KEY MOMENTS AND LESSONS OF 2022

CRYPTOCURRENCY & BLOCKCHAIN

Research by Lesia M., Ken Chan, Sixte C.

2022 for JKL Group

Looking back, 2022 was a year full of challenges and opportunities. There has been plenty of volatility to navigate and bullets to dodge, as a lot of players were forced out, unable to withstand the financial strain.

Our greatest landmark by far has been the launch of our first Bitcoin Mining facility in Texas, US, operating 35MW of power capacity. Following this milestone, JKL transitioned into JKL Group covering two business lines: JKL Mining and JKL Capital.

In the overall spirit of building in the crypto winter, JKL Team grew almost threefold this passing year. Having kicked off 2022 as a Hong Kong based team of 12, JKL Group currently has over 30 employees including a UK and a US based team.

JKL Capital

JKL Capital is the financial arm of JKL Group offering a full range of products including quantitative investment strategies, crypto lending solutions and OTC services.

This crypto winter has been a stress test for JKL’s risk management and resilience — a test which we passed with 5 nominations from Hedgeweek US Digital Assets Awards 2023 for our two quantitative trading strategies assigned to JKL in December 2022.

Arbitrage quantitative trading strategy (or Basis Spread Mean Reversion strategy) aims to deliver market-neutral return by identifying arbitrage opportunities available in cryptocurrency spot and derivatives market, taking long/short positions to capture divergences between markets with sufficient liquidity. JKL’s Arbitrage strategy delivered stable returns throughout 2022, with an annualized return of 7% as of November end and an annual risk of 0.7% (measured by the standard deviation).

Directional quantitative trading strategy utilizes over two hundred statistical models which predict short-term price movements and capture the volatility of digital assets. JKL’s directional trading strategy takes long/short positions in top 30 liquid cryptocurrencies in accordance with a combination of Trend Following and Mean Reversion signals. JKL’s Directional strategy delivered an annualized return of -6.4% in 2022 (as of November end), with an annual risk of 8.9% (measured by the standard deviation).

JKL Capital’s AUM reached $300M in 2022. “Growing AUM is a testament to the asset manager’s high standards, sustainability of JKL’s quantitative trading strategies over time and rigorous risk management processes,” commented JKL Group Chairman Jingyuan Ye.

Jingyuan Ye also addressed the future outlooks: “As a group, we have a broad diversification across business lines: OTC, Asset Management, and Lending. All of the core business lines generate strong cash flows, allowing us to reinvest into future expansion.”

JKL Mining

After China’s regulatory reforms on Bitcoin mining in 2021, we launched JKL Mining to leverage the opportunity and bolster our products and services to the blockchain industry. Headquartered in Hong Kong, JKL Group was already tactically positioned to serve as a gateway between China and the rest of the world.

JKL Mining is focused on developing, operating, and owning world class facilities for Bitcoin mining across the world. The first facility was launched in Texas in July 2022 to host over 10,000 machines with 35MW of power. We further plan to build out to 82MW of total capacity by Q1 2023 and rapidly scale up to over 200MW by the end of next year.

Texas was strategically selected for the new mining operations due to its expansive energy infrastructure, welcoming legislative support and robust regulatory environment. JKL Mining is a registered member of the Texas Blockchain Council and the Bitcoin Mining Council alongside industry leaders.

Watch an overview of our first hosting facility in Saddleback, Texas HERE (July 2022): https://youtu.be/0KAiNhxv9UI

JKL Mining — Saddleback site, West Texas

Conferences

Despite Hong Kong remaining under COVID-related travel restrictions for the bigger part of 2022, JKL team had a tight travel schedule attending Bitcoin 2022 Conference, Paris Blockchain Week, Mining Disrupt, Financial Summit, Token 2049 and the AIM Summit.

We also had the honor to speak at several global leading conferences focused on cryptocurrencies and blockchain.

  • Lin Cheung, JKL Group’s CEO, spoke in a panel discussion at the AIM Summit in Dubai in an energy debate “Proof of Stake vs Proof of Work”.
  • Watch Lesia Marchenko, Head of JKL Institutional, with JKL’s introduction and keynote at the Mining Disrupt conference in Miami — world’s largest Bitcoin Mining Expo.

Incubating LENA

JKL’s VC arm is focused on supporting early-stage projects to power Web3 disruptive digital era. Our input goes beyond financial investments. We take on advisory role and handpick those with highest potential for our Incubation Program. In 2022, JKL Group incubated LENA — the newest Web3 liquidity provider.

LENA protocol facilitates decentralized and permissionless borrowing & lending of all NFT collections, while also offering crypto liquidity pools for staking rewards, borrowing, lending, and more. We chose to incubate LENA in-house since we firmly believe that unlocking liquidity sealed in NFTs (think bluechips, lands, GameFi, SoFi, Art, and more!) will be a great catalyst for the next upcycle in the crypto space!

Here are Some of the Project’s Highlights:

  • LENA is backed by two veterans in digital asset investment, JKL Group and Satori Research.
  • LENA’s advisors are seasoned experts in the crypto industry, amongst which you’ll find:
    o Hamzah Khan, Head of DeFi at Polygon.
    o Tim Frost, Founder of YIELD App.
    o Andy Ann, CEO of YAS Digital.
  • Pre-seed round of $1 million was closed in Q2 2022 led by JKL Capital and Satori Research.

Moving forward, LENA will release its test net early 2022 with exclusive access to Beta releasing through various community events and upcoming partners. Join project’s Discord and follow LENA on Twitter for the latest updates!

Macro: 2022 Overview and 2023 Outlook

“A rising tide floats all boats, but only when the tide goes out do you discover who’s been swimming naked.”
- Warren Buffet

AI generated image

Correlation with equities

Bitcoin’s 30 days rolling correlation with S&P500

Ever since the beginning of 2022, correlations between crypto and US equities have been vividly strong. Interesting observation: while both Terra AND Celsius crashes coincided with strong headwinds for risk-on assets, the final black-swan of the year — FTX fiasco — was unraveling with the backdrop of recovering equities. It looks like November hopes for an improving macro environment have indeed mitigated FTX’s impact on the crypto market (BTC down 28% post-FTX vs -45% post-Celsius and -33% post-Terra). On the other hand, hawkish dot plot released on Dec 14 with no rate cuts projected in 2024 led to stocks retracing into the year-end. As we stand, it is hard to see a short-term catalyst in the crypto market which would fuel the next bull run without improving macroeconomic conditions.

Institutional Adoption

Growing correlation between crypto and equities is often assigned to ongoing institutional adoption of digital assets, whereby institutions see the latter as part of a larger risk-on portfolio of tech stocks. While institutional adoption is a positive advancement for the crypto industry, treating Bitcoin as a high-risk high-reward tech stock is a rather limited approach in terms of fundamental analysis. Even though BTC returns currently not being driven by the narrative of ‘digital store of value’, the underlying fundamentals did not change, most important being:

  1. Bitcoin’s total supply is always going to be capped at 21 million;
  2. There is a limited number of Bitcoin mined every year, with a halving event every 4 years — meaning that every 4 years the number of mined BTC is being cut in half. The next halving event is scheduled for March 2024 at the time of writing.

These two conditions alone grant Bitcoin higher similarity to a nonrenewable resource rather than a stock. In order for decoupling to happen, market participants need to reach a consensus of placing Bitcoin into an asset class of its own. Moreover, as time passes, analysts will be able to upgrade existing models with larger data sets and to develop more sophisticated valuation methods, native to this particular asset (e.g. upgrading the Stock-to-Flow, valuations based on the Metcalfe’s law, etc).

Remember when in 2017 the announcement of CME launching Bitcoin futures rocked the market? BTC jumped almost 2x in the few weeks following the announcement. Well, 2022 was full of announcements that would have made headlines a few years back but went completely under the radar, overshadowed by negative news. Here are only some disclosures of large institutions entering or growing their digital asset exposure in 2022:

Citadel Securities is building a crypto trading marketplace with Virtu Financial, backed by Sequoia and Paradigm;

BlackRock has partnered with crypto exchange Coinbase to offer institutional investors access to Bitcoin;

Nasdaq starts crypto custody service for institutional clients;

JPMorgan uses public blockchain to execute first DeFi trade for Singapore’s central bank.

2023 Market Structure and Liquidity

Moving into 2023, market analysts expect heightened volatility in the crypto space and BTC in particular as a result of contracted liquidity. This is mainly due to

(1) lack of marginal sellers following an extensive bear market on the one hand, and
(2) an increase of long-term hodlers accumulating BTC on the other hand.

Let’s analyse both factors in detail.

(1) Low selling pressure

  • Long-term BTC MVRV Ratio (365d) has been deep in the negative territory throughout the whole year essentially, with the average P/L of every trader who entered their BTC position within the last 365days currently sitting at -32%.
Source: Santiment
  • Net Unrealized P/L currently sits at 2-year lows, signaling mass capitulation.
Source: Glassnode

(2) Diamond hands continue to accumulate

  • According to Intotheblock on-chain data, 72% of all BTC addresses today have been holding their asset for over a year — a figure that has been under 60% just some 7 months ago.
Source: Intotheblock
  • Glassnode’s Accumulation Trend Score indicates that on aggregate, a big part of the network is currently accumulating BTC.
Source: Glassnode

Liquidity is a measure of outside demand and supply of an asset. Naturally, liquid assets with substantial depth are less volatile and therefore more attractive to investors. Conor Ryder from Kaiko Research recently came up with a liquidity ranking framework to evaluate liquidity risk inherent in the top cryptocurrencies based on primarily three criteria: volume, marked depth and spreads. Outliers are easy to spot following the author’s methodology: LINK, ATOM, FIL have a better liquidity rank vs market cap rank, while DOT and UNI are amongst top underperformers from the liquidity standpoint.

Source: Conor Ryder, CFA, Kaiko Research

State of Early Stage Venture

o First two quarters of 2022 continued the tremendous run-up in the crypto venture capital started in 2021.

o The third quarter’s results, however, saw a massive drop of over 66% in capital inflows, dropping from over $14 billion in Q2 to just under $5 billion in Q3.

o While not all the numbers are in for the fourth quarter, funding to Web3 VC-backed companies failed to hit even $1 billion in October, coming in just under $900 million, per Crunchbase data.

o The two largest investments in 2022 were raised by large legacy companies looking to further expand their exposure to blockchain and Web3: EPIC Games raised $2 billion to deepen the gaming giant’s expansion into the metaverse; Citadel raised $1.15B led by Sequoia and Paradigm and is reportedly building a crypto trading marketplace.

o The top crypto deals may have used the term “Web3”, but most of these investments were centered around building blockchain infrastructure, GameFi, NFTs and digital asset exchanges.

The recent FTX crash has had a significant impact on the reputation of some of the largest venture capital firms in the industry. Sequoia Capital, Tiger Global, BlackRock and Paradigm, among others, have seen their expertise questioned due to their substantial investments in the mismanaged cryptocurrency exchange.

In the wake of the FTX crash, it is clear that large VCs need to rebuild trust and rethink their approach to investing in the industry. This includes a greater focus on due diligence and increased scrutiny of potential investments. It is also crucial that VC firms work to build strong relationships with their portfolio companies and provide ongoing support and guidance.

Source: Cointelegraph

Global Crypto Regulation

Global crypto regulations have been a hot topic in recent years and 2022 was no different, with regulatory bodies around the world working to establish clear rules and guidelines for the industry. Here is a sum up of the most notable global regulations that have been introduced in the crypto space in 2022:

EU:

Markets in Crypto-Assets (MiCA).

The framework’s latest agreed text was published by the Council in September 2022, and it is expected to come into force in early 2023. The European Union introduced the MiCA framework to provide a clear set of rules for crypto assets, including initial coin offerings (ICOs), security tokens, and stablecoins. The framework covers areas such as investor protection, market integrity and financial crime prevention, as well as brings rules contained in Mifid, Market Abuse and the Prospectus Regulation to the digital asset industry.

Hong Kong:

Hong Kong Monetary Authority (HKMA).

The legislative council of Hong Kong has passed an amendment to the Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Bill 2022, set to come into effect from June 1, 2023. The Bill will require virtual asset service providers (VASPs) operating in the region to obtain a license and comply with anti-money laundering guidelines and investor protection laws. Those who fail to obtain a license may face a fine of $5 million and imprisonment for 7 years. In December 2022, Hong Kong also launched its first two cryptocurrency futures exchange-traded funds as part of its efforts to become a major digital asset hub in Asia.

US:

Commodity Futures Trading Commission (CFTC).

In August 2022, bipartisan senators introduced the Digital Commodities Consumer Protection Act (DCCPA) that would establish the Commodities Futures Trading Commission (CFTC) as the primary regulator of digital asset commodities and thus close one of the biggest gaps in the existing crypto regulatory system. In Fiscal Year 2022, the Commission brought 18 actions involving conduct related to digital assets, representing more than 20% of all actions filed during FY 2022.

Securities and Exchange Commission (SEC).

The SEC nearly doubled the size of its unit responsible for protecting investors in crypto markets in 2022. Memorable cases of this passing year include

  • A lawsuit against a crypto influencer for not disclosing incentives liked to an ICO. In the same case, the SEC implied that all transactions on the Ethereum blockchain fall under the US jurisdiction, since the majority of the Ethereum network’s nodes are located in the United States.
  • In July, the SEC used its first case on insider-trading to declare 9 more cryptos as securities.
  • In December, the SEC charged SBF with defrauding investors, while investigating other securities law violations.
  • The SEC also published its Strategic Plan for FY 22–26, where it stated that “the rapid growth in crypto assets ... represents evolutionary risks.”

Financial Crimes Enforcement Network (FinCEN).

In December 2022, Senators Warren and Marshall proposed the Digital Asset AML/CFT bill, which directs FinCEN to treat a broad range of crypto service providers as ‘Money Service Businesses’ (MSB) and thus require compliance with AML programs and KYC rules.

So far, 2022 has seen a significant amount of regulatory activity in the crypto space, but it’s likely that we will see even more in 2023. Here are some of the ways that global crypto regulation is expected to evolve in the coming year:

Black Swans of 2022

2022 was a year of unprecedented “black swan” events for the cryptocurrency market. The volatility of the market led to a lot of players being forced out, as they were unable to withstand the financial strain.

Terra

Terra was the first domino to fall in 2022, which sparked a chain reaction that played out through the rest of the year. What happened to Terra? In our March newsletter we explained the mechanism of TerraUSD (UST), which is Terra’s algorithmic stablecoin.

UST is an algorithmic stablecoin and LUNA is a token helping it maintain its peg. UST maintains its peg to the US dollar thanks to arbitrage incentives and protocol mechanisms. Any market participants can mint 1$ worth of LUNA and burn 1 UST or mint 1 UST and burn $1 worth of LUNA.

Under bear market conditions, LUNA’s price is likely to lose value. If LUNA is used to keep UST peg, users can naturally speculate the peg may fail if they sell their UST. If UST supply is not satisfied by sufficient demand, UST will go under the peg. The protocol will then proceed to mint more LUNA to keep peg, causing LUNA to lose more of its value and the theoretical “death spiral” is born.

As a precautionary tactic against the death spiral, Terra was accumulating its Bitcoin reserve in months leading up to the collapse. The Luna Foundation Guard (LFG) began its purchases in January with roughly 9,100 BTC, and continued with additional purchases in March, April and May. At its height, this reserve was 42,531 BTC and worth more than $1.7 billion. The LFG was planning to implement an additional layer of defence that could add stability to the UST stablecoin.

The logic goes as follows: instead of interacting with the protocol that mints new LUNA to keep the peg, users could also interact with the BTC reserve. The reserve will give out $0.98 worth of BTC to any users that provides 1 UST. So, if UST is trading under $0.98, market participants will be incentivized to buy BTC at a discount using UST. The increase in UST demand will recover its price to peg. Therefore, BTC is not used to mint or burn UST but only to recover its peg to $1.

In practice, the Terra ecosystem’s death spiral played out slightly differently. It did not start with Luna losing value, but with a bank run on UST. Before UST lost its $1 peg, 75% of all UST were deposited on Anchor Protocol. Offering almost 20% APY on UST deposits, Anchor was the main driver of UST adoption but was also its point of failure.

On 7 May, over $2 billion worth of UST was unstaked and taken off Anchor, and users quickly withdrew hundreds of millions of their deposits. Since for most of them the only reason these USTs were bought in the first place was Anchor’s promised high fixed interest rates, users naturally proceeded to sell their USTs on the open market. The huge selloffs brought down the price of UST to $0.91, from $1, and triggered the death spiral.

To save the UST peg, the Luna Foundation Guard (LFG) not only deployed its entire Bitcoin reserve to defend the peg, but also loaned $1.5b in Bitcoin and UST to market makers in a last-ditch attempt. Both attempts failed. LFG’s BTC and USD reserve are empty, UST did not recover the peg, and LUNA lost nearly all its value.

In the aftermath, Terra founder and CEO Do Kwon was quick to propose a recovery plan. The plan included the fork of the Terra chain into the legacy Terra Classic (LUNC) and the new Terra (LUNA) chain. One billion new LUNA tokens were issued and airdropped to the LUNC and UST token holders, as well as developers. The new LUNA network is fully community owned. It does not support LUNC or UST tokens which came somewhat unexpected.

The crypto community, backed by Ethereum co-founder Vitalik Buterin and Binance CEO Changpeng Zhao (CZ), suggested that small retail investors should be refunded before whales. However, Do Kwon’s revival plan was highly frustrating because it provided little differentiation between retail and large-sized holders.

Ultimately, the revival plan went forward following a governance vote with a meagre 65% approval rate. It was reluctantly passed, as it represented the only hope for legacy Terra stakeholders to be whole or at least receive a decent number of cents on their dollar.

Since what had happened in May, there have not been many updates about Terra apart from the occasional burning of LUNC tokens that provided temporary boosts to price. However, the burn rate has been decreasing — from 18.8 billion in October to 9.2 billion in November, and further towards 7.8 billion in December. This is not enough to support the ever-dwindling token price.

Above all, there has not been much progress in the restructuring of the Terra ecosystem. It is still highly uncertain where Terra 2.0 is headed towards. Meanwhile, despite the LUNC and LUNA token losing 99% and 83% of its value year-to-date, they are still ranked 40 and 124 respectively in terms of market cap. If the lack of progress continues, we could anticipate the slow bleed for both tokens to continue into 2023.

The South Korean government launched official criminal charges against Do Kwon, including fraud and breaches of South Korea’s capital markets law. He also faces several class action lawsuits from investors from South Korea, Singapore and the US. So far, Do Kwon has evaded from persecution by fleeing out of the country and staying at destinations that do not have an extradition treaty with South Korea. According to a report on 13 December, he was seen in Serbia and converted some of his Bitcoin into cash.

Disclaimer

This material is intended for use solely by professional investors (as defined in the Cayman Islands Monetary Authority from time to time). It should not be reproduced, redistributed, passed on to any other person or published, in whole or in part, for any purpose without the written consent of JKL Digital Capital Limited (‘JKL’). Although information contained in this material has been compiled from sources believed to be reliable, JKL does not represent or warrant the accuracy, completeness or reliability of the information contained in this material.

The contents of this material have not been reviewed by any regulatory authorities. You are advised to exercise caution in relation to the contents of this material. If you have any doubt about any of the contents of this material, you should obtain independent professional advice. Neither JKL nor any of its affiliates, nor any of its or their respective directors, officers, employees, and representatives will accept any responsibility or liability whatsoever for any direct, indirect, or consequential loss arising from the use of or the reliance upon any information contained in this material. This material does not constitute an offer or an invitation to subscribe for or purchase any financial product. It is not intended to provide the basis of any credit or other evaluation and should not be considered as a recommendation to purchase any financial product.

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JKL Group

Quantitative fund focused exclusively on trading digital assets and blockchain technology. Find out more on www.jkl.capital