"Grayscale Report" When will the bear market end in 2022?

Grayscale analyzed past bear markets and made predictions for the current bear market.

Bear Markets in Perspective

Source: Grayscale Insights

Compiled by: Chengdong Zou Gong, MarsBit

background

On October 31, 2008, a message appeared on the Cyberpunk mailing list that read:

“I am developing a new electronic payment system that is completely peer-to-peer and has no middlemen.”

A few months later, on January 3, 2009, an individual using the pseudonym Satoshi Nakamoto created the Bitcoin network. Thirteen years later, Bitcoin has inspired an entire new industry and a new asset class worth nearly $1 trillion. While Bitcoin has been called “the best performing asset of the decade,” after gaining more than 40,000,000% since its inception, the journey has not always been smooth.

Figure 1: Ideal vs. Reality

Born out of the 2008 financial crisis and recession, crypto has grown from a nine-page white paper on decentralized networks to trillion-dollar industry innovations such as sustainable energy, finance, entertainment, art, and more. Given our perspective on this cycle, uncertainty will continue to loom over the crypto market despite the painful price drops we have experienced. The length, time to peaks and troughs, and recovery time from peaks and troughs, and previous historical highs in each market cycle may indicate that the current market may be similar to previous cycles, which has led to continued innovation and new highs in the crypto industry.

Crypto Market Cycles

Like traditional economic and financial markets, crypto has its ebbs and flows. Crypto market cycles last, on average, about 4 years or about 1,275 days. While methods for defining crypto market cycles vary, we can quantitatively define a cycle as a realized price below the market price (i.e., the current trading price of an asset), using the price of Bitcoin as an example. Note: We exclude the realized price cross below the market price in March 2021 due to extreme market volatility at the time in response to the COVID-19 pandemic.

Figure 2 Bitcoin market cycle: price vs. realized price

The realized price is the sum of all assets capitalized at their purchase price or realized market, divided by the supply to see how many positions are in profit or loss.

Realized price = realized total market value / current supply

Realized prices below market prices mean that most assets are held at a price higher than the market was buying them at at the time. Conversely, realized prices above market prices mean that assets are held at a price lower than the purchase price. Determining when most assets are above the purchase price helps determine when the market begins to move out of a bear market and transition into a new cycle (or vice versa).

As of June 13, 2022, Bitcoin's realized price is below the market price, indicating that we may have officially entered a bear market. In normal mode, some believe that these points in the market cycle may represent the best buying opportunities. The chart below shows the average price of Bitcoin in the area where the realized price < Bitcoin market price.

With only 21 days in this range, we may still have about 250 days of buying opportunities compared to previous cycles.

Figure 3: BTC realized price

Market cycle data

According to the above framework, crypto market cycles have taken longer to reach their peak each time. In 2012, the market took 603 days to reach its peak, and each subsequent cycle added about 180 days, 786 days in 2016, and 952 days in 2020 to reach its peak.

From peak to trough, the cycles in 2012 and 2016 lasted about four years, or 1,290 days and 1,257 days in 2012, respectively, taking 391 days to fall by 73%, and 364 days in 2016 to fall by 84%.

In the current 2020 cycle, we have 1198 days as of July 12, 2022, meaning there are about four months left in the cycle until the realized price crosses back above the market price. Bitcoin is 222 days below its all-time high, meaning we could see another 5-6 months of falling or sideways price action. Historically, each market bottom seems to have been a month in advance.

In the 2012 and 2016 cycles, it took less than three years to return to the all-time high. It took 1,082 days and 1,059 days respectively. After that, it took another year to reach a new all-time high.

Figure 4 Cycle

Compared to the previous two cycles, which rose and fell sharply, the 2020 cycle seems to be longer, floating within the range of all-time highs. This may be due to the increasing maturity of crypto technology, a market that did not exist in previous cycles. Not only is crypto becoming more accessible to retail investors, but it is also related to the surge in crypto exchange-traded products. For example, Bitcoin and Ethereum ETFs in Brazil, Canada, and Europe. They may not have been able to invest in the asset before. In addition, the development of decentralized applications (DAPPs) is gaining momentum and finding a foothold in decentralized finance, games, art, and other fields.

A brief historical review of crypto market cycles

From a qualitative perspective, each cycle marked a period of product and adoption, providing a springboard for the next cycle. Here is a brief overview of what happened starting in 2012:

2012-2015: Hacker Era + Birth of Ethereum

In 2012, the crypto market was almost entirely made up of Bitcoin. CoinmarketCap was not available for sale until almost a full year later, in 2013, tracking less than 30 coins. Aside from trading, the main use of Bitcoin was to buy goods online, on sites like Silk Road. At the time, Silk Road was a major driver of new users to the Bitcoin network, and the largest Bitcoin exchange was still Mt. Gox, which dominated the majority of Bitcoin transactions worldwide.

The main theme of this cycle is new crypto exchanges and wallets. Although the asset is still in its infancy, entrepreneurs hope to profit from trading. However, operations around custody and management of Bitcoin assets do not exist yet, leading to multiple hacks on centralized systems and the theft of more than 1 million Bitcoins.

Many early developments, such as Linode and Bitcoinica, looked worthless, and the impact on the overall price continued into 2013 as the price of Bitcoin continued to rise.

Figure 5 2012 Cycle - Expansion

After setbacks including the closure of Silk Road, China’s ban on banks processing Bitcoin transactions, and the Mt. Gox hack that stole 850,000 Bitcoins, to name a few, Bitcoin’s price fell by about 80% the following year, peaking on December 16, 2017. The Mt. Gox hack was the last and largest exploit that marked the end of the bull phase of the cycle. The price decline came as investor confidence in the asset class faltered, as did many newer asset classes. New players left the industry. Those that stayed continued to build, develop complex asset custody of centralized entities, and new crypto technologies. Arguably, the most important project of the 2012 market downturn cycle was Ethereum.

The creation of Ethereum opened the floodgates to a wide range of possibilities beyond simply sending and receiving digital assets. While previous innovations featured incremental improvements, such as larger blocks and faster block times, Ethereum introduced the power of “smart contracts,” which would allow for the creation of advanced applications such as decentralized exchanges, lending platforms, entertainment, and NFTs on the chain. This innovation made it possible to program applications on decentralized blockchains that offer advanced functionality beyond simply transferring tokens. While Ethereum was officially launched in 2015, applications created on top of it needed several years of bear market construction to gain traction.

2016-2019 ICO Experiment and the Birth of DeFi

During this period, sentiment recovered and Ethereum brought more programmable crypto. Initial coin offerings (ICOs) gained a lot of attention as both a fundraising tool and a scam mechanism. Many retail investors collectively invested millions of dollars in tokens to support visions and projects that ultimately failed to materialize. At the peak of excitement, projects could raise more than $10 million in seed funding through websites and unknown teams. In addition, the crypto exchange BitMEX launched perpetual contracts (PERP)

– Innovative futures products that do not exist in traditional financial markets

– Provide traders with new ways to trade with leverage. Leveraged trading of worthless ICO tokens only exacerbates the crazy price action.

Macro drivers such as quantitative tightening and trade disputes led to a sell-off in emerging markets and risk assets (e.g. crypto) from October 2017 to 2018. ICO liquidations also wiped out a large portion of the market cap.

The total market capitalization of crypto fell from $700 billion to $100 billion, and although it was very painful, the continued sell-off did not kill the market. On the contrary, Bitcoin's dominance in the market fell to an all-time low as funds flowed into altcoins and ICO tokens.

Despite the lackluster price performance, many of the core decentralized applications that now represent the industry were launched during this period. For example, the automated market maker Uniswap, a concept proposed by Ethereum founder Vitalik a year ago, made it possible to exchange permissionless assets more efficiently than any previous product. Aave, a lending protocol, was also created during this period, marking one of the first applications that allowed depositors to earn interest by borrowing using smart contracts. These protocols expanded the utility of Ethereum and laid the foundation for the DeFi summer through adoption by new users.

Figure 6 Protocol

These dApps built during the bear market became an important catalyst for the next cycle of DeFi summer in 2020.

2020-Present: Leverage, Institutions, and the Test of DeFi

The 2020 market cycle is a story of leverage. Investors were attracted to leverage amid the growing popularity of perpetual contracts and the launch of Bitcoin futures by the Chicago Mercantile Exchange (CME), as governments supported their economies in response to the COVID-19 pandemic.

Bitcoin’s initial price peaked at $64,800 on April 14, 2021, but was thawed by the expiration of high leverage from perpetual contracts and other derivatives. Funding rates — periodic payments between traders to bring futures prices in line with spot prices — showed a bullish trend, indicating that the Bitcoin market was disproportionately long and willing to pay huge fees to maintain their positions. This bullish funding rate environment lasted for more than six months, and traders continued to increase leverage, using crypto as collateral for their positions. Falling collateral prices led to forced sales and liquidations, which also led to BTC’s drop to $29,000 in the summer of 2021.

Figure 7 BTC perpetual contract interest rate and open interest price interest rate

In late summer 2021, the market seemed to have learned the lesson of over-leveraged trading from previous experience. When open interest began to rise, funding rates were milder than before. However, during this period, leverage was mainly in the hands of CeFi companies and hedge funds. The lack of transparency in the operations of these businesses led to a second wave of momentum, and after the market peaked again at $68,900 on November 10, 2021, the wave of leverage began to subside.

CeFi is a simple and easy way to access DeFi and earn income, with an annualized rate of 5%-20%. CeFi platforms can offer users an annualized rate of about 3-8% to use their deposits, exceeding the advertised rate of return, and provide it to users to capture the difference. This is relatively easy to do in a market that is at its peak.

Importantly, interest rate arbitrage strategies are often subject to various risks, namely macroeconomic challenges and duration mismatches. When the Fed began to raise interest rates due to concerns about inflation and rising prices, prices fell for the second time from their all-time highs and leveraged positions began to unwind. It started with the collapse of UST, which cost the crypto market more than $35 billion. The Anchor protocol is an important part of the UST ecosystem and is the main source for generating income, as it provides about 20% annualized interest rates in UST.

Another source of revenue used by CeFi platforms is liquid ETH staking - mainly through Lido Finance. In addition to rumors that the Ethereum merger may be delayed, which caused wider market panic, the stETH to ETH interest rate fell from the historical 1:1 to below 0.95, causing a large amount of stETH to be liquidated, further exacerbating the market sell-off.

In addition to CeFi, many institutional trading firms were also severely affected. They participated in Terra, stETH, and leveraged trading. Many crypto prime brokers issued loans that were ultimately unable to be repaid or liquidated, expanding the crisis beyond those companies that lost money for investors.

Despite the challenging market conditions, the core DeFi protocols that sparked the growth continue to operate as expected. Unlike their centralized counterparts, Aave, Compound, and MakerDAO are still around, resilient to the market, maintaining their loan-to-value ratios, and not assuming any non-performing assets. As of July 5, 2022, Uniswap has processed over $42 billion in transactions

The past 30-day trading volume and Metaverse tokens such as AXS, MANA, and GALA have outperformed Bitcoin and Ethereum in the same period.

What happened on the chain?

In the development of the crypto industry, the price of digital assets only represents part of the broader ecosystem. The price of Bitcoin has been volatile, and during periods of market uncertainty, in addition to traditional financial assets, the underlying network continues to operate as designed, with the potential to process nearly $18 trillion in fees, as shown in the figure below, with a value of $13 trillion in 2021. Mexico is the third largest recipient of remittances and one of many countries using this technology. According to data from Bitso, a crypto exchange based in Mexico, cross-border remittances increased fourfold from Q1 2021 to Q1 2022.

Figure 8 BTC network value

Smart contracts like Ethereum and Solana can also be used to send remittances for users who prefer to transfer assets other than Bitcoin, such as stablecoins. Regardless of the blockchain used, assuming the network has strong security, users can securely transfer value to anyone in the world over the internet, sometimes just for less than the transaction costs paid for traditional remittances.

The 30-day net exchange position change, which measures the amount of Bitcoin, saw the largest outflow on record in June 2022 on centralized exchanges, indicating that holders are moving their tokens off exchanges and centralized lending platforms. This suggests that investors may be wary of centralized funds using user funds for riskier strategies and lenders that may face liquidity issues. Instead, users appear to be passively choosing to hold their digital assets.

Figure 9 BTC: Changes in exchange positions (BTC)

Many of these outflows are likely due to investors taking advantage of the discounted opportunity to increase their positions. The number of wallet addresses holding .001-.01 BTC, .01-.1 BTC, and 1-1 BTC has increased dramatically to record highs. This marks an interesting change in market sentiment, as smaller investors have historically reduced their position sizes in times of crisis and in the face of uncertainty, especially after the price of Bitcoin fell from around $20,000 in 2018.

Figure 10 BTC: Balance of small retail investors

DeFi has also had an interesting year. In 1997, James Dale Davidson published a book called “Personal Sovereignty” in which he predicted: “The spread of jurisdiction means experimenting with new ways to enforce contracts and otherwise secure personal and property.”

CeFi companies and hedge funds facing bankruptcy used a combination of DeFi protocols, such as Aave, and centralized lenders to borrow capital. Interestingly, DeFi positions are repaid before central lenders or equity holders. Centralized lending protocols operate autonomously according to code, written in smart contracts. With decentralized lending protocols, there is no way to negotiate the terms of a position - if it falls below the loan-to-value ratio, it will be liquidated directly.

The transparency of on-chain activity also gives market participants insight into the positions of these institutions — traditional markets can be more opaque — giving the market time to prepare and adjust to potential liquidations. Despite capital outflows due to user debt reductions, overall borrowing on lending platforms such as Aave and MakerDAO is still higher than at the beginning of 2022.

Figure 11 Total lending on decentralized lending platforms (ETH)

Uniswap, the largest decentralized exchange, has also seen impressive growth during this market cycle. Founded during the bear market in November 2018, it has grown into a core pillar of the DeFi ecosystem. Research by the Uniswap Foundation and venture capital firm Paradigm shows that Uniswap has greater market depth for ETH/USD and BTC/USD pairs. This is particularly impressive because Uniswap has already delivered all assets being traded and can be traded without the need to transfer or deliver assets until the user takes custody of them. On stablecoin trading pairs, its liquidity is higher than that of centralized exchanges, and on the USDC/USDT trading pair, Uniswap's liquidity is almost 5.5 times that of Binance, the world's largest exchange.

Figure 12 Market depth comparison of ETH/USD and ETH/BTC

Monthly decentralized exchange (DEX) volumes have remained stable even in volatile market conditions. A year ago in June 2021, when DeFi barely existed, DEXs processed billions of dollars in volume. As of June 2022, DEXs on Ethereum, such as Uniswap, traded around $75 billion. July 2022 DEX volumes were also on par with February 2022, when Ethereum prices were about 2.5 times higher, at around $2,800 and around $1,100 today.

Figure 13: Ethereum decentralized exchange volume

The creation of Ethereum — a decentralized network like Bitcoin, but with smart contract capabilities — has created endless possibilities. The Metaverse is one of the fastest growing categories in crypto, with over 230 assets and a value of over $11 billion according to CoinMarketCap. Axie Infinity, a popular blockchain game based on Ethereum, has over 778,000 active addresses in the past 30 days. Existing companies are also starting to make moves, interested in the intersection between crypto and gaming entertainment. Gala Game, a blockchain-based game developer, recently formed a partnership with Epic Games, the studio behind Fortnite. Gala and Epic Games will provide easy access and exposure to over 194 million users. This could be their first-ever blockchain-based video game — a big step forward in advancing the industry.

Another category in the crypto market is decentralized infrastructure. Filecoin, the decentralized file storage network – launched a hyperdrive upgrade in June 2021 that increased transaction throughput by 10-25x. The chart below shows that after the network upgrade, network usage (daily active transactions) grew exponentially despite the increase. While protocol revenue is important, development does not always depend on it. In the case of Filecoin, the upgrade expanded the network and continues to provide users with file storage at a cost of 0.001% of Amazon AWS S3 fees.

Figure 14 Filecoin active transactions

Next Steps

Experienced crypto investors are no strangers to wild price swings, even an 80% drawdown in an emerging asset class. We believe the technology underpinning the industry has the potential to revolutionize every aspect of digital life, from fintech to entertainment. In the 40 years since the advent of the internet, there has never been a way to truly own digital assets without having to operate physical hardware, until the birth of Bitcoin.

It’s easy to overlook how far we’ve come as an industry, but in our view, bad news can be seen as good news for investors. Over a long enough time frame. What started as a hobby project of an anonymous cryptographer who was declared dead time and again now provides value to countless industries around the world. Blockchain technology is helping to achieve financial inclusion and equity in developing countries.

Inspire innovation in finance and cryptography, and drive the Internet to a new stage - digital ownership of assets and independence from centralized authority.

At the time of writing, every category in the crypto industry has gone through this cycle, and the ecosystem is stronger than before. In crypto, we have seen that failure is not fatal to the industry, but rather, it is a necessary step towards the future. This market cycle has provided us with battle-tested DeFi and infrastructure protocols, innovation in scaling solutions, a growing metaverse industry, and more. Despite price drops, liquidations, and volatility, the crypto industry will continue to build and innovate beyond the boundaries of imagination.