinion on its long-term success. That has been out of the scope of today's analysis. I personally believe Ethereum will not be replaced by other Layer 1's because of its decentralization. I know all this is up for debate, but this is my opinion. The only thing that can give ETH a run for its money, is Bitcoin with its potential for smart contracts.
Because of the risky nature, and high uncertainty, I personally would not make crypto more than 5-10% of my total portfolio. But, if you make the right bet, that can pay you handsomely – and of course, you'll have to endure periods of high volatility.
Hope you enjoyed today's content... and let me know your thoughts! Are you investing in crypto today, or passing?
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