Market Shrugs at Hot CPI

The latest Consumer Price Index (CPI) data indicated a hotter inflationary environment than forecasted for February. Despite the surprise in the numbers, market participants appeared largely unmoved, suggesting that the potential impact had already been factored into their calculations prior to the release.

This resilience reflects a broader sentiment that a rates-driven selloff, in response to the CPI figures, is not a significant near-term risk. This interpretation is further supported by the modest adjustment in the Fed funds futures market, which saw an increase of merely 10 basis points in the anticipated fed funds rate for December.

The prevailing market demeanor implies a notable shift in expectations, with investors increasingly inclined to trust the Federal Reserve’s guidance. As we have noted in prior notes, the burden of proof, it seems, has now shifted towards the hawks to demonstrate a resurgence in inflation, rather than on the doves to prove its decline.

Real Near-Term Risk: Tax Season

Below we see that the Fed Liquidity metric that we like to track for domestic liquidity conditions has remained high, bolstered by a 20% YTD drawdown in the Reverse Repurchase Agreement (RRP), which enhances the reserves within the banking system. This movement signifies capital transitioning from the Federal Reserve’s banking account into the commercial banking sector.

While this doesn’t directly increase the broad money supply in the economy, it does elevate reserves, fostering a better-capitalized banking system that’s more conducive to lending and supportive of overall risk assets. This effect has been marginally counterbalanced by QT and tax receipts flowing into the Treasury General Account (TGA). It’s important to note that tax payments to the TGA withdraw capital from the banking system (bad for risk) whereas government spending from the TGA reintroduces capital into the commercial banking system (good for risk).

As tax season approaches, following a year where both the economy and market showed strong performance, we anticipate a significant increase in deposits into the TGA. This expectation is further bolstered by the likelihood of many investors liquidating assets to settle unexpected tax liabilities. Our observations also indicate a clear seasonal pattern associated with the TGA, where March and April traditionally experience a rise due to higher tax receipts relative to government expenditures. It’s doubtful that the current rate of RRP drawdown will fully counterbalance this uptrend.

This dynamic represents the near-term risk we identify for the crypto market. However, as we will update everyone on below, the current flows dynamic could make this a nothingburger.

Flows Continue to Be Positive

Macro factors are important to monitor as they can affect the level of flows, but ultimately, if more dollars are buying BTC as opposed to selling, naturally, price will benefit. The ETF flows have been the best proxy for this supply/demand dynamic, and they have continued to impress.

Monday March 4^th through Tuesday March 12^th saw net inflows into ETFs of over $3.8 billion. This is a serious amount of capital and is merely a continuation of a pattern that has been ongoing for some time. While there have certainly been plenty of sellers in the $69-$72k area, which is understandable, given that is just above where the previous ATH was, the amount of supply changing hands in the near-term lifts the cost basis of the overall network higher, and creates a quasi-level of support for prices.

Thus, we would caveat any of our thoughts on the TGA that we discussed above that we would need these exogenous flows from outside the crypto native ecosystem to slow to truly be concerned about a near-term pullback.

Capital flows are also positive on the stablecoin front. We see below that capital has been entering the crypto ecosystem at a blistering pace, The total stablecoin market cap is now nearing $146 billion in total.

ETH ETF Approval Odds Down to 40%, Favor ETH Over ETHE

At the start of the year, our assessment of ETH ETF approval odds by May 23rd was roughly akin to a coin toss. Our reasoning hinged on Blackrock’s involvement, which, with its nearly impeccable track record in ETF application approvals, seemed promising. However, Gensler’s remarks post the approval of the spot BTC ETF hinted at a potential politically motivated rejection of a spot ETH ETF, in contrast to what should have been a straightforward approval.

We speculated that the SEC might not rely on the correlation argument previously used to reject BTC ETFs. Instead, they might pinpoint a different issue, possibly the trading volumes of ETH in DeFi or another characteristic unique to smart contract platforms, citing concerns over potential manipulation.

Fast forward to today, Bloomberg’s ETF experts have signaled growing skepticism regarding the approval, adjusting their expectations to a 35% chance for a May approval. Given their accurate predictions during the spot BTC ETF process, this adjustment is a noteworthy indicator.

However, the key takeaway shouldn’t be perceived as bearish for ETH. In our view, the potential market impact of an ETH ETF is less significant compared to the BTC ETF, mainly due to lower institutional engagement. This difference is starkly illustrated in futures volumes on the CME, the preferred platform for U.S. institutional traders seeking leveraged exposure to BTC and ETH. As of Monday, March 11th, BTC futures boasted an impressive $11 billion in open interest, in stark contrast to ETH futures, which, while still noteworthy, posted a significantly lower $1.4 billion.

In summary, ETH ETF approval odds by May are lower, but we remain bullish on ETH the asset. This means that in our view, one should favor spot pure spot ETH and ETH-beta exposure over ETHE, which, since we recommended it, has performed remarkably well, closing its discount to 10%. Should the SEC deny the ETF in May, there will likely be an opportunity to add ETHE back at a greater discount to NAV.

Removing ARB and Adding IMX and RON

The Ethereum network successfully completed the Dencun upgrade yesterday, which should lower fees on L2 networks by 10x. This is certainly considered bullish for L2 adoption, and should be a tailwind for Arbitrum and Optimism, both components of our Core Strategy, however, as we have discussed in recent notes and videos, ARB has a massive unlock upcoming, which should double the circulating supply. It is often difficult to project token performance following cliff unlocks, as many constituents may have already sold their tokens in OTC transactions, or the unlock may be completely priced in. However, given the sheer size of this unlock, we think that it is right to derisk, removing ARB for the time being from the Core Strategy, and adding some exposure to gaming platforms, which, anecdotally, appear to be garnering more attention. We are also inclined to reduce OP exposure, merely due to its 4x runup into the Dencun upgrade and some possible profit-taking post Dencun.

Our choices for gaming exposure include Immutable X (IMX) and Ronin (RON).

Immutable X

Immutable X (IMX) is a Layer-2 scaling solution for NFTs on Ethereum, utilizing Zero-Knowledge Rollups to achieve scalability and support up to 9,000 transactions per second. IMX, an ERC-20 utility and governance token, is used to pay transaction fees and incentivize both users and developers on the platform. Key features of Immutable X include Layer-2 ZK-Rollup technology and a REST API, enabling developers to build NFT applications more efficiently. The protocol was developed by Robbie Ferguson, Alex Connolly, and James Ferguson and launched by the NFT technology company, Immutable, in 2018

Technological Components:

• Security and ZK-Rollups: IMX emphasizes security as its paramount feature, leveraging zero-knowledge (ZK) rollups for scalability without compromising Ethereum’s security. This approach supports EVM compatibility, allowing developers to easily migrate or create games on Immutable X.
• Global Order Book: Aims at resolving liquidity fragmentation across marketplaces by allowing assets to be listed in one venue and purchased from another, facilitating better asset prices and liquidity management.
• Immutable Passport: A wallet solution designed to enhance user experience by enabling easy onboarding with self-custodial features and interoperable funds across games, ensuring users don’t need to deal with complex crypto wallet setups.
• Gas Sponsorship: Immutable X addresses the challenge of gas fees by allowing game developers to cover transaction costs on behalf of their users, ensuring a frictionless gaming experience.
• Cross-Rollup Liquidity: Ensures assets listed for sale on any supported rollup can be bought on any other, promoting seamless asset transfers and enhancing liquidity across the ecosystem.

Token Function:

• Transaction Fees and Network Operations: A portion of every transaction fee on the Immutable X platform is payable in IMX tokens. This system ensures that the token is fundamentally integrated into the platform’s operation, fostering demand for IMX as the network’s usage grows.
• Staking Rewards: Users can stake their IMX tokens to contribute to the security and efficiency of the platform. In return, stakers receive rewards, which can include a share of the transaction fees generated on the platform. This mechanism incentivizes token holders to actively participate in the network’s health and growth.
• Governance: IMX token holders may have a say in the future development of the Immutable X platform, including decisions about feature developments, upgrades, and changes to the protocol. This gives the community a stake in the platform’s direction, aligning the interests of users, developers, and stakeholders.
• Developer and User Incentives: The Immutable X ecosystem can use IMX tokens to incentivize behavior that contributes positively to the platform. This might include rewards for developers who build popular games on Immutable X or for players who engage actively with those games.
• Ecosystem Grants and Funding: Part of the IMX token supply is allocated for ecosystem development, such as grants for game developers, marketing initiatives, or partnerships that drive growth and adoption. This ensures that there are resources dedicated to expanding the platform’s reach and utility.

Examples of Adoption:

• Games: Guild of Guardians, Gods Unchained, Illuvium, Embersword, and War Riders are examples of games built on Immutable X.
• Partnerships with major gaming companies: Mentioned partnerships with notable industry players like Ubisoft, indicating broad industry interest and the platform’s potential to support major gaming titles.

Since Transitioning from Starkware-enabled rollup to a zkEVM in January, we have seen adoption move steadily higher, a sign of both games migrating to the zkEVM as well as new games building.

From a token supply perspective, while there is still a decent amount of supply to come online (about 30%), it will be vesting linearly, with no cliff unlocks set to hit the market.

Ronin

Ronin (RON) is an EVM-compatible blockchain, specially designed for gaming applications. Developed by Sky Mavis, the creators of Axie Infinity, it has facilitated over $4 billion in NFT transactions and supports millions of daily users. Ronin sets itself apart by offering near-instant transactions and minimal fees, making it an ideal platform for Web3 games. Its exceptional blend of scalability, security, and gaming optimization establishes it as a premier blockchain in the rapidly growing Web3 gaming industry.

Technological Components:

• EVM Compatibility: Ensures seamless integration with Ethereum-based applications and smart contracts.
• Consensus Mechanisms: Began with Proof of Authority (PoA) for efficient and quick transaction validation by trusted validators. Later, it transitioned to Delegated Proof of Stake (DPoS) to improve decentralization, enabling RON token holders to become validators or delegate their stake.
• Security Measures: Adopted stringent security protocols in response to the Ronin Validator Breach, including comprehensive code reviews and audits. Also introduced slashing rules to deter and penalize malicious actions by validators.
• Scalability: Engineered to support high transaction volumes with minimal fees, ideal for games with millions of daily active users.
• Node Infrastructure: Accommodates diverse types of nodes, including validator, non-validator, archive, and bridge operator nodes, to uphold network integrity and support cross-chain transactions.
• Ronin Bridge: Enhances interoperability within the blockchain ecosystem by facilitating asset transfers between Ronin and other EVM-compatible chains. Although we will say that the Ronin bridge could be more interoperable as the only current route on and off the network is via ETH mainnet.

Token Function:

• Transaction Fees: RON is used to pay for transactions on the Ronin blockchain, facilitating smooth and efficient operations within the ecosystem.
• Governance: Token holders can participate in the governance of the network, influencing decisions such as updates to the protocol and the election of validators.
• Staking Rewards: Users can stake RON tokens to support network security and operations. In return, they receive staking rewards, incentivizing their participation and investment in the ecosystem.
• Validator Incentives: Validators are required to hold and stake RON to participate in the process of validating transactions and securing the network. They earn rewards in RON for their contributions.
• DeFi Applications: RON enables various decentralized finance (DeFi) applications within the Ronin ecosystem, offering users opportunities for lending, borrowing, and earning interest on their digital assets.
• Ecosystem Development: The token is used within the Ronin ecosystem to fund and support new projects, games, and applications, driving growth and innovation.

Addressing the Elephant in the Room:

The Ronin Bridge hack in March 2022 resulted in a significant security breach where attackers stole approximately 173,600 Ethereum (ETH) and 25.5 million USDC, totaling around $625 million. This incident was attributed to a sophisticated social engineering attack rather than a direct technical vulnerability in the Ronin blockchain. The hackers gained control over the majority of validator nodes by compromising the security protocols, allowing unauthorized transactions. In response, Sky Mavis, the developer behind Ronin, implemented enhanced security measures, including code audits and stricter security protocols, and committed to reimbursing affected users while working to prevent future incidents. While it would seem to us that this occurrence would make security top of mind for the Sky Mavis team, it is important to understand that a social engineering attack like this remains a tail risk here.

Examples of Adoption:

• Top games on Ronin: Pixels, The Machines Arena, Battle Bears Heroes, Apeiron.
• Usage Growth: The charts below speak to the recent parabolic growth that Ronin has experienced.

On the token supply front, only about half of the total RON supply is circulating. However, much like IMX, there are no major cliff unlocks in the token’s vesting schedule.

Core Strategy

Flows into the crypto ecosystem remain strong. The market is still being led higher by BTC, which is a generally healthy sign for a crypto market rally. We view the next near-term risk for a pullback to be increased tax receipts and concurrent asset sales as we approach tax season. However, should the deluge of capital pouring into the crypto ecosystem continue, any dips could be shallow. Following the successful Dencun upgrade, we are reducing exposure to ETH L2s and adding exposure to different ETH beta and gaming ecosystem tokens in RON and IMX. We think it is right to continue to lean into the continued strength in SOL and remain allocated to STX through the Nakamoto upgrade in April. Reminder that Core Strategy changes are featured at the bottom of every strategy note.

A brief summary of the theses behind each component of the Core Strategy/Active Trades:

• Bitcoin ($BTC): Censorship-resistant money that serves as a liquidity sink in developed markets and base layer money in the global south. It is provably decentralized and can be used to build out a more robust, green energy grid throughout the globe. Potential catalysts include the halving (April 2024).

• Ethereum ($ETH): Distributed internet architecture whose proven use cases include the distribution of fiat currencies on global rails and a venue through which one can exchange digital assets globally in a permissionless fashion. Potential to supplant rent-seeking intermediaries via immutable smart contracts and digital ownership rights.
• Solana ($SOL): The monolithic competitor to Ethereum’s layered strategy. High throughput L1 relying on the eventual reduction in hardware costs to scale. Goal is to be a global shared state operating at the speed of light.
• Optimism ($OP): As ETH looks to scale in layers, more applications and users will migrate to layer 2 networks.
• Stacks ($STX): A bet on the development of a bitcoin economy. Key catalysts include the bitcoin halving and the Nakamoto upgrade in Q1 2024.
• Helium ($HNT): DePIN is an emerging theme in crypto that we think is bound to make waves in traditional markets. Helium is a leader in this category and has shown signs of early traction in its 5G product. Helium also adds Solana beta to the portfolio.
• Immutable X ($IMX) & Ronin ($RON): Both networks have displayed impressive traction and are poised to be the category leaders among crypto gaming platforms. As appendages of the ETH ecosystem, they also offer a different flavor of ETH beta.
• DOGE ($DOGE): Given (1) the return of animal spirits in the crypto market, and (2) two impending space missions with connections to DOGE, we think it is an opportune time to think about developing a position for a near-term (1-3 month) trade.
• Filecoin ($FIL): Despite its recent rally from $5 to $8, FIL remains 96% below its ATH. With several narrative-based and fundamental tailwinds at its back, we think that FIL presents a compelling short-medium-term trade at these levels. Narrative-driven tailwinds stemming from the integration with Solana, alongside the potential fundamental boosts from liquid staking, instill a degree of confidence in the risk/reward proposition of FIL over the next 1-3 months.