Part 3: The harsh reality of the crypto casino


Both parts 1 and 2 of this series articulated the promising rationale behind why Bitcoin or Ethereum could receive institutional adoption due to their theoretical abilities to act as ‘haven’ assets.

These bull theses are interesting and often poorly understood. The lack of understanding behind why anyone was buying these assets in the first place was my primary motivation for presenting the bull theses first; as I believe you cannot provide a well-considered counter argument without appreciating the opposing perspective.

However, my own personal allegiance lies with the bears — at least for the short to mid-term — but for reasons deeper than the traditional ‘hot take’ that “if it can’t be seen or felt, it has no value”.

I promised from the beginning that this article series would first present the bull theses, and then quickly get bearish. In some ways, it is a shame that this article series which I have worked on for a couple months is ending at a time when the analysis will appear retrospective; but in any case, it is done, so I think it is worth sharing.

Anyway, time for some FUD (Fear, Uncertainty and Doubt).

If you don’t act like a haven, you’ll never be one

The below graph shows the 40-day correlation between Bitcoin and the tech-heavy NASDAQ 100 index since Bitcoin’s creation in 2011 up to April 11th of 2022.

Source: Bloomberg, as of April 11th

Since mid-2020, the correlation between Bitcoin and the NASDAQ has grown to concerning levels. It is already high at approximately 0.70, and its trending upwards. Correlation coefficients range between -1 and 1, with a correlation of +1 indicating that two assets have a perfect positive linear relationship and a correlation of 0 indicating no relationship exists at all.

It is not just Bitcoin either; given Ethereum and Bitcoin have a long run historical correlation coefficient of 0.85, the observed correlation between Bitcoin and the NASDAQ is also true for Ethereum and the NASDAQ.

Why are Bitcoin and Ethereum, assets that are supposed to be vying for the title of ‘digital gold’, showing such strong linear relationships with the share prices of high growth companies like Facebook and Amazon? There are at least three compelling explanations:

1. Shared Interest Rate Sensitivity

Tech stocks don’t like high inflation because the typical response from central bankers when inflation runs too hot is to “tighten” monetary policy. This pushes rates higher, making money more expensive to borrow. When money is more “expensive” the value of companies which are expecting to be most profitable far into the future declines, as the value of having money today increases.

In Part 1 of this series, we discussed how central banks printed a ludicrous amount of new money to stimulate their economies during the pandemic. Ultimately inflating the M3 supply in the US by 26% in a single year. This money printing caused many people to purchase Bitcoin in anticipation that more money in the system would pump up asset prices — especially those which theoretically should benefit from a weakening US Dollar. The same money printing and low interest rate environment also boosted the valuations of high growth tech stocks favored by retail traders.

As monetary policy tightens, the growth of money supply decreases and interest rates increase. For the price of Bitcoin, this has a dual effect:

1. People reduce their exposure and sell assets like Bitcoin which were positioned to benefit from rapid USD supply growth.

2. Money becomes more expensive so traders who trade with leverage by using borrowed money reduce their debts and sell some of their positions to reduce their debt servicing costs.

Therefore, when tech stocks lose value because of higher rates, Bitcoin and Ethereum could be losing value due to a decline in the growth of money supply.

2. Shared ‘Risk-On’ Asset Classification

A perhaps more complete explanation of why BTC/ETH and tech have become so correlated is that they are both tagged as “risk-on” assets. As macroeconomic sentiment improves, markets tend to increase their appetite for more volatile assets as they provide the greatest upside during times of prosperity. When the outlook becomes more uncertain, people flock to lower volatility assets to be defensive and protect their wealth.

Bitcoin and Ethereum’s high historical volatility likely earned them the ‘risk-on’ classification, along with high growth technology companies which are usually ambitious in their future earnings estimates.

3. Algorithmic Trading Strategies

A possible explanation for the observed correlation becoming stronger over time is the use of algorithms in high frequency trading. It is conceivable that proprietary trading firms have noticed the substantial correlation which exists between Bitcoin and equity markets and have begun using the signals from one market to trade the other.

These sorts of strategies tend to become self-enforcing, resulting in a correlation coefficient which grows over time as more and more algorithms perform the trade and thus increase the co-movement of assets.

Of the three explanations offered, it is likely all three play a role to an extent, but by far the most dominant force is Bitcoin and Ethereum’s risk-on classification. Being considered “risk-on” is obviously a detrimental label given ‘risk-on’ and “safe-haven” are direct opposites.

Most of the people trading Bitcoin and Ethereum likely have no real thesis for doing so. Their only ‘thesis’ is the belief that the volatility of the asset can make them rich if it moves their way. Forget the ‘digital gold’, or ‘digital oil’ theses — right now crypto is just digital volatility and traders are queuing up for their turn in the crypto-casino. It is a sad reality. While these traders, who care not for the technology or properties of the assets, beg for the price to go up; their speculative pressures threaten the fundamental value offered by the assets themselves.

This gambler mentality is only exacerbated by the excessive use of leverage on crypto trading platforms. The advent of DeFi promised to ‘democratize’ access to financial services which were gatekept by traditional institutions. But mostly DeFi has just enabled people to do the things that traditional finance was genuinely trying to protect them from. Decentralized derivatives platforms allow retail users to get 30–150x leveraged exposure without any KYC or accreditation required.

Offering leverage to average Jane’s and Joe’s without checking if they understand the riskiness and complexities of their positions, is itself an ethical dilemma. But the fact that these highly leveraged positions can, and often do, cause cascading liquidations only exacerbates the price volatility these assets experience. Making them appear more and more like risk-on assets, reinforcing the deterioration of their utility.

You simply cannot expect a massive inflow of institutional capital into Bitcoin or Ethereum when the only reasonable rationale for investment, the digital gold and oil theses, empirically do not hold yet.

A catalyst will eventually break crypto’s cursed correlation with tech. I expect it’ll be this bear market coupled with the Federal Reserve’s inability to resist the temptation to start printing money again when they need to finance the USA’s massive current account deficits. They’ll struggle to attract foreign investment to do this because of how their decision to cancel Russia’s USD reserves damaged the perceived stability of the USD as a reserve currency. To get around this they’ll resort to some Modern Monetary Theory style money printing.

Value-add ‘DeFi’ isn’t real yet

In the 8 months I have worked in DeFi I have witnessed very little genuine innovation. The space hasn’t meaningfully progressed since 2020’s “DeFi Summer” which was a period in history where decentralized protocols literally paid people to use their platforms or hold their tokens through processes known as ‘airdrops’ and ‘liquidity mining’.

Almost 99% of the value locked in DeFi is just people trading assets for other assets or derivatives, leveraging up against these assets, and then trying to optimize the yields they earn from providing liquidity to other people trading the same assets. It is a closed system, which doesn’t interact with the real world in any way to assist the creation of real economic output.

The only new protocols which have come out and gained traction have been elaborately disguised ponzi-schemes and new ‘money Legos’ which build upon this same closed system. Tracer, where I have worked, is one of a few rare exceptions trying to build novel products which attempt to bridge the gap between the crypto and ‘real’ world’s. Regardless of whether the team successfully executes — I respect the vision and courage to try and build something with real world utility.

Financial systems only add value when they are connected to the real world. There are a small number of protocols at the fringes of what is popularly viewed as “DeFi” which are attempting to do this which I have a great deal of respect for. Meanwhile, less legitimately value-add projects have had their valuations pushed to unsustainable levels by flying under the banner of “DeFi”.

Most of the people who use DeFi aren’t even crypto believers for the most part. They’d rather use stablecoins with increasingly shaky designs to trade assets and earn profits denominated in USD. They are not crypto believers, they’re just gamblers with an internet connection.

When one wolf gets fleas, the whole pack does

Building permissionless DeFi infrastructure which makes everything composable sounds great in theory. In practice, it’s an absolute web of systemic risks and avenues for financial contagion.

Decentralisation and a lack of regulation presents an opportunity for rapid innovation and experimentation. This environment could result in the creation of new products and services which add genuine value. But it also creates a wild-west environment where opportunistic or predatory actors can ruin the fun for everyone by ‘innovating’ the space into the ground. DeFi ‘experiments’ which look, smell, and feel like multi-level marketing/pyramid schemes are not helpful for the legitimacy of the space.

More concerningly, when they collapse, it is difficult to prevent the effects from spilling out into the rest of the ecosystem. A few things I have witnessed in DeFi seem eerily like the roll-up and repackaging of financial products which made the GFC so chaotic.

Stablecoins, are the obvious source of systemic risk. To see what I am talking about you need to look no further than the very recent collapse of UST. UST is a ‘stablecoin’ on the Terra network which is supposed to be pegged 1:1 with the USD. It’s most recent trading price at the time of writing is 40 cents.

I do not think the creators of UST were malicious actors, but they did create an unsustainable flywheel which many critics labeled as a ponzi. The attractive 20% yield offered on UST and the meteoric rise of Terra’s native token, LUNA, caught everyone’s attention. But I, and many others, decided not to touch it with a 10-foot pole because there were so many vocal critics of the design of UST shouting to anyone that would listen that it was doomed to eventually collapse.

Yet, people either don’t do their research; or thought they could exploit the system for a short while and participated anyway. Despite a huge portion of the DeFi community predicting what inevitably occurred; they were powerless to stop UST from filtrating throughout the DeFi ecosystem and spreading its risk to other assets.

The 50 billion USD in value that was destroyed by UST and LUNA has had, and will have, far reaching effects. The inherent systemic risks of open, permissionless infrastructure is a serious threat which makes me wonder if truly public blockchains will ever be a viable place to build robust, alternative financial systems.

Shark infested waters

The promise of DeFi when marketed to masses is to democratize access to financial services and products which have been gatekept from society by centralized institutions.

Crypto’s first believers were all hyper skeptical of centralized, traditional institutions for good reason — the GFC was a failure of the traditional financial system, and many people wanted a replacement. However, by removing centralization and stepping away from regulators they moved towards a highly adversarial environment. The traditional system is broken in many ways because of bad actors. Bad actors will always exist, but in a decentralized environment, these bad actors can misbehave with a degree of anonymity and lack of recourse.

DeFi is a dark pool, player vs player ecosystem. It’s exciting, it’s degenerate and if you aren’t aware that whales and sharks rule these waters then you’re probably a fish or plankton.


Market makers and the smartest quantitative/proprietary trading firms are not in the space because they believe in it. They are here to make money and do it in broadly one of two ways. The first way they make money is by arbitraging dysfunctional markets, a noble deed which helps everyone. The second is by performing something called MEV.

Blockchains don’t process events in chronological order like you might expect, instead you submit a transaction and place a bid to have it executed. In theory the higher the bid, the quicker your transaction gets processed by a ‘miner’ who wins the right to execute the next batch of transactions called a ‘block’. Maximum Extractable Value (MEV) is a process where these miners figure out what are the best transactions to include for their own gain. They can reorder and insert new transactions at their discretion to profit, often at the expense of somebody else.

MEV is obviously a very complicated area; if you’re interested in learning more start here.

Liquid Exits and Token Distributions

This is definitely not true in every case. But in far too many cases, DAO token ICO’s and airdrops are not an opportunity for retail investors to ‘invest’ early in a business or be rewarded for being early adopters. It is an opportunity for the protocol to go public and create a liquid exit for insiders.

If you are well-versed in traditional finance — think of token ICO’s and airdrops as SPAC’s on steroids. There are no disclosure requirements, everything is murky and retail investors get absolutely dumped on in far too many cases.

Hacks and Exploits

Smart contracts when written well are epic tools. However, when mistakes are made, and security is compromised — there is virtually nothing which can be done to prevent the capital tied up within a smart contract being stolen. These issues will become less prevalent over time; but every public failure is a massive setback for the space.

Shake the trees

For many reasons, this bear market is necessary. Many in the space saw it coming from a mile away and I pray that most people took profits along the way rather than letting greed get the better of them.

Protocols which add no value need to have their valuations go to zero.

Irresponsible and uninformed VC’s with cheap capital need to stop FOMO-funding bad ideas.

Gamblers and speculators need to lose interest.

Retail traders and investors need to be scared off so hackers and exploiters can stop feeding off their ignorance.

Speculative bubbles are hurtful for many reasons. People lose money, which is terrible; but they also lose faith. Without faith, new funding is hard to attract — and the collection of teams doing their best to solve real problems and advance society rather than just extract profits from speculative mania will suffer because of it.

I have often likened the state of the “web3” and “crypto” industries to the bubble when asked privately; and I think this comparison is reaching its most dramatic alignment right now. In the same way that the internet was destined to become the future back then; I do believe some applications of blockchain technology are genuinely promising.

Disrupted clearing and settlement services; tokenization of real-world assets; collateralized money markets; digital art; ‘DeFi’ protocols which market themselves as fintech’s built on blockchain infrastructure; and play-to-earn gaming models are just some areas which I think are likely to survive in the long-term.

Crypto probably isn’t dead, but it is cleansing.

Disclaimer: None of what I write is intended as financial advice. All opinions represented are my own and are presented solely as an attempt to timestamp my own thinking or provide entertainment. Do not act on or interpret any of my content as financial advice.

Twitter: @isthatPatJaffe