Institutional top of mind | #1

We all know the digital assets markets move fast and it can be challenging to keep up with all the movements and news impacting the institutional space. Our institutional team shares their top-of-mind digest in an easy to read TL;DR format, so you can stay informed on the big picture. Kelvin Lam, CFA, Head of Institutional Research for OKX, looks at two top-of-mind issues in this installment: What Curve Finance's recent exploit means for the DeFi Space, and why an uptick in volatility could be happening soon.

Top of mind: Curve Finance's exploit exposes risks in the DeFi space

Curve Finance, one of the largest protocols on Ethereum and a popular stablecoin exchange, has recently fallen victim to an exploit, as revealed in a tweet from the project. The exploit has affected several pools (alETH/ETH, msETH/ETH, pETH/ETH, CRV/ETH) using an older version of Vyper, resulting in an estimated loss of over $70 million in funds. While the damage appears to have been contained as of the time of writing, the vulnerability of Curve Finance concerns traders and the DeFi community at large. Curve Finance plays a significant role in DeFi trading, serving as the primary venue for traders to swap stablecoins on-chain and maintain the peg of stablecoins through market forces. The recent hack has raised concerns about potential ripple effects in the DeFi space and the risks associated with trading on DeFi platforms.

TL;DR

• The DeFi ecosystem started to take shape in 2018 with the birth of Compound and Uniswap. DeFi summer in 2020 further accelerated the ecosystem with massive liquidity and infrastructure growth. At the same time, the booming DeFi space provides ample opportunities for traders and institutions to generate profit by running different kinds of strategies. It begins with simply providing liquidity on AMM, lending out tokens through lending/borrowing pools, and then later using a more complex DeFi strategy that involves arbitraging, flash loans, conducting leveraged yield farming, liquid staking, derivatives trading etc. All of these are driven by the same motive - to generate additional alpha apart from trading on centralized exchanges (CeFi), which is still the primary trading venue for cryptocurrency.

Following FTX's bankruptcy, there's been a significant increase in Spot trading volume between Decentralized Exchanges (DEX) and Centralized Exchanges (CEX), mainly due to concerns about counterparty risk associated with centralized exchanges. However, the recent exploit of Curve protocol has brought to light the inherent risks of smart contracts in DeFi and the potential for a systemic crisis triggered by hacks.

• Over $665M was lost in DeFi hacks and scams in the first half of 2023, according to data reported by De.Fi. Below is a selected list of DeFi hacks over the past few years, which have had a material impact on institutional traders and DeFi market participants. From these events, several observations can be made regarding the nature of these attacks:

• Decentralized Finance (DeFi) protocols and tokens are becoming increasingly interdependent, with many protocols relying on others for liquidity, collateral, or derivatives. While this interdependence can create efficiencies and synergies, it can also lead to systemic risks in the event of a hack or exploit, which causes collateral damage to be far greater than the original hack or exploit itself.

• Despite advancements in security and risk management, common vulnerabilities continue to pose significant risks to the security and stability of DeFi protocols. Two such vulnerabilities that have been repeatedly exploited in recent years are Bridges and Flash Loans.

• The largest and most established DeFi protocol on the market doesn't inherently guarantee its safety and security. In fact, these protocols are often the primary targets of unethical hackers, who are constantly searching for vulnerabilities and weaknesses in DeFi systems to exploit.

Top of mind: Why the prolonged period of low volatility may be nearing its end

In assessing the current market landscape, it's clear that the US equity markets and cryptocurrency markets are both witnessing a 1-year low in volatility (see chart below).

TL;DR

• For the US equity market, the CBOE Volatility Index (VIX) is commonly known as a fear gauge of the market. Despite the prevailing bearish sentiment initially observed at the beginning of the year and the banking crisis in March, the recent developments in the S&P 500 rally and positive economic data have shed light on the potential for a soft landing scenario. This leads the market to believe in a gradual and controlled deceleration of economic growth, mitigating concerns of a sharp downturn. Furthermore, hedge funds that employed CTA strategy (trend-following) and Risk Parity strategy (prefer assets with lower volatility) have been actively increasing their long exposure to US Equity. This strategic shift is driven by the outperformance of US Equity and a relatively lower level of volatility throughout the year. As a result, these hedge funds' buying continues to push the VIX lower, reflecting the prevailing trend of reduced market volatility.

• For the cryptocurrency market, the depressed level of implied volatility can mainly be attributed to the lowered trading volume and market sentiments. Major market makers reportedly slowed their crypto trading business in May and on-chain analytics data shows that the long-term holders of Bitcoin are accumulating Bitcoin, absorbing the available supply. With the tighter trading range that Bitcoin has been undergoing, traders have also been more hesitant about major market movements in the short term. More specifically, crypto option traders have been leaning toward short-vol strategies over the past few months.

The road ahead

Interestingly, there are indications that the prolonged period of low volatility in both equity and crypto markets may be approaching its end. Examination of 33 years of historical data for the VIX reveals a seasonal pattern, characterized by a decline during H1, reaching a trough in summer, and rising in Q3. Currently, the VIX is trading at its post-pandemic low, and optimism surrounding a soft-landing scenario has already been factored into the market. Any unexpected economic data or central bank guidance can send shockwaves to markets. This can be a turning point for the VIX, triggering a surge in volatility that follows the established seasonality pattern.

According to data from Glassnode, Bitcoin's Bollinger bands are now at their tightest, comparable to the levels seen in early January when it rose from $16k to $21k. Historically speaking, this pattern has been followed by significant price movements. Upcoming central bank meetings and any progress updates on spot ETF applications could potentially bring volatility back to the cryptocurrency market. Additionally, the current market depth for Bitcoin (as measured by 1% market depth in native units) is significantly lower than January's levels, indicating weakened liquidity. Therefore, any increase in volatility could potentially be amplified.

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