Although Powell's statement indicates that there may be no more interest hikes, continued high interest rates will become a "liquidity ceiling" that is temporarily difficult to penetrate in the crypto market, and the hedging behaviors from market makers and traders further suppresses market volatility, making the "ceiling" thicker and thicker. Considering that Aug is the "summer vacation" of the Fed, the low volatility of BTC and ETH prices may continue throughout the summer. However, the current market environment is undoubtedly "happy hour" for passive income strategies, especially those based on selling volatility.

It Won't Get Worse, but It's Even Less Likely to Get Better

July's Fed rate decision may be the least suspenseful of all Fed rate decisions. The 25 bps rate hike did not exceed anyone's expectations, and Powell's usual hawkish speech did not bring more new ideas. "Further rate hikes" will only happen if the economic data is significantly overheated, and "maintaining high rates" is the more likely solution until data supporting the "significantly overheated" is fully supported. Interest rates above 5.25% will continue until at least March 2024, and a rate cut is not possible until after May.

Of course, the possibility of further interest rate hikes is somewhat priced in. Interest rate market data show that traders expect the possibility of one more 25bps is about 30%. Traders' concern is not unreasonable: real-time inflation data show that after a year of falling inflation, in mid-July, on the back of a rebound in the prices of necessities such as food, housing, and transportation, the headline inflation level began to bottom out and rebound, which means that the probability of reflation is not zero, and the possible policy easing may cause the failure of inflation control like the 1970s. Therefore, for whatever reason, Powell will not easily consider cutting interest rates.

The possible path of Fed rate changes, as of Aug 2, 2023. Source: CME Group

US real-time inflation data, as of Aug 2, 2023. Source: Truflation.com

US real-time food inflation data, as of Aug 2, 2023. Source: Truflation.com

For the crypto market, investors seem to have become accustomed to daily life at high interest rates. The lack of liquidity has left investors with little interest in "trading." Most investors are sitting on the sidelines. As a result, the monthly spot trading volume was even lower than Christmas in Jul, while the trading volume of BTC Delta 1 contracts was only slightly better than Christmas and New Year. It looks like the crypto market has a "summer vacation."

Monthly spot volume changes in the crypto market. Source: The Block

Monthly trading volume change of Bitcoin Delta 1 contract. Source: The Block

"Summer vacation" means low volatility. BTC and ETH's Volatility Index (DVOL) broke a new 2-year low, and even with this record-low volatility expectation, option sellers can still get profits, which means that the realized volatility in the market is still significantly lower than expected. In 2021, few would consider a scenario in which the intra-day price movement of BTC was less than 1%. In contrast, in mid-2023, the 0.1% daily price movement has become normal in the crypto market.

BTC and ETH volatility index (DVOL) changes. Source: Deribit

BTC and ETH variance premium changes. Source: Amberdata Derivatives

Similarly, crypto investors have become less sensitive to interest rates due to the pervasive wait-and-see sentiment and low volatility. Even if Powell and Lagarde raise interest rates 1-2 times, it will only be "one step further on Mount Everest"-the liquidity situation will not worsen. Many "smart money" have already left, but the sinking liquidity will not leave the crypto market quickly, providing the necessary price support for cryptos. However, sinking liquidity is usually inactive: Judging from the crypto market cap changes, the total market cap has hovered around $1.2T for over four and a half months since mid-March.

Changes in the total market capitalization of the crypto market. Source: CoinMarketCap

If we compare the price data of recent months, it is not difficult to find that when the price of BTC is around $30,000, and the price of ETH is around $2,000, both will lose further upward momentum here, hovering for a while, and then fall. The time to hit both levels was short or long, but further price breakouts did not occur. There seems to be an invisible ceiling around these two levels, blocking the upward pace of crypto assets.

BTC and ETH price changes since the beginning of 2023. Source: blofin.com

Ceiling

Liquidity level changes are essential for forming the "crypto ceiling." With high interest rates, money market funds have shown relatively higher attractiveness. At the same time, US stocks (especially technology stocks included in the Nasdaq index) have also become strong competitors of the crypto. Excess returns from BTC's rise appear to have been concentrated only at the beginning of this year, and in the following six months, BTC has significantly underperformed the Nasdaq index.

In this case, for retail investors, the wealth-creating effect brought by crypto has been partially inferior to that of US stocks, which means that most retail investors are more inclined to "remain silent" in the crypto market. Since retail investors usually tend to go long, the absence of retail investors makes the crypto market have lost an important source of upward momentum.

The YTD changes of Nasdaq index and BTC price, source: Tradingview

The behavior of institutional investors is even more intriguing. Looking back at the weekly crypto asset flow from the beginning of 2023 to the present, it is not difficult to find that the behavior of institutional investors has a significant "tidal" feature: when the crypto market has a sharp rise, institutional funds pour in, and when the market tends to be calm, institutional funds begin to flow out.

Weekly net inflows/outflows from crypto funds in the past year, source: CoinShares

To some extent, institutions behave similarly to 0DTE traders: they tend to profit from short-term price movements rather than market cycles, called the "gamma effect." Under the influence of the "gamma effect," institutions tend to sell after the price rises to a certain level and turn to buy after the price falls to a certain level. Although the above actions strongly support crypto asset prices (especially when considering the position of institutions in liquidity providers), the trigger selling behavior undoubtedly makes the "crypto ceiling" thicker.

More evidence from VPVR (Volume Profile Visible Range) data supports the "gamma effect." Taking BTC as an example, near $30,000, sell orders dominate, shown in red, while near $29,000, the part showing a clear green color dominates buy orders. On ETH, there is a similar distribution of buy and sell orders.

BTC and ETH perpetual contract VPVR data changes. Source: Tradinglite

The hedging behavior of market makers is another factor supporting the "crypto ceiling." For options market makers, to maintain delta neutrality near the strike prices with positive gamma, market makers usually adopt a strategy of "selling high and buying low." In contrast, the opposite is true near the strike price with negative gamma. In a positive gamma-dominated market, market makers tend to dump their delta inventory when prices rise, suppressing prices - precisely what has been happening these weeks.

Considering that market makers are one of the few active groups when investors are not very enthusiastic about trading, the hedging behavior of market makers to balance risk exposure makes the upward path of prices even more "difficult."

Distribution of BTC and ETH gamma exposure, Source: Amberdata Derivatives

Another consequence of hedging is the suppression of market volatility. Due to the lack of trending market and directional trading opportunities, investors are not enthusiastic about trading, tend to make profits through passive income strategies (such as selling options), and even embrace risk-free income. The market was further stabilized with the hedging behavior of market makers. Volatility is an indispensable element in breaking through the "crypto ceiling." However, in the absence of volatility, "narrow shocks" may have become the theme of the crypto market in the whole Aug.

Aug Outlook: Potential Tail Risk and "Happy Hour"

Volatility sellers appear to be the few winners in the market in August. Although the implied volatility of BTC and ETH has hit a record low since 2021, compared with the realized volatility, the selling volatility strategy is still profitable, and the current volatility premium is even the highest since May—one of the good moments. Investors' tail risk management and speculative demand persisted regardless of the market environment, resulting in continued positive cash flow for options sellers, especially during quiet times like August.

In addition, low volatility means that the uncertainty of the price direction has increased, and there is a lack of income expectations brought about by the trending market. Considering that sell volatility strategies are less correlated with the direction of price movement, sell volatility strategies have better-earning potential in moments of low volatility than strategies based on Delta 1.

VRP changes of BTC and ETH, source: Amberdata Derivatives

However, continued low volatility does not mean that tail risks will not occur. For the crypto market, the potential risks from the macro still cannot be ignored.

From the economic data perspective, the US macro data and employment performance were stronger than expected. With the complete ease of the supply chain, "relatively overheated" demand may have become the main factor leading to inflation. The above situation means that the Fed may further manage the demand side to suppress inflation completely. Economists at the Fed believe in the theory of "limited economic growth"; they think the economy will overheat and possibly lead to inflation when the growth is too fast.

Therefore, for the Fed, it is not an unacceptable option to take more than expected behavior (such as raising interest rates again or extending the peak period of interest rates) or even trigger a short-term recession to achieve the inflation target. Still, for the crypto market, this means further liquidity pressure.

Changes in the proportion of leading factors in inflation since 2017. Source: Federal Reserve of San Francisco

In addition, the action on the west coast of the Pacific cannot be ignored. As one of the main liquidity providers in the financial market, the Bank of Japan has long provided the "Mrs. Watanabes" with a steady stream of funds through the magic of "Yield Curve Control" (YCC). However, the BOJ has become reluctant to be so generous as inflationary pressures build within Japan; they have loosened their grip on the YCC, which is the beginning of a shift in liquidity policy. We must know that the liquidity released by the Bank of Japan is not only distributed in traditional markets; BTC and ETH are facing additional risks.

Of course, some unexpected events in the crypto market can also be a source of tail risk. The Curve event has caused some investors to worry; similar events are usually hard to be priced in time. At the same time, the regulatory authorities have not stopped because of the failure of the XRP lawsuit; the SEC is still trying to bring other tokens besides BTC into the scope of supervision. Those above "extra events" are precisely what we need to guard against; buying some tail protection while collecting theta is still necessary.

To sum up, we still need to be vigilant to a certain extent while spending the summer vacation. Fortunately: the probability of the events mentioned above is not too great, and even if it happens, the likelihood of unexpected events in August is even smaller. August is a good vacation season; while selling volatility, pay some necessary costs and do an excellent job of tail protection. Let's enjoy "happy hours" with theta.

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Blofin takes its due diligence to ensure the report provides a true and fair view without potential influences of any third parties. There is no association between Blofin and the subject referred in the report which would harm the objectivity, independence, and impartiality of the report.

Trading and investing in cryptocurrencies (tokens) may involve significant risks including price volatility and illiquidity. Investors should fully aware the potential risks and are not to construe the content of the report as the only information for investment activities. None of the products or Blofin Inc, nor any of its authors or employees shall be liable to any party for its direct or indirect losses alleged to have been suffer on account thereof.

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The gradual separation of correlation between BTC and ETH indicates that the overall change in the narrative of the crypto market is nearly complete. As a widely recognized "liquidity container," BTC has become one of the essential macro underlying assets, gradually approaching the status of FX and precious metals. In contrast, the narrative of ETH is turning to mega stocks. Unless there is a grander narrative and widespread application, the attractiveness of ETH for liquidity may continue to be weaker than that of BTC, especially in the era of lack of liquidity.

Authors:

Matt Hu, Blofin CEO

Griffin Ardern, Blofin Macro Trader

"Time, Forward!"

In just 15 years, the crypto market, which has one of the fastest-changing microstructures in the world, has become very different. In 2010, BTC was little more than an "experimental toy" for a group of geeks to exchange for pizza or handle small private transfers. In 2023, from BlackRock to Goldman Sachs, BTC and related derivatives have entered their product lists, and according to a survey by PwC and AIMA, Cryptocurrencies have also become an essential part of nearly one-third of hedge funds' portfolios.

At the same time as the microstructure changes, the macro narrative is also quietly changing. "Decentralized distributed ledger" was the design goal at the beginning of the birth of crypto. In traditional markets, cross-border transfers are a time-consuming and laborious thing: to ensure "safety and credibility," banks need to confirm the identity of users and the source of funds and then complete the whole process through the complex SWIFT system, the time is measured in days, and the cost cannot be ignored.

Cryptos represented by BTC solve this problem. With the blessing of blockchain technology, people link liquidity to the BTC network and complete transfers in the form of Bitcoin through the network. The transfer process has been shortened to seconds.

As a result, liquidity began to enter the crypto market one after another. This brings a new feature to the crypto market: volatility. On the coin standard, 1 BTC is always equal to 1 BTC; when converted to the fiat standard (such as the USD standard), the rapid liquidity changes bring considerable price fluctuations.

In the early history of BTC, it was not surprising that the 10% level fluctuated up and down, and even the price halved occasionally. High volatility makes risk hedging a "hard demand" in the crypto market and brings many speculation opportunities. Coin-margined derivatives began to appear, constituting the current crypto derivatives market prototype.

Cryptocurrency operates based on blockchain, and the characteristics of blockchain that cannot be forged and tampered with make people begin to explore more uses of blockchain. Commercial contracts can be notarized through blockchain. Blockchain-based programs can complete funds transfers and other complex operations without trust. Game drops and artworks can also be authenticated and traded through the blockchain network. The addition of smart contracts turns all the above possibilities into reality and thus opens the second narrative of the crypto market: projects and applications.

As one of the first public chains to introduce smart contracts, Ethereum's first-mover advantage at the application level has made it the core of the Crypto 2.0 narrative. Whether it is DeFi, NFT, or GameFi, most applications are built on Ethereum; the distinction between "application" and "liquidity container" begins here.

However, during the bull market, the widespread influx of liquidity made this distinction less obvious - investors' preferences for BTC and ETH did not differ according to different narratives. At the same time, because ETH can also be used for payment, transfer, and other purposes, the differences between BTC and ETH are further concealed.

90-day price correlation between BTC and ETH from 2021 to 2023. Source: CoinMetrics

From 2021, BTC and ETH were once regarded as "hard currency" representatives in the crypto market. Cash liquidity in the form of fiat currency and stablecoins will first be exchanged for BTC and ETH, and then used to buy NFTs, project investments, etc. On the contrary, investors will first exchange the altcoins for BTC and ETH, then exchange them for cash and leave the market. Before 2023, backed by the "hard currency" attribute, the correlation between BTC's and ETH's performance gradually rose and became closer with the market cycle changes.

Crypto 3.0

In fact, the change in the crypto market narrative in 2023 was already foreshadowed in the last bull market round. In early 2021, not many people cared about the Fed's interest rate decision, and not many cared about what Powell said every time. In 2022, investors in the crypto market began to pay attention to changes in economic data, and analysis of macroeconomic factors started to appear in AMAs, crypto media columns, and crypto blogs.

Why 2023? Let's take a look at what has happened in the last 6 months:

Continuous liquidity outflows caused by internal turmoil in the crypto market (Luna, 3AC, FTX collapse, etc.)

The banking crisis has pushed safe-haven liquidity into the crypto market, and more institutions have begun to buy in cryptocurrency.

AI is becoming a new trend. In contrast, the scale of primary investment and financing in the crypto market has hit a new low since 2021.

Regulators are trying to adopt stricter regulatory measures for cryptocurrencies other than BTC and ETH.

Based on the above situation, a new Crypto 3.0 narrative has emerged. We call it "macro + AI + other."

Macro: Under the combined effect of existing liquidity preferences and external liquidity preferences (mainly institutions), the macro attributes of BTC have been continuously strengthened. As a global liquidity network, the Bitcoin network, like gold and the US dollar, directly reflects the economic changes in its liquidity changes, meaning that BTC has become a natural macro underlying asset.

In addition, BTC is a fully compliance asset. Although ETH is not recognized as a security by the SEC, the SEC's ambiguous attitude implies risk, while BTC has been clearly identified as a "commodity" rather than a "security." Institutions will not easily take risks on compliance, and BTC is the best choice at this time.

AI: The artificial intelligence revolution has begun to trigger profound societal changes. AI is gradually replacing simple but repetitive tasks, and the financial system supporting AI needs to become simple, automated, and ready to use. At the same time, rights and obligations can be confirmed in a "simple and direct" way during disputes.

Blockchain-based smart contracts can fully meet the above needs: Financial rules are clearly written into smart contracts for automatic execution. The blockchain system will not be on vacation and is available anytime. Any transaction record exists permanently in the blockchain network, which is theoretically immutable and can be queried at any time with sufficient credibility.

It is not difficult to imagine that the blockchain represented by Ethereum and a series of applications based on it will be deeply integrated with AI in the future. In addition, the simultaneous favor of investment institutions for AI and blockchain also promotes the combination of the two to some extent.

Others: In addition to macro trading and AI, sentiment, speculation, digital art collections, and other needs will also exist in the crypto market for a long time, but the influence of these demands is much smaller than that of macro and AI.

Crypto 3.0 has actually been launched. Due to the shift of BTC to a store of value and ETH to applications, the ecological niche of the two is gradually separating and ultimately affecting investor preferences. At the moment of lack of liquidity, macro traders tend to buy and hold BTC. In contrast, AI investors tend first to prefer US stocks and then cryptos such as ETH, which has caused the correlation between BTC and ETH to decline since the beginning of 2023.

90-day price correlation between BTC and ETH since January 2023. Source: CoinMetrics

So, what profound impact will the Crypto 3.0 narrative have on BTC, ETH, and other cryptos? Let's take a bold look at their future together.

"Darling of Institutions": Why BTC?

In the contemporary financial system, the central bank is the source of liquidity for the financial market. When the central bank begins to release/contract liquidity, the changes in liquidity are reflected in real-time in the price changes of bonds, commodities, FX, and financial derivatives, as well as in the changes in stock indices.

Bitcoin has not been a new "macro club" member for a long time. However, the US government holds the largest amount of Bitcoin, and the number of ETFs that include Bitcoin in their portfolios has gradually increased, with top asset management institutions such as Fidelity among the publishers of these ETFs.

List of Bitcoin ETFs, as of Jul 17, 2023. Source: Bitcoin Treasuries

Compared with other cryptos, BTC is genuinely decentralized. The deeds of His Excellency Satoshi Nakamoto are widely known, but no one knows "who he is." However, "who he is" may no longer matter; the Bitcoin network has matured, and anyone's influence on the Bitcoin network is negligible - this "truly decentralized" attribute is also one of the characteristics of qualified macro assets. Gold and minerals are generated from the universe, agricultural products are produced by nature, and Bitcoin comes from the cyber universe of algorithms and information.

Since BTC is a product of the cyber universe, the liquidity manipulation magic of central banks does not affect it. The dollar price of BTC changes, but 1 BTC is always 1 BTC. Native crypto investors use BTC as an investment and store of value to combat inflation under the fiat standard.

For fund managers from traditional markets, they value BTC's role in Risk Diversification more. The price performance of BTC and gold has never reached a "strong correlation" level, and the correlation with the US stock indices has fallen to near 0 in 2023. At the same time, BTC belongs to a completely different asset class, which can somewhat diversify the portfolio's overall risk. The compliance of BTC is also widely recognized, significantly reducing the legal risk of investing in BTC.

Changes in the 90-day price correlation between BTC and gold from Jul 2020. Source: CoinMetrics

The correlation between BTC price and US stock indices since January 2021. Source: Block Scholes

Macro hedge fund managers pay more attention to liquidity. Their strategies usually invest in bonds, FX, commodities, stock indices, and other assets, and they prefer to trade through derivatives rather than spot; "liquidity" is the core. Macro trading requires accurate timing of liquidity movements and "entry and exit" at the fastest speed and lowest cost. As an emerging asset, with the global liquidity of the Bitcoin network and abundant derivatives, the liquidity of BTC can be comparable to that of FX.

More importantly, due to the high speed and low transaction costs brought about by the Bitcoin network and crypto infrastructure, traders can complete the deployment and exit of liquidity in seconds without constantly negotiating with numerous third-party institutions on the phone or waiting for bids to be accepted in the over-the-counter system with poor liquidity. These advantages above make BTC more sensitive to market sentiment and macro events, reflected in its price fluctuations and volatility movements.

BTC price movement from January to Jul 2023. Note the purple parts in the graph, which correspond to the banking crisis in March, the Fed rate hike in May, and the spot Bitcoin ETF submissions around Jul. Source: blofin.com

Changes in BTC DVOL Volatility Index and realized volatility levels since May 2021. It is not difficult to find that BTC's Volatility Index is more sensitive to macro changes. Source: Amberdata Derivatives

Changes in BTC DVOL Volatility Index and realized volatility levels since May 2021. It is not difficult to find that BTC's Volatility Index is more sensitive to macro changes. Source: Amberdata Derivatives

Changes in BTC DVOL Volatility Index and "Volatility of Volatility" since Aug 2022. The vol of vol in BTC moves more rapidly and sensitively compared to the volatility index. Source: Amberdata Derivatives

In short, whether it is a crypto believer, a fund manager in the traditional market, or a trader in the macro Hedge Fund, BTC meets the requirements of almost all types of investors in terms of functionality, compliance, risk management, liquidity, and trading. It is difficult to have a macro target that can meet these needs at once; in other words, BTC is a natural macro trading target.

Ethereum: A "Software Company" whose P/E Ratio Is 312.58

Crypto market investors like to compare BTC and ETH together. Regarding market capitalization, BTC and ETH rank first and second in the crypto market cap rankings, and every crypto trader will know both.

Investors in traditional markets are not. They are more cautious about ETH: leaving the possible compliance risks of ETH aside, considering the influence of Ethereum founders and developers on the development of the Ethereum blockchain, as well as Ethereum's "smart contract as a service" model, it is more like a "software company" similar to IT giants such as Amazon and Microsoft, rather than a "pure liquidity container" like the Bitcoin.

In fact, some researchers and traders have interpreted ETH using a corporate finance-based framework:

Ethereum Income Statement. Source: artemis.xyz

Then, it seems reasonable to use an analytical framework based on stock fundamentals to analyze ETH. Fortunately, due to the transparency of the blockchain itself, it is not difficult to obtain real-time supply and real-time price of ETH. Similarly, with the efforts of researchers such as Sam Andrew, we have also obtained the financial situation of the Ethereum network in a more feasible way. Let's estimate the current P/E Ratio (P/E Ratio) of Ethereum together:

Calculated from the time of official introduction of ETH into PoS, from 2022q4 to 2023q2, the total net income (USD) of the Ethereum network is: (3,959 * 1,301) + (79,210 * 1,589) + (227,147 * 1,861) = $553,735,916, equivalent to an annualized net income of approximately $738,314,555;

The average spot price of ETH (Jul 17) is around $1,920;

The real-time total supply of ETH (Jul 17) is about 120,201,013;

Therefore, the P/E Ratio for ETH = 1,920/(738,314,555/120,201,013) = 312.58.

312.58! This is an amazing P/E Ratio number. We have attached the P/E Ratio for Magnificent 7 (the seven largest tech stocks by market capitalization) in the US stock market as a comparison *:

AAPL: 32.38

AMZN: 164.24

ETH：312.58

GOOGL: 27.93

META: 38.32

MSFT: 36.92

NVDA: 207.62

TSLA: 82.76

*: The price for the P/E Ratio calculation is based on the Jul 14 closing price for stocks. The price for the ETH P/E Ratio calculation is based on the Jul 17 intraday average price.

Undoubtedly, Ethereum, as a "software company," has significantly exceeded our original expectations. Considering that it does not pay dividends and is still in the stage of rapid growth after turning to PoS, its high P/E Ratio is similar to NVDA under the blessing of AI. Compared to AMZN's P/E Ratio, as the core infrastructure provider of the crypto industry, ETH's high P/E Ratio is not difficult to understand. In summary, investors have given a high valuation to ETH and look forward to the infinite possibilities of ETH's future development.

However, while Ethereum can be completely self-consistent under corporate logic, BTC and ETH have officially gone down different paths.

Parting Ways

Where will BTC and ETH go under the narrative of "Crypto 3.0"?

BTC: Crypto Is Macro

There is no doubt that the price of BTC will depend on macroeconomic conditions and changes in macro conditions within the crypto market. Therefore, interest rates and market share will be important influencing factors for BTC. Interest rates affect expectations, while market share affects market cap size.

From the interest rate market, the Federal Reserve will not cut interest rates in the next 6 months, while the European Central Bank will not show weakness under the threat of high inflation. The above sitation means that high interest rates will continue to weigh on BTC's performance. However, some potential positive factors also support BTC price, such as the possible listing of spot Bitcoin ETFs.

The Fed's latest interest rate path forecast, as of Jul 17, 2023. Source: CME Group

In addition, the internal allocation of liquidity in the crypto market will also affect BTC price and market cap. From the beginning of 2021 to the end of 2022, due to the impact of the bull market and the "alts season," the market share of BTC gradually decreased from more than 60% to between 40% and 45%. Then, benefiting from institutional buying and liquidity return, BTC's market share rebounded from Jan 2023. By Jul 2023, BTC's market share was about 50%.

At the time of 0% interest rate, the total market capitalization of the crypto market is about $3T. At a time with a 5.25% interest rate, the total market cap of the crypto market has fallen to about $1.20T, about 40% of the highest point. Between Nov 2021 and Mar 2022, the crypto market lost nearly $1T in market cap due to the Fed's expectations management. In Mar, the Fed raised interest rates by 25 bps, at which time the total market cap of the crypto market was about $2T, 67% of the highest point.

Considering that the Federal Reserve is not expected to adopt the unlimited QE policy like 2020-2021 in the next few years, the total market cap of the crypto market due to expectation changes will not exceed $1T.

Let's expand based on the above logic.

Considering the current lack of external liquidity entering the crypto market, we assume that the future price of BTC depends entirely on changes in interest rates and market expectations and is reflected in changes in market share.

With the continuation of high interest rates and the lack of external liquidity, it isn't easy to see a significant increase in the total market capitalization of the crypto market before Jan 2024. Even if "buying in expectations" happen, in the most optimistic scenario, the expected increase in the crypto market capitalization will not exceed $500b.

The total supply of BTC is about 19.43m, and the total supply will not change significantly by more than 5% in a year.

Briefly consider 3 situations below:

Investors have no better expectations, and the crypto market capitalization is limited. The total market cap will stabilize between $1.20T and $1.40T, and the market share of BTC will not change much, remaining around 50%. The above means that the market capitalization of BTC will fluctuate between $600-$700b, and the price will fluctuate between $30,880-$36,026.

The Spot Bitcoin ETF passed, giving investors good expectations. The crypto market capitalization rebounded to around $1.50T - $1.60T.

- If the market share of BTC does not increase, the market cap of BTC will stabilize at around $750b to $800b, and the price will reach $41,173 at the highest point. Even if the rebound is not strong enough, the price of BTC will be higher than $38,500.

- If a spot ETF passes and pushes BTC's market share up to 60%. In the best case, BTC's market cap will reach $960b with a unit price of over $49,400. Even if the overall crypto market rally is not dramatic enough, BTC's market cap will rise to $900b with a unit price of $46,300.

Interest rate cuts are expected to be superimposed with positive expectations such as spot Bitcoin ETFs and Bitcoin halving, promoting the flooding return of liquidity in the crypto market, and the crypto market capitalization rebounded to more than $1.70T.

- If the market share of BTC does not increase, the market cap of BTC will reach more than $850b, and the price will rebound to more than $43,700.

- If the market share of BTC rises to 60%, the market cap of BTC will reach more than $1.02T, and the price will reach around $52,500.

In conclusion, macro factors are relatively favorable for BTC, and the peak of the BTC price mainly depends on interest rates and market expectations.

ETH: "How to Be a More Profitable Company"

Considering that BTC has become the protagonist of the macro narrative, it may be more sensible for ETH to make efforts in its application. Therefore, for ETH, the factors affecting its price mainly come from its new narrative and whether it can be widely used. Since these factors will be reflected in the net income of the Ethereum network, we can get the possible price movement of ETH based on the changes in the P/E Ratio.

Similarly, simply consider 3 situations below:

The Cancun upgrade significantly improved the Layer2 speed of Ethereum, reduced transaction costs, and promoted the outbreak of the Ethereum Layer2 ecosystem. The profitability of the Ethereum network continued, with net income increasing by 50% per quarter before the Cancun upgrade and net income doubling per quarter after that.

- Assuming no significant change in the ETH P/E Ratio, strong investor expectations drive the P/E Ratio to remain around 300. In 2023, the Net Income is $423m in Q2, $635m in Q3, and $953m in Q4. In this scenario, the total revenue of the ETH network in 2023 would reach $2.137b. Considering that ETH deflation will cause the total supply of ETH to fall to around 120m, the average price of ETH may exceed $5,300 in early 2024 and $9,700 in the first quarter after the Cancun upgrade.

- Assuming that investor expectations are more neutral, causing the ETH P/E Ratio to fall back to around 150 (close to comparable companies such as AMZN), in this scenario, the average price of ETH will reach about $2,670 in early 2024 and close to $4,900 in the first quarter after the Cancun upgrade.

The profit of the Ethereum network is relatively stable, with a 25% increase in net income per quarter. After the Cancun upgrade, the net income in 2024Q1 increased by 50% compared with 2023Q4.

- Assuming no significant change in the ETH P/E Ratio, strong investor expectations drive the P/E Ratio to remain around 300. In 2023, the net income is $423m in Q2, $529m in Q3, and $661m in Q4. In this scenario, the total net income of the ETH network in 2023 will reach $1.739b, and the average price of ETH may exceed $4,300 at the beginning of 2024 and $6,500 in 2024Q1. If the P/E Ratio falls back to around 150, the ETH price could average around $2,150 in early 2024 and break above $3,200 in 2024Q1.

The profit of the Ethereum network showed a marginal decline. The net income increase in Q3 and Q4 was 20% and 15%, respectively. The benefits from the Cancun upgrade only curbed the marginal profit reduction in 2024Q1.

- Assuming no significant change in the ETH P/E Ratio, strong investor expectations drive the P/E Ratio to remain around 300. In 2023, the net income is $423m in Q2, $508m in Q3, and $584m in Q4. In this scenario, the total profit of the ETH network in 2023 will reach $1.641 b, and the average price of ETH may exceed $4,100 at the beginning of 2024 and $5,400 in 2024Q1. If the P/E Ratio falls back to around 150, ETH could average around $2,050 in early 2024 and break above $2,700 in 2024Q1.

To sum up, the future of ETH is highly related to its profitability. The blessing of narrative, combined with sustainable and growing profitability, is the key to driving the price of ETH up, which is far different from BTC.

Junction

In fact, the "divergence" already exists not only in theory and between BTC and ETH. According to statistics, in 2023, the correlation between BTC and ETH decreased significantly, and between BTC and mainstream altcoins also decreased significantly. BTC seems to be going its own way, and the correlation between ETH and different types of coins, such as XRP, LTC, and BNB, is also weakening, but it still correlates with public chain coins and project tokens more, such as ADA and CRV.

As the correlation among cryptos weakens, the analytical logic and trading strategies previously available to reuse wholly or partially become ineffective. Pair trading no longer profits from the desired correlation regression, and the general investment framework based on market cap and tracks are no longer applicable to some extent, which means that further analysis based on the fundamentals of the project itself becomes more important.

Changes in the correlation between BTC and mainstream cryptocurrencies other than ETH, as of June 2023. Source: Kaiko

ETH correlation movement with mainstream cryptocurrencies other than BTC, as of Jul 2023. Source: CoinMetrics

It's time to analyze the crypto market by adopting two or more methods. Crypto 3.0 is here; the times are moving forward. Bitcoin will be more closely integrated with the macro economy and traditional markets, while Ethereum needs to become a "great company," and other cryptocurrencies have to go their own way. In the crypto market, where macro and microstructures are rapidly changing, we need to keep up with the pace of the times.

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"Good expectations within the market" is one of the important reasons for the latest rebound in the crypto market. However, in the absence of significant improvement in liquidity conditions, especially in the case that the "crypto balance sheet reduction" has not ended, the overall sound performance of crypto assets may not be sustainable, and "sector rotation" may be the main feature of the crypto market in 2023H2. Fortunately, BTC's performance may be more robust under macro factors, regulation, and institutional preferences.

Is the Dawn Coming?

BTC's rally seems a bit unexpected. In theory, investors should not have more optimism at a time when the SEC regulatory turmoil has just passed and the macro environment has not improved. However, investors in the crypto market have waited too long for good news, and any news could be a catalyst for a rally.

Under the low liquidity, pushing up the price does not cost much. Therefore, under the influence of good news such as "giants are preparing to enter the crypto market" and "BTC spot ETF may be approved," the price of BTC quickly rose. For HODLers, the simple "buy and hold" strategy has brought them gains several times higher than holding S&P 500 bulls. At the same time, Delta 1 bulls have also profited much from the rally. Even for the bears, due to the bullish mood, although the bear liquidation scale is more significant, did not reach a new high since Mar.

Movement of the S&P Cryptocurrency MegaCap Index and S&P 500 Index since 2023, as of Jun 28, 2023. Source: S&P Global

Change in the Delta 1 derivatives liquidation scale during 2023q2, as of Jun 28, 2023. Source: Coinglass

Investors' optimism also flooded the options market. Driven by the price increase, the preference for call options has pushed the skewness of almost all BTC and ETH options above 0, especially for BTC. As the price rises, option sellers have become the most stressed group in the crypto market: many call options have become ATM, meaning they must continue to buy underlying assets as the price rises to hedge against price changes. Option sellers have become catalysts for price increases. Subsequently, more follow-up investors bought call options, increasing hedging pressure and prices.

Change in skew of BTC options by maturities, as of Jun 28, 2023. Source: Amberdata Derivatives

Change in skew of ETH options by maturities, as of Jun 28, 2023. Source: Amberdata Derivatives

Daily trading volume of BTC options on the Deribit exchange, as of Jun 28, 2023. Source: Deribit Metrics

Many people are already anticipating the return of the bull market. Interest rates should be no longer higher than expected; inflation has fallen and is about to approach the Fed's stated target of 2%. The endorsement of the world's top asset managers is about to bring new liquidity to the crypto market. At the same time, the impact of regulation has made liquidity more concentrated in mainstream crypto assets such as BTC and ETH, which may push BTC and ETH to enter the "technical bull market" earlier.

US real-time inflation, as of Jun 28, 2023. Source: truflation.com

Weekly net inflow/outflow of funds from crypto asset management institutions, as of Jun 28, 2023. Source: Coinshares

However, the "return of liquidity" seems to be a debatable issue. Since the start of the bear market in 2022, the crypto market has experienced several brief price rallies but then slipped to lower price levels due to lower expectations and event shocks. So, will the latest rally be like previous recovery cycles, "like a meteor"?

"Crypto Balance Sheet Deduction" and Liquidity Redistribution

Let's first take a look at stablecoins in the crypto market. As a medium of exchange between crypto assets and fiat currencies, stablecoins are regarded as "cash" within the crypto market. For any asset, cash liquidity is crucial: the overall amount of cash tied to the asset is directly related to the asset's value, while changes in active cash liquidity directly affect the asset price, and the use of leverage further amplifies its influence.

For traditional markets, statistics on cash liquidity are more complex. In most cases, we can only get a rough estimate. Fortunately, due to the transparency of blockchain, we can relatively accurately measure the level of cash liquidity in the crypto market.

Changes in the aggregate supplies of stablecoins in the crypto market, as of Jun 28, 2023. Source: glassnode

It seems that the facts reflected in the chart of the overall cash liquidity level of the crypto market have deviated somewhat from investors' expectations. In fact, the process of declining cash liquidity in the crypto market (also known as "crypto balance sheet reduction") that began in Apr 2022 has not been interrupted by a brief rally in prices, meaning that the current price level lacks sufficient liquidity support, and any shock may lead to profit-taking.

So, where did the impetus for the latest rally come from? Internal liquidity redistribution, rather than external liquidity entry, is the more likely source of "rally power." The reserves of stablecoins on exchanges reveal this secret to us. Generally speaking, a decline in in-house stablecoin reserves means that investors are more inclined to exchange crypto assets for cash liquidity, driving down the price of crypto assets. In contrast, a rise in stablecoin reserves means a possible buying flow and a price rise.

Since mid-Jun, the reserves of stablecoins in major crypto exchanges have rebounded significantly, and at the same time, they have brought about a rebound in the market. Unlike in Mar, the inflow of safe-haven funds in Mar did not affect the downward trend of internal liquidity in the crypto market, which external funds mainly drove the rally. Meanwhile, the market in Jun was most likely caused by internal funds in the crypto market. Their buying promoted the rise in the prices of crypto assets such as BTC and ETH.

Change in the supply of stablecoins on exchanges, as of Jun 28, 2023. Source: glassnode

In addition, the change in the proportion of coins' market capitalization also reflects the change in the proportion of liquidity allocation. At present, BTC occupies 50% of the crypto market cap. At the same time, the proportion declined to vary degrees in mid-Jun for other cryptos, whether ETH, stablecoins, or altcoins. Considering that external liquidity has not yet returned to the crypto market on a large scale, from a compliance perspective, BTC is undoubtedly more compliant than other crypto assets, which promotes investors to convert other crypto assets into BTC.

Bitcoin dominance chart, as of Jun 28, 2023. Source: CoinMarketCap

To sum up, BTC's rise has come at the expense of the liquidity of most other crypto assets, which also partly explains why ETH and even many altcoins have not performed as well as BTC since the beginning of this year.

However, the rebound from liquidity redistribution is not a "free lunch." What is the cost?

Pin Risk

In the short term, BTC's rally appears to be one of the signs that the market is starting to turn around. But the good long-term performance of any market cannot be separated from sufficient liquidity support. Internal liquidity redistribution provides limited support; moving money back and forth between two bank accounts does not increase your total wealth. However, given that most assets in the crypto market are tied to one or more derivatives, the redistribution of internal liquidity is still a source of risk, for it may affect trading behavior in risky markets.

The "Pin risk" is one of the risks implied by liquidity redistribution. Market makers have sold many call options around the strike of $30k, which have become ITM. It doesn't seem to matter; most market makers will use delta hedging tools to control their directional exposures.

But we can't ignore that the speed of delta movement, or gamma, also significantly impacts the hedging behavior of market makers. Recall the basics in the Options 101 course: Gamma is the rate of change of delta; it's highest for at-the-money options. As the expiration date gets closer, the gamma increases non-linearly, which means that the delta will change faster and faster as the option expiration date approaches. When the delta changes slowly, the hedging size of the market maker within a certain frequency is relatively small. Still, when the delta changes rapidly, the market maker's hedging frequency and size will increase accordingly.

In situations where liquidity levels are low, frequent buying and selling by market makers can significantly impact prices. Of course, market makers don't sit still; they control gamma exposure lower than risk control thresholds through strategies such as synthetic futures (in fact, they are already doing so). But market makers may have no choice in a sudden price move (such as crypto whales' sell-off); they can only follow whales' steps to reduce gamma exposure.

Since gamma exposure will become extremely large before the expiration date, the scale of the sell-off caused by hedging gamma risk will be considerable. More than 40% of options are about to expire on Jun 30, and the current dollar gamma of BTC options has reached over $100m and is concentrated around $30k. This means that once the price of BTC falls below $30k, with every 1% downward movement in the price, market makers even need to add shorts worth $100m, which will undoubtedly put enormous pressure on the price performance of BTC.

BTC options dollar gamma level movement, as of Jun 28, 2023. Source: Amberdata Derivatives

BTC options gamma exposure distribution, as of Jun 28, 2023. Source: Amberdata Derivatives

Fortunately, "pin risk" usually doesn't happen. "Maintaining market stability before quarterly settlement" seems to have become a consensus. However, nothing is impossible in the crypto market; we still need to be careful.

After the Settlement...

After the semi-annual derivatives settlement, the 2023H2 will officially begin. Judging from the movement of gamma exposure, the positions of investors in the options market reflect some interesting implied expectations:

The decline in the price of BTC will be more limited, with a relatively small probability of falling below $28k, while the upward space is relatively large, and there is even hope for a rebound to $35k and above.

The price performance of ETH will improve compared to May and Jun, but the rebound will be limited compared to BTC. The price of ETH is more likely to be "stuck" around $1.9k. Even if there is a breakout, ETH will encounter significant resistance above $2k. However, in the event of a breakout fall, ETH will struggle to gain sufficient price support before reaching $1.6k.

Distribution of BTC options gamma exposure after settlement, as of Jun 28, 2023. Source: Amberdata Derivatives

Distribution of ETH options gamma exposure after settlement, as of Jun 28, 2023. Source: Amberdata Derivatives

If we further interpret the above expectations, it is not difficult to find that under the influence of macro factors, supervision, and institutional preferences, the allocation of liquidity has changed, and the expectations for liquidity allocation have changed. The compliance attribute of BTC has been widely recognized. Whether it is the existing liquidity within the crypto market or the new liquidity entering the crypto market in the future, the preference of institutions and retail investors for BTC may significantly surpass other crypto assets.

However, before the Fed releases liquidity again, investors' preference for BTC means there will be less liquidity for other assets. In the liquidity "zero-sum game," the emergence of some new narratives may also get liquidity from BTC and cause BTC's short-term sluggish performance.

Given the current level of market depth, the shift in liquidity may bring about a "sector rotation" effect similar to that in the stock market. Some crypto assets will perform well in the short term, while others will underperform due to the withdrawal of liquidity. But what can be expected is that the good performance of each part is temporary - like a meteor; this may be one of the new characteristics of the crypto market that we will face and adapt to. Let's follow the changes in liquidity together and welcome the arrival of 2023H2.

The SEC's lawsuit against Binance and Coinbase undoubtedly increases the regulatory risk of the crypto market. Still, the regulatory risk is mainly concentrated on altcoins investors, which has a limited impact on holders who only hold BTC and ETH.

However, Once the SEC lawsuit is successful, all altcoins may be recognized as securities and need to be regulated by securities standards, which means that the trading of altcoins will be more offshore and decentralized. Moreover, liquidity will be more concentrated in BTC, ETH, and other mainstream cryptos.

Author: Matt Hu

"This Glass of Water Is Like Security"

As an emerging global market, regulatory authorities and their actions have never been lacking in the crypto market. Whether to control a series of risks contained in it or for other purposes, the regulatory authorities of various countries hope to gain some voice over the crypto market through supervision.

The frequent actions of the regulatory authorities have also become one of the critical sources of additional uncertainty in the crypto market. The regulatory in May 2021 interrupted the last bull market for nearly two months, and in 2023, the regulatory storm seems to be coming back - this time by the SEC.

Before the SEC took action, the CFTC had already sued some exchanges for "violations." In the indictment, the CFTC accused the exchange of providing derivatives trading services without registration and assisting customers in evading regulation. This does not appear to have impacted investors; they can trade on compliance or offshore platforms. Money in the crypto market is global and comes and goes as it pleases.

The SEC's indictment adds perhaps the most significant element to the previous list: the illegal offering and sale of unregistered securities and financial products by certain exchanges. At worst, the charges against the exchanges will push investors to withdraw their funds or move to other exchanges. However, the charge of "unregistered securities and financial products" means that the SEC treats token assets held by users, especially altcoins, as "unregistered securities" and cannot list or sell them on exchanges and trading platforms. A total of 68 tokens have been recognized as securities by the SEC , including all categories from public chain tokens, exchange tokens, and project tokens - except for BTC and ETH.

Wow, that is not a small case. Let's think about the possible consequences of a successful SEC prosecution:

1. The SEC has gained regulatory authority over tokens other than BTC and ETH. "The 68 tokens being recognized as securities" is just the beginning. Any other tokens intended to be listed on CEXes or already traded on the DEXes may be compared by the SEC to these 68 tokens and considered "securities" based on their similar properties to these tokens, requiring them to be regulated.

2. Any trading platform with US operations may be sued and fined for listing certain "non-compliant" tokens. Even if these trading platforms are offshore, the SEC may invoke previous successful litigation cases to enforce financial sanctions against them.

3. Due to "compliance requirements," centralized exchanges may choose to strictly review the publishing of tokens or abandon altcoins to obey the requirements, making financing through ICO/IEO more difficult.

In fact, the SEC's battle for the crypto market regulation power may not stop there. In 2018, MIT professor Gensler said ETH is "not a security." Still, in April 2023, SEC chair Gensler stated that "most crypto assets are securities" and refused to answer "whether ETH is a security." Considering that the CME has been listed ETH futures and options for a long time, Gensler and the SEC may not make a statement in the short term, but once more support is received, the SEC will not rule out the possibility of identifying ETH and even BTC as securities. After all, even the business of selling oranges needs to register with the SEC.

But regardless of whether altcoins are securities, the SEC's lawsuit has significantly impacted the crypto market. Online trading platforms such as Robinhood have announced the delisting of altcoins identified as "securities" in the SEC indictment, triggering panic selling by investors. Market makers have chosen to withdraw liquidity from the altcoins and US crypto markets under the threat of compliance risks. As a result, the market depth available to US retail investors has dropped by a quarter in just one week.

Market depth changes of altcoins and BTC of US crypto exchanges from Feb to Jun 2023. Source: Kaiko

Changes in market depth of US crypto exchanges since the beginning of 2023. Source: Kaiko

Although BTC and ETH have not been recognized as "securities" for now, and have become "safe havens" for liquidity from altcoins, are altcoins securities? Let's use the SEC's criteria for determining securities to make a quick judgment.

Is This Glass of Water a Security?

The SEC's standard for determining "whether a product is a security" dates back 77 years to 1946. Let's leave aside the rationality of the standard established before all modern financial products; the law is the law.

The criterion is named the "Howey Test" -- the name comes from the SEC's lawsuit against a company that makes a living buying and selling oranges. In the lawsuit, the SEC determined that the company's "citrus planting agency contract" was an "investment contract" that met securities standards and should be regulated. To illustrate, then-Justice Frank Murphy established the following criteria to define "security":

Investment of Money: The buyer should provide funds to the project initiator through cash as a form of consideration.

Common Enterprise: The wealth of each investor is tied to the fate of other investors, usually combined with the proportional distribution of profits. Whether investors can obtain benefits depends on the efforts of the project initiator. The benefits of investors and the efforts of others are combined with the final operating results.

Expectation of Profit: The "profit" here can be the capital appreciation generated by the initial investment or business operation or the income generated using the funds provided by the buyer. The appreciation caused by external factors such as the general inflation trend or economic development affecting the supply and demand of underlying assets does not belong to "profit."

Derived From The Efforts of Others: The project initiator, organizer, or other related third party has made necessary management efforts, and this effort will critically affect the success of the business. Investors only need to pay the specified fees and costs and do not actually participate in the operation and management of the project.

Let's use this framework to judge crypto.

The trading and settlement of cryptocurrencies are usually conducted in BTC, ETH, and stablecoins and are sometimes anchored to other tokens. BTC and ETH are not cash; stablecoins are not sovereign currencies issued based on national credit but synthetic targets based on underlying assets such as bonds, more like the existence of "banknotes." Therefore, this does not meet the definition of "investment of money."

So, will investors who purchase cryptocurrencies receive dividends? Unlike securities in the usual sense, cryptocurrencies do not provide dividends. Crypto holders may have voting rights or some discounts. In addition, due to decentralization, the benefits obtained by investors are not necessarily related to the efforts of the project initiator or the final operating results. "Emotion" and "speculation" may have a relatively greater impact on investment returns. Perhaps some attributes of cryptocurrencies are linked to "common enterprise," but most cryptos do not have such features.

From the perspective of expected returns, most altcoin investors get their returns from external factors, such as tokens being listed on major exchanges, market recognition of new concepts or narratives, and even the discovery of speculative opportunities rather than initial investments and business operations. The impact of market makers on investor returns cannot be ignored. As of June 2023, the proportion of derivatives trading volume in the crypto market has exceeded 75% of the total trading volume, and the market-making and hedging behavior of derivative market makers has a continuous and significant impact on prices. Compared with this, "the efforts of project operators" are not even the main influencing factor.

Comparison of the total in-house spot trading volume and derivatives trading volume. Source: TokenInsight

Similarly, because most of the factors that affect altcoin returns come from external factors (macro liquidity, emotion, speculation, etc.), the management of project initiators, organizers, and affiliates may not play a critical role. In addition, since the operation of the crypto community usually adopts the DAO model, investors holding altcoins have the right to participate in the operation and management of the project.

In fact, investors play a key role in the operation and management of the project: community voting by token holders will directly determine the future of the project, and anonymous developers and contributors from the community have made indelible contributions to the operation and maintenance of various projects, and these people are investors and participants in the project. The success or failure of the project depends on the community's joint efforts, and of course, the impact of the macro environment cannot be ignored. Still, it can be sure that the crypto market will not develop to its current level only through the efforts of project initiators.

Therefore, altcoins seem like "securities"; however, most altcoins do not meet Howey Test's criteria. Perhaps some altcoins can be judged as "partially meeting Howey Test," but this cannot define them as securities. The genetic similarity between humans and corn is close to 50%; however, it is evident that humans are not corn.

If Water Is Eventually Recognized as a Security...

Although we have proven through many facts that "altcoin is probably not a security," we must prepare for the worst.

If the SEC ultimately prevails (which may take several years or even a decade), altcoin issuers and liquidity providers will face unprecedented difficulties. Before passing a Howey test, the US financial and banking systems will not provide services to high-compliance-risk clients represented by web3 project teams; they must choose other systems. In addition, even if the project's tokens are temporarily not considered securities, compliance issues will still accompany a series of links such as token issuance and trading.

Places like Hong Kong, Dubai, and South Korea may be viable choices; the regulatory authorities in these places are more friendly to the crypto market. However, compared with the U.S. market, the service level and financing scale that can be provided by regions such as Hong Kong still have a lot of room for development. However, the replacement of financing channels is undoubtedly a good thing for the landing place. For the crypto market, this means "internal rebalancing"; the dominant position of North America in the crypto market may be weakened.

For another important participant in the crypto market - asset management institutions, the altcoin investment portfolio that once brought them considerable returns has become a "hot potato." Leaving aside the losses caused by high volatility, compliance risks alone can make them decisively choose to close all altcoin positions. In fact, after the SEC's lawsuit, investors have withdrawn from fund managers who manage altcoins; some altcoins portfolios lost 65% of assets under management (AUM) within a week, and the weekly outflow scale of funds from major crypto asset management institutions has reached $39m.

Fund netflow of crypto asset management products. Source: CoinShares

Of course, institutions will not necessarily give up altcoins. Holding OTC return swaps on altcoins does not violate compliance requirements (as long as the counterparty agrees); likewise, having index futures and options on altcoins is a viable option. It can be expected that for some crypto-regulatory friendly areas, altcoin-related indices and derivatives seem profitable. However, before this happens, altcoins may temporarily "retreat behind the scenes" in institutional portfolios - this is difficult to avoid.

Comparison of decentralized and centralized exchanges' spot trading volume, as of June 2023. Source: The Block

For retail investors, compliance does not seem to be a problem; they are more willing to hold crypto assets rather than bank accounts. Therefore, for retail investors, offshore and on-chain markets are acceptable; they can trade anywhere. Retail investors have actually been voting with their feet; additional regulatory risks for centralized exchanges are pushing investors towards decentralized exchanges. With more regulation events, we may witness further development of on-chain markets.

Changes in market share of major crypto assets, as of June 2023. Source: Coinmarketcap

But overall, regardless of whether altcoins are securities or not, the impact of risk aversion is long-term. Although institutions and retail investors have a variety of channels to avoid compliance risks, compliance itself is a risk—it protects investors while increasing the trading costs of all investors, and the consequences are already beginning to show. Retail investors and institutions are regaining their preference for BTC and ETH, while altcoins are being neglected, and their share continues to shrink.

In addition, the crypto market's liquidity pressure is increasing in the current macro environment. BTC, ETH, and stablecoins are currently the safest liquidity destinations for crypto investors. The altcoin bear market may last long, and we must be prepared for it.

The lack of liquidity in the crypto market became more severe in June. Continued liquidity pressure, shifting narratives in risky asset markets, and declining uncertainty levels in the crypto market are the main reasons for the "drought" in the crypto market.

In the case that spot and perps trading is difficult to bring significant income expectations, investors' preference for alternative strategies, especially those for selling volatility strategies, further depresses market volatility in the context of low liquidity.

The uncertainty of the June rate hike may bring some liquidity to the market. Still, the lack of liquidity in the crypto market will continue until the interest rate hike cycle officially ends.

There Is No Worst, Only Worse

Entering June, although the hottest time of the year has yet to come, the crypto market has already suffered from the market liquidity shortage for a long time. The in-house spot trading volume in May hit a new low since Dec 2020, while the average daily in-house volume was even on par with the volume in Christmas and New Year holidays.

Cryptocurrency monthly in-house trading volume changes. Source: The Block

Daily in-house volume changes, as of Jun 2, 2023. Source: The Block

The sluggish trading volume has kept the realized volatility of mainstream crypto assets persistently low. Market volatility in May is usually higher than in April, as lots of macro data and major economic meetings' decisions are typically released in May rather than April.

The law was broken in this year: the resolution of the debt ceiling and the arrival of interest rate peak were already priced in. Even though dovish speeches from Fed officials raised the probability of a pause in interest rates in June, traders' expectations for interest rates have not changed significantly. No new expectations mean volatility is difficult to generate. Given how closely the crypto market is related to the macro economy, the current performance does not seem incomprehensible.

Comparison of 7-days realized volatility and implied volatility levels for BTC from April to date. Source: Amberdata Derivatives

Comparison of 7-day realized volatility and implied volatility levels of ETH from April to date. Source: Amberdata Derivatives

The expectations of Fed interest rate changes. Source: CME Group

In addition, the rise of the concept of AI has made speculative liquidity more inclined to choose US stocks rather than the crypto market. As one of the macro trading tools, the macro fundamentals faced by BTC have not improved. In comparison, a bet on NVDA can allow them to obtain an absolute gain of more than 20% immediately when the financial report is released (regardless of leverage). In contrast, Bitcoin, "once a highly volatile asset," was down more than 5% in May amid near-low volatility.

Comparison of price changes between BTC and NVDA in the past month. Source: Tradingview

Liquidity providers are rational: Many institutions and high-net-worth investors have begun to cut their positions in the crypto market in the face of difficulty in obtaining excess returns. According to Coinshares, the crypto market has experienced six consecutive weeks of outflows since May, and crypto fund managers have lost nearly 1% of their AUMs under management in a month or so.

Weekly inflows/outflows from crypto funds, as of June 2023. Source: Coinshares

Ouroboros

Schematic of the financial market "Ouroboros Cycle." Source: Artemis Capital Management

For investors who have the flexibility to deploy their funds as needed, they can deploy their funds to invest in other markets when the crypto market is hard to earn. However, many traders rooted in the crypto market, such as portfolio managers of crypto funds, must "find a path from the dead zone"; liquidity providers want them to earn in the crypto market rather than in other markets.

In the absence of price movement, portfolio managers must consider flexibility. Because markets are stable, selling tail risk at a profit seems reasonable: according to "simple probability logic," a "Black Swan" event in which prices move significantly beyond expectations does not happen for months, a year, or even years. Options provide investors with a tool to trade tail risk. For buyers, their portfolios receive tail protection; for sellers, stable cash flow returns allow them to be accountable in their client's eyes.

As a result, trading based on selling volatility has become one of the essential sources of income for crypto investors in 2023, and this selling volatility operation forms a suppression cycle for volatility:

The significant increase in option sellers has led to a relative imbalance between supply and demand. Option sellers are willing to accept relatively low bids to speed up trading.

As the seller's ask prices decrease, the buyer also begins to lower the bid, and the implied volatility declines. At the same time, crypto whales have also gradually accepted relatively low buyer bids, driving implied volatility further downward.

The impact of selling volatility can be seen directly in the variance premium (the difference between the realized and implied volatility). The variance premium is significantly higher in both 2021 and 2022 compared to 2023, which means a significant reduction in the profitability of selling volatility.

Changes in the variance premium between BTC and ETH from May 2021. Source: Amberdata Derivatives

In addition, since investors mainly sell volatility, option market makers have gradually transformed into relative volatility buyers (holding positive gamma). When hedging, volatility buyers usually tend to "buy low and sell high," that is, by buying the underlying assets at a low level and selling at a high level to hedge the risk of price changes.

When liquidity is abundant, option market makers have a limited impact on prices; when liquidity is scarce, option market makers, one of the few "active players" in the crypto market, significantly impact the market and further reduce market volatility.

Showers

How long will the drought in the crypto market last? It's hard to tell. Affected by the poor macro environment, it is certain that liquidity in the crypto market will still be challenging to recover before the end of 2023. In fact, liquidity has not stopped leaving the crypto market; compared to April, the in-house stablecoin supply has fallen again, meaning a deterioration in cash liquidity.

YTD changes in the level of in-house cash liquidity, source: glassnode

Fortunately, macro uncertainty can still bring some liquidity to the crypto market. Due to the Fed's emphasis on "making final decisions based on data," a series of macro data in June and July will also become the essential basis for investors in the crypto market to trade, especially the CPI data, while the June and July Fed meetings may also bring some good trading opportunities.

However, on the whole, the liquidity accumulation brought about by macro events is like a "shower" and does not play a role in alleviating liquidity pressure. In the absence of new expectations, investors' enthusiasm for trading has decreased significantly, and investors tend to wait and see. A small amount of liquidity will not relieve the "drought" in the crypto market before the end of the interest rate hike cycle; we still have to wait.