When the tide goes out, that’s when you see who swims naked

Let me change the script a little bit this week and get away from the usual content. This week I am not going to show charts or talk about the market from a technical point of view. I am going to make a series of deep reflections on the current situation that I believe that as an investor may be more useful to you than commenting once again that we are in a situation of uncertainty aggravated by this week’s fall.

The fact is that the process of degradation of market strength continues. It has been constant since the highs of the last quarter of last year, but it is true that the situation is very different from the initial moments. We have gone from a technical decline to a systemic decline affected by several important factors.

Technical Analysis now, the least important thing

At this point, technical analysis is probably the least important thing. It is necessary to understand the context in which we find ourselves, and the truth is that the situation is not a pleasant one.

We have gone from seeing declines and technical corrections to the emergence of serious structural problems for the simple reason that we have seen a prolonged period of declines in the market.

One of Warren Buffett’s famous quotes is:

When the tide goes out, that’s when you see who swims naked

This is quite a sentence in the financial markets and it has been fulfilled again. In a situation of strong downward pressure for purely technical reasons we have ended up seeing how certain projects that were not or are not properly managed collapsed or got into trouble. And the problem is the strong contagion effect

Dangerous practices in the markets

The objective I am pursuing in today’s post is to make the reader reflect on the composition and the way of working that must be identified as correct, because that will help protect our capital.

And what we are seeing these days, shows that some of the practices and strategies that have been used by some projects, in this race to give astronomical returns have a dark side, and we are referring to those who “swim naked”.

Undoubtedly, one of the wonders of decentralized finance is that we are the custodians and managers of our capital. This allows us to act with full independence as investors. Decentralization in its purest form.

But it also gives us the possibility to further optimize our investments.

The dark side of compounding

By holding our own investments, often represented by tokens such as LPs, we indirectly hold in our hands our assets, even though they are invested, and this in itself is an asset to which we can again make a profit, creating a recurrence capable of multiplying our profits.

But… this is not free

This strategy, used by many, involves several dangers:

  • Issuer risk: In this case, we have deposited our capital in a protocol to produce a profit and as a representation of our position we are given a token colatelarized with our assets. And in principle, its price should be linked to them. However, if this is not the case, the dreaded depegg occurs and we have a serious problem. To this risk we have to add the fact that this issuer may have a problem, go into default or disappear.
  • Automatic liquidations: These investment systems, which in the end we can define as structured products or derivatives, are subject to maintaining the price of the underlying assets in certain ranges, under the threat of automatic liquidation of our position in the event that the collateral is devalued and thus protect the integrity of the protocol. This casuistry produces huge cascading liquidations in the markets when massive sales start to occur.

New system with old vices

Some have lived in the fallacy that this new financial system could replace the old one, because it could not reproduce traditional market situations. But this ignores the fact that these products, like the traditional ones, are simply tools, and therefore, these types of errors or bad practices are not caused by the tools, but by who uses them.

To illustrate this concept, I will draw a parallel that will have a great impact on the reader:

2008. Subprime crisis

In 2008 we experienced one of the biggest economic crises in history. The origin lies in the dangerous domino effect that the financial system experienced, caused by the presence in many of the investment portfolios of a certain financial instrument: the so-called subprime mortgages.

Without going on too long: a subprime mortgage was granted to a person or entity whose financial rating indicated that it might not be able to repay the loan as agreed. But they were required to present real estate as collateral or security for the loan. 

Real estate was an asset that was continuously revalued, therefore, at the time of foreclosure, the value represented by the collateral ever exceeded the value of the loan.

Until they started to fall… and the financial institutions found themselves with a large mass of undercollateralized loans. We all know the end

2022. Crypto crisis

What we are experiencing now bears an extraordinary resemblance to that situation. In many cases we have assets collateralized with other assets that were thought to be going up and up (cryptoassets). As this was a reality, it was possible to be flexible when designing protection or collateralization policies.

Until this was no longer the case and we have seen who was swimming naked…..

The decisive fact here and differential with respect to other market crashes, is that this one occurs with Decentralized Finance in full expansion. Finance has provided or favored the proliferation of this type of financial instruments with a more than dubious risk management.

The important thing is the value vs. price comparison

I believe that the immediacy, the prolonged bull market and other factors have influenced the general level to lose perspective and not pay attention to what really matters, which is the difference between value and price.

Without going any further, two days ago we had a request from a media outlet for us to make an assessment of the current market situation… from a price point of view. No one is asking about the value of assets, which is what prevails in the long run

This is a dynamic that we have to change as investors. There is little point in an astronomical return now, if the value of the assets that support it will tend to go down in the long term or is much lower than what we brought in at the time of the investment

Crypto-assets and their more complicated context

I think we have to recognize that a large part of the problem is external to the cryptoasset market itself. We cannot close our eyes to what is happening.

And undoubtedly, one of the most outstanding facts is to note the importance that an institution such as the Federal Reserve has gained in this market. Although it may sound paradoxical, assets that advocate decentralization and, therefore, the dismantling of central banks, have ended up dancing to the tune of its policies, and how.

We have visualized this fact several times with Bitcoin prices and their movements in the days and hours following the FOMC committee meetings, but this has been at its peak when the central bank has had to change its monetary policies to combat inflation, ending a prolonged period of expansion.

This contraction at the monetary level is something completely new for the crypto ecosystem, and it will have to adapt to this new context. In all likelihood, this new scenario discourages, for the time being and to a greater or lesser extent, investment in cryptoassets.

It remains to be seen how this ecosystem fits the fact that we are seeing a significant decline in system liquidity, not least because we are seeing how the latest drops in the cryptoasset market are not isolated. All financial markets are in contraction

Lessons learned

I believe that this whole situation should lead us to draw conclusions that serve as important lessons, and above all that make the crypto ecosystem mature emotionally and psychologically. 

We must be especially cautious in our decisions, and above all always make a detailed and accurate analysis of the risks

  • Perhaps… there are certain practices or actions developed by the traditional system that are not dangerous or pernicious in themselves, and can be useful.
  • Perhaps… total decentralization exposes us to more dangers than advantages.
  • Perhaps… the development of highly leveraged products and practices based on an huge compounding is not a good idea from the point of view of risk management.

In the end as always, and more so in this market, the sole and full responsibility for our investment decisions lies with us. Remember that there is no counter here to complain.

And as a final thought, I will quote Carlos Gómez, Belobaba’s CIO:

When you don’t know where profitability comes from, profitability is YOU

We must always understand the products in which we are investing, otherwise we will end up losing our money.