Founder’s Bear Market Musings: We Are Not Yet Truly in Crisis

In a conversation between Forbes and Nic Carter, founding partner of early-stage crypto venture capital Castle Island Ventures and founder and CEO of data analytics firm Coin Metrics, the two discuss how the crypto market crash fits with broader macro trends , how venture capital should adapt to new market conditions, what the future of DeFi will look like, and how regulators should respond to these leveraged and high-risk transactions.

Forbes: How do you evaluate the current downturn in the market?

Carter: This carnage is not just for Crypto, but for all asset classes. Some thought it was just a cryptocurrency sell-off or a sell-off along with risky assets, but that was not the case. Sovereign debt and U.S. Treasuries selling stocks at the same time should never have happened, they should be negatively correlated. So not only are we headed for a very deep recession, if liquidity continues to be drained from the financial system, we could have a recession, a sovereign debt crisis.

Forbes: Why do you feel so strongly that many Wall Street bankers and analysts are downplaying the likelihood and duration of a recession?

Carter: The Fed is wrong and Congress passed this huge stimulus package in 2020 along with other unnecessary stimulus packages. This is the collective fault of this administration and that of its predecessors, and the basis of deflation.

The solution to the problem that the Fed has come up with is to raise interest rates, basically restricting the activity of private companies. We are in an extremely fragile, highly indebted system. Further damage to supply chains would crowd out private investment and make it harder for governments to service their debts. Rapid moves in any economic indicator, whether it's the mortgage-backed securities market or its two-year yield, indicate a lack of confidence in the U.S. government, many of which are among the worst on record.

We are entering stagflation. The problem of inflation is far more entrenched than short-term trends and factors, and it is indeed related to the deglobalization and underlying energy shortages caused by the epidemic, which will not be resolved at present.

It would be like 1969/1970, when inflation rose, the Fed raised rates in a short recession, inflation managed to come down, and then surged to new highs in the late 70's as the energy crisis didn't abate. I think that's what's going to happen. But a recession doesn’t solve the underlying problem, our dollars buy less and less real resources because real resources are harder to mine, and our dollars buy less and less products because products are harder to come by. I think it's going to be a decade of stagflation, and I don't think recessions will beat inflation.

Forbes: In addition to the decline, have you seen any growth trends in the encryption field?

Carter: Right now every crypto agency that was supposed to be a "dominant snake" is being looted or destroyed. The stalwarts of the industry are being squeezed dry. Terra, the fourth largest project, was destroyed along with its algorithmic stablecoin. Three Arrows Capital is the largest private fund in the entire crypto industry, but Voyager Digital said it may issue a default notice if the fund cannot repay the loan. Celsius, the largest or second largest retail bank in the crypto space, may go bankrupt. So basically the entire structure of leverage and loans, as well as the link between DeFi and CeFi yields, have been severely questioned by the market. It can be said that the neo-banking structures that have been built in the crypto space in the past two or three years are being completely destroyed.

The basis of future DeFi (including the rate of return) will not be this false Ponzi cycle game, re-pledging and securitization, but must be based on actual economic returns.

Forbes: According to surveys, 70% to 80% of DeFi activities are purely speculative. Why is the bubble so big?

Carter: I think DeFi should have high standards and strict requirements, because the goals it pursues are very important. I believe in DeFi, it should be transparent finance with disintermediation. However, it does a terrible job of executing it. There are many builds, but not thought through. For example, placing customer deposits in high-risk DeFi protocols, as happened with UST and Anchor. I would like to say to industry practitioners that without thinking, it is equivalent to planting hidden dangers in the early stage.

Forbes: Are bear markets a good time to create wealth? Where should big investors put their money now?

Carter:We will continue to implement the established strategy-early venture capital. Many primary and secondary market funds will suspend their crypto strategies. Many crypto funds will not be trading for the rest of the year because they are too worried about market conditions.

Regarding the liquidity crisis, we're not really in one yet, but we may be heading in that direction. In a liquidity crisis, you have no liquidity, so you cannot decouple yourself from the market environment. Unless you are really prepared, it is easy to wipe out the whole army. Now some crypto funds and hedge funds are facing redemption, and then venture funds are facing LPs and telling them not to make capital calls. Venture funds don't get all their money on day one.

LPs may be distressed, they may not want to allocate more funds to cryptocurrency or early stage venture capital, even if they signed a limited partnership agreement, they have legal obligations. All the backup funds that you see on the sidelines, the money that was raised probably wasn't really put to work, something like that happened in VC in '08 and '01. Especially with falling valuations, I think there will be less activity in the market, and this bargain-hunting may be constrained by institutions.

Forbes: Do you have any suggestions for retail investors to invest?

Carter: Actually the best position right now is cash.

Consider the entire asset universe, not just cryptocurrencies; consider fixed income and the relative value between equities and real estate commodities. There hasn't been a massive drawdown in traditional markets yet, and I'd consider buying listed stocks. With a market cap of $1 trillion, all cryptocurrencies seem pretty cheap, but there's no fundamental way to value them. The total value of Bitcoin is 400 billion US dollars, which is less than 1/20 of the total value of gold. In the long run, I think bitcoin may surpass gold in importance as a savings tool for society.

These prices are attractive, especially for Bitcoin and now L1. All of Ethereum's competitors had a big year in the last year. These narratives will be truly challenged this year. Their popularity is due to the large demand for Ethereum block space, this demand spreads to other chains, especially EVM compatible chains, but other smart contract chains like Ethereum will not have such blocks in the future Space requirements, which are cyclical.

Ethereum is heading towards consolidation, moving to PoS and inserting staking protocols, which really puts a lot of pressure on all competitors. I would invest cautiously in rosters, or keep an eye on L1, which was very hot last year.

Under the current circumstances, liquidity continues to deteriorate, and there is no end in sight for the Fed to raise interest rates. Things could get worse in the crypto market. Defaulting lenders and large funds are spreading.

Your best positional tactic is to hold cash and not be active all the time; I would also look at the most liquid, highest quality companies, and the companies with the lowest internal leverage.

Forbes: What do you mean by "internal leverage"?

Carter: A lot of things are based on a set of well-defined protocols that use L1 underlying assets as collateral. The total value locked in these protocols is growing. This results in a supply lock, Token The units are locked and then the market floats the contract, which drives the Token s price. When the market deleverages and the total value locked drops, the collateral is dumped and returned to the open market. At the same time, many of these protocols are venture-backed, which means vested, so there is a lot of supply on the lock. A lot of liquidity is on the network because venture funds investing in the protocol have to liquidate their positions, especially now.

Another huge source of selling pressure is the liquidity of institutional backers of these protocols locked into these grants, which will be spit back into the market. Nobody wants to hold because we're in a period of big selloffs. Almost everyone who invests in L1 invests in these various Token , which is the behavior of institutional allocators who will liquidate these Token . Any less established company trying to build itself through institutional support and building a DeFi ecosystem, I think these companies are the worst performers in this down market phase.

Forbes: How will the "infectious disease" of encryption institutions spread, and in what direction will it develop?

Carter: I was shocked by the Three Arrows incident. I'm not surprised that Celsius and Terra crashed. It is clear that Terra is not robust and will eventually crash. Celsius has been in the red signal for many years, and Celsius is an active participant in DeFi, so they will allocate customer funds in DeFi. What I didn't expect at all was Three Arrows Capital.

These centralized lenders and participants have injected a lot of liquidity into DeFi, and many of these DeFi structures are Ponzi structures that are doomed to fail, but that hasn't stopped many entities from participating in the system. There are actually a lot of interconnections, and even centralized lenders like Celsius are affected. But other central banks that lent to these private companies, who may be illiquid or insolvent, are now also affected.

Now there is a hole in their balance sheet. In my opinion, the largest institutions in the industry have balance sheets to absorb these funds, so in the end they will be safe and sound. Celsius has an ICO vetted overseas Token , they put customer funds in DeFi. They don't all follow the same risk management standards, which is dangerous. Some are onshore and support regulation. I think there will be more well-capitalized institutions that will survive this.

Forbes: For those investors who still want to earn passive income through holding encrypted assets, what is the best way?

Carter:In the United States, basically all channels for retail loans are blocked by the US Securities and Exchange Commission, which is a regulatory issue. Other countries still have plenty of options. Now, you have to be very careful with yields. Some people like to refer to the income from speculating in options as the rate of return. I don't take that yield into account, it just lifts the risk position. There are many suppliers who will let you do structured products, which is extremely risky, especially for retail investors. So it doesn't actually pay off in my opinion. You just drastically change the level of risk in your investment. Don't just focus on yield.

Also, staking is like an anti-dilution yield. Real yields are based on actual economic activity. You give somebody a loan and they're doing some sort of venture capital investment. There is a risk of failure, but you will be compensated. If economic activity is productive, they reward you.

Forbes: In addition to transactions, what are the "real economic activities" of DeFi that you focus on?

Carter: There are now more and more protocols putting cryptocurrency funds into real-world lending and lending. Goldfinch, which does microfinance, is an example. Different lenders are starting to look outside the market, not just lending to other DeFi market participants, such as Maple. It's launching a mining pool focused on bitcoin miners, and I think they'll expand to make mining more complex.

It's an interesting model that miners wanting to hedge their exposure may just want to lock in an interest rate that yields 20% over the next year, rather than being exposed to the price of Bitcoin. I would love to see more of these protocols exist on DeFi. They do envisage real economic activity, creating structures that are useful to producers and consumers.

Forbes: Can DeFi's decentralized governance really work? We are seeing a liquidity crisis in many protocols, the Curve pool between stETH and ETH is drying up.

Carter: I think decentralized governance is an ambivalent term. If your governance means centralization, in the case of equity, the shareholders are the owners of the company. They should govern - it is their responsibility and their right. Under the agreement, if there are pledgers, Token holders, it must mean that it is not decentralized. Because crypto players know nothing about corporate governance. for a large group of small Token For holders or shareholders, there is no incentive to implement governance, because governance needs to collect important information to function.

That's why there are VCs. There needs to be major shareholders in charge of corporate governance. Therefore, having highly distributed Token holders means no governance, no supervision. In a corporate setting, a director is the person who operates the agreement. Decentralized governance basically means governance doesn't work. One or two entities in centralized governance are responsible for information collection and oversight, ensuring that the managers of the system protocol do not expropriate the system, because this is an important reason for the existence of corporate governance, which requires a centralized agency. In fact, holding a large number of Token Exposure is large venture capital funds. They hide their investment footprint because they don't want regulators to know where they are investing.

If you want to really enforce governance, need to be dynamic and change, then it will be centralized. If your protocol is static and doesn't change, then you don't need as much governance. In my opinion, that's when you can have complete true decentralization. Bitcoin doesn't change very often, so there aren't many decisions to make, it's decentralized. But apart from Bitcoin, there aren't that many protocols that can really do that and minimize governance.

Forbes: What will the encryption industry face next?

Carter: I think the industry regulation in the future will be strict, and encryption participants had better welcome the next policy. If you lost money in Celsius or Terra or hacks, regulation is not bad for you. After a financial crisis, there will always be more regulation. This is how the market works.

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