Weekly Edition #70

In this edition:

As you have probably guessed we are not big fans of crypto. In a nutshell we believe that crypto is filled with fraud, there are very limited legitimate use cases (if any), and blockchain is a complex solution looking for a problem (by this we mean we haven’t seen a use case for blockchain that wouldn’t be best served by a simple database, which is all blockchain is). However, the most damaging and dangerous aspect of crypto is the cult like nature of it. We’ve seen (both on the internet and real life) people talk about crypto as the technology that will change the future, replace fiat currencies (dollar, euro, etc.) and be “the best collateral”. The hype surrounding crypto has meant that investors have lost billions of dollars in the ecosystem. These losses stem from buying something and it going down in price (like can happen in any investment), but also from buying into outright scams and frauds. Back in 2017 there was a boom in Initial Coin Offerings (ICOs, like an IPO but for crypto tokens), many of them were designed to simply take investors money and run. More recently there have been other projects which were simply poorly designed and grew to billions of dollars before they collapsed. The most recent example is Terra Luna which had a market cap of $18 billion before it crashed around 99%. Now another protocol is in trouble. 

Celsius promised to pay around 19% interest on various cryptocurrency holdings if you deposited them in their network. What they did was essentially run an unregulated bank. They would take deposits from their customers and lend and invest them to generate a yield to pay out to customers. Celsius’ marketing consisted of trashing traditional banks and saying they had a better business model with lower fees which allowed them to pay higher yields. Well now it seems they were speculating and lending their deposits to very risky projects and have halted withdrawals. Basically, people cannot get their money out. Posts have been surfacing on the internet about people investing their life’s savings into Celsius and now are probably left with nothing. 

The biggest problem with crypto is that people fall for all the marketing bullshit and forget the most basic principles of investing: diversify and if it seems to good to be true, then it probably is. Because of this, tens of thousands and maybe even millions of people will be left with nothing. By trying to get rich quick these people will end up poor. The deeper issue here is people feeling like the only way they will make it is by gambling away their life savings on crypto. There are deeper societal issues at play here that we will not get into. The other issue here is regulators are asleep at the wheel. How is it that (as the article describes) if you ask for two withdrawals of $9,999 from a bank of your own money you will get flagged and investigated; but stuff like Celsius and Terra Luna are allowed to exist and incinerate investor money, and nothing happens… 

Btw, the article is behind a paywall but we strongly recommend you subscribe since they have some of the best, most thought provoking and well researched articles out there, and they delve into many topics, not only investing.  

Interesting presentation talking about the state of alternative assets (private equity, private debt, hedge funds, real estate, crypto). Here are a couple of things that caught our eye: 

Valuation multiples for private equity deals reached an all-time high during the 1st quarter of 2022. As most of you probably already know, the more you pay for an asset the harder it is to generate strong returns. If you buy something which is priced to perfection, then everything needs to go right for you to be able to generate a return. Any slight hiccup and the deal can go south very easily. 

There has been a record amount of money going into venture capital. 2021 saw record deal volume, and more importantly record deal value. The amount of money invested in VC in 2021 was roughly double that of 2020. This means that there are more deals being done at higher valuations than ever before. Same as above, the more you pay for something the lower the return will be. 

This chart goes to show what we talked about above. Deals are being done at ever increasing valuations. Especially for later stage deals. The liquidity the Fed and the US Government pumped into the economy made its way into asset markets. This drove valuations of public and private stocks to all-time highs. Now that this liquidity is being taken away we expect the opposite effect.

Generally, private equity (PE) funds (and venture capital as well) have defined lifetimes. The funds are usually 8 – 10 years in duration with the option to extend the fund for an additional 1 – 2 years. Since PE is an illiquid asset class (you cannot sell your stake in the fund very easily), the 10-year life is there so that investors have an idea of when they might expect to get their money back. The drawback to this is that the fund may be forced to sell investments due to the fund life coming to an end. This means that funds may be forced sellers at inopportune times. Maybe the fund sees extra upside in the business, or maybe the market is in a downturn and there isn’t much IPO or M&A activity. 

What PE funds have been doing is selling the companies from one fund to another. So, if the company is in Fund 1 run by company X, the same company X will raise another Fund 2 and sell the company from Fund 1 to Fund 2. This gets rid of the timing issue since the same company still controls the investment. But it’s riddled with conflicts of interest between Fund 1 and Fund 2. Fund 1 investors will want to sell at the highest price possible and Fund 2 investors will want to buy at the lowest price possible. Since Company X runs both funds, they are on both sides of the transaction. The incentive for them might be to sell the company on the expensive side in order to realize gains for Fund 1 (and charge performance fees) and boost their track record in order to raise more funds. This trend has been growing and with the market downturn and the record amount of money still waiting to be invested in PE, will probably grow. 

One of the tools implemented by central banks after the 2008 financial crisis was buying longer dated bonds. Central banks implement monetary policy by controlling short term interest rates (amongst other tools). When rates hit 0%, they developed new tools in order to affect longer dated rates. One of these tools was setting a cap on long term interest rates. In Japan the current cap is set at 0.25%. The way the Bank of Japan (BOJ) controls this is by being committed to buy unlimited amount of bonds in order to prevent yields from rising above the set level. A lot of the way this works is by signaling. Since the market knows that the BOJ will prevent yields from rising above 0.25%, then market participants don’t trade above that level. However, there is a point in which market forces are too strong and signaling is not enough. When this isn’t enough the BOJ has to deliver on their promise and actually buy the bonds. This has been increasing dramatically in recent weeks and reached all-time highs several weeks ago. The chart below shows weekly purchases of Japanese government bonds (JGBs) by the BOJ. 

This has gotten to an extreme point in which there have been days that the only buyers of JGBs has been the BOJ. This means that market participants are not willing to buy bonds at these low yields and the BOJ has become the only buyer of JGBs. This really puts in perspective the whole MMT framework. The limit on government spending isn’t if they have money or not, rather it’s if it will create inflation. The purchases of JGBs by the BOJ shows that the government can spend whatever it wants (in its own currency), it doesn’t have to borrow first to spend. 

US Treasuries are often considered to be the most liquid markets in the world. It is one of the largest ($30.4 trillion debt outstanding, compared to US equity market cap of ~$41.5 trillion), and is the risk-free asset for the entire US$ based financial system. Bond and equity markets trade in a different manner. Stocks are mostly traded electronically and on exchange. This means that when you hit buy on your brokerage screen, the order is routed to an exchange and is executed against the order of another client. Most bonds don’t trade on exchanges, but rather over the counter. This means that if you want to buy a bond you will most likely be trading with a dealer. Dealers are specialized market makers which have bond inventories that buy and sell bonds to clients. This means that bond markets are much less transparent, less efficient (in a trading sense), and generally more expensive to trade than stocks (this is partly why bond ETFs have become so popular, because they move bond trading to exchanges). Since bond transactions have to go through dealers, when there is stress in the market, liquidity often vanishes, and spreads blow out. The treasury market is a bit more sophisticated but still largely a dealer-based market. 


The recent moves in the Treasury market have been exacerbated by this lack of liquidity. After March 2020, the Fed started buying large amounts of US Treasuries (amongst other things) which provided liquidity to the markets. Recently the Fed has started the process of removing liquidity from markets and this has affected the Treasury market. With the recent inflation prints, yields across the curve have been moving very briskly, which is due in large part to lower liquidity. If this is happening in the largest, most liquid market in the world, then other markets are feeling the pain as well. 

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