Wall Street renowned investor Howard Marks, also the co-founder of Oaktree Capital, once said, “Unfortunately, the greater fool theory only works until it doesn’t. Valuation eventually comes into play, and those who are holding the bag when it does have to face the music.”
For crypto markets, it is usually Ethereum that is seen as something of a great pretender to the original Bitcoin though even the fast-growing lending market, be it centralized or decentralized, is sometimes seen as a gimmick. What we know from traditional capital markets is that access to cheap money, vanilla lending products and especially more exotic products tends to encourage speculation, asset bubble formation and overcrowded trades.
The DeFi and CeFi market has been exhibiting a steady growth rate and yet Ethereum has performed somewhat below par and some are beginning to question whether the very market that is booming on the back of Ethereum blockchain is also suppressing its valuation. The first sign of bears using DeFi to short ETH would be a spike in ether loans – short sellers would borrow ETH to sell it. What is interesting is that by the closing stages of Monday trade in London, the composition of loans originated over the course of 7 previous sessions was as follows – 76% DAI, USDC 13%, Ethereum closely followed at 11%. In terms of protocols, dYdX lead the way, albeit marginally at 39%, with Compound v2 at 38% and Maker at 23%. In comparison, in mid-August, the composition was much more tilted towards USDC which accounted for around 20%, with Ethereum at 9% and DAI at 71%. In other words, DAI being used as collateral increased, the number of ETH loans increased marginally while USDC loans fell as reference rates declined to a 1-month low.
The use of dYdX is also something to keep track of, as it is geared toward experienced traders and lets users lend, borrow, or margin trade any supported asset (as of May 2019: ETH, Dai, and USDC, with more planned). Traders can take leveraged long positions of up to 4x the value of their collateral (3x for shorts). Loans and margin trades can remain open for a max of 28 days, after which they’re automatically closed out.
As pointed out in the past, factually speaking, there are several reasons that will cause the contango to collapse. For one, interest rates would have to decrease substantially (indirectly applicable in crypto but worth keeping an eye on the lending market). Another reason for such a move is so-called “delivery concern”. When a producer, dealer, or speculator is short the front month, come expiration, it has a choice whether to make delivery or not. If not, the holder essentially needs to cover shorts and lease/borrow the asset from someone else and/or roll your shorts to a back month. Most interestingly, the Commitment of Traders (COT) report by the CME shows a steady unwind of shorts in the “other reportable” category, with short positions falling from the June peak of 1,967 to 1,131 in the latest report, whereas longs are also down from 490 to 309.
Thank you for reading,
The BeQuant’s Analytics team