About karmcy

https://karmchoudhry.com

Posts by Karm Choudhry:

shutterstock_1653095863 (1)
karmcy
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$10k to Start a Manufacturing Business?

Forget manufacturing in China and spending millions to set up a plant. What if i told you, you could set up a manufacturing business for $10k. Here’s an industry that is now set to grow in dimensions we don’t fully understand. Additive Manufacturing. What’s Additive Manufacturing? It’s 3D printing. It’s called that because it’s different from subtractive method of production – which removes unnecessary materials from the final material.

The technology for 3D printing has existed for many years now, but what makes this moment special is that it has advanced enough where it is price competitive to larger manufacturing players in several categories already. In fact, according to research from grand view research below, it is already a 5 to $10 billion USD market, and set to grow at a very healthy CAGR of 21% for the rest of the decade – creating opportunities in many interesting ways.

north-america-additive-manufacturing-market

 

One of the first successful applications was in the dental clinic. Patients who needed a dental implant or crown – Instead of waiting for a week, could now have one during a single doctors visit. This was a game changer in terms of patient experience.

Perhaps you know someone who has had Invisalign? That’s another medical procedure enabled through the use of accessible 3D printing. Retainers are produced for only a few dollars each, and sold at a roughly 95% gross margin.

There are several existing and to be developed niche applications to 3D printing – from construction to jetfuel (yes fuel for fighter planes!) so the sky is literally the limit. Barriers to entry are relatively low with potential first mover advantages in several new categories. The person who develops the channels first, will have distinct advantages over future challengers. Here are some sample prices of 3D printers used for medical (dental) applications – TLDR, it’s not a whole lot.

Screenshot 2024-07-16 at 3.13.42 PM
I’ll present a case study of a firm who has successfully identified a very interesting and promising niche in this space soon.
karmcy
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Problems: We all have them, now what?

Lets face it, we all have problems and the number of them grow over time. Health problems, family problems, problems in business or your career. The focus of this post is really about professional problems, but for the others, my opinion is that they are typically symptoms of something broken in system. If you can find and fix them before they become “terminal”, you can transform your reality in ways you don’t see yet.

In my professional life, it turns out that I tend to seek out problems. I’ve complained and I’ve suffered through them – skimping on meals to support my startups struggling with cash flow, or staying up all night wondering how to move a key strategic partner who has become a bottleneck and is killing my momentum. And unfortunately, as my ambition grew, and my impact in the business world grew – so did the quantity and magnitude of my problems.

As time passes, and as I’ve seen some successes at the end of my struggles, I’ve started to view problems very differently – as simple things that show me where opportunity lies. And often the big, most consuming problems – represent the biggest opportunities of them all (if it is not too late to fix).

If you think about it differently, finding and solving problems is the actual goal of businesses. If you’ve improved a workflow or adapted your product or business to deal with a pressing problem, you’ve likely just created tremendous value – something will will likely be financially or personally rewarding. I’d venture so far to say that in my opinion, the pursuit of success is pretty much the pursuit of more problems for yourself. And I can’t speak for anyone besides myself, but while a part of me craves a peaceful life, I know that if I found a life without daily struggles, I’d feel like I wasn’t living up to my potential.

In summary, there seems to be a universal law where one’s success is directly correlated to the volume of problems one has solved – you only need to look to people like Elon Musk and the cash flow constraints at Tesla or SpaceX, or the constant legal battles to see a manifestation of that.

So I wish you bigger professional problems, and also the fortitude and creativity to solve those problems. Because when you get over the initial frustration and find a way to solve it – you’ll likely make yourself, your net worth, and the world a little bit better.

… And if you have a particular professional problem that you’d like to brainstorm – don’t hesitate to reach out and I’m happy to see how we can untangle it together.

karmcy
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Four reasons why I turned down the chance to bid in the FTX bankruptcy auction at a 50% discount.

And why i think you should've done the same

Yesterday I was invited to participate in the liquidation of assets from bankrupt crypto lender FTX, along with a group of other accredited investors. Winners of the last auction won Solana SOL tokens at roughly half the current market price. Is this a no brainer deal? Here are 4 reasons why I said no and why I would not suggest you invest $100k in this deal either.

1. Liquidity (Lack Off)

FTX received it’s tokens from Solana for pennies, with the contingency that they remain locked on an unlocked schedule until Jan 2028. Despite acquiring SOL tokens 50% discount, part of the deal is that the assets acquired would be unlocked at the same pace: 1.75% every month, with a cliff unlock of 23% in March 2025. On the positive, all locked SOL are staked at ~7% APR, and all staked yields are completely liquid.

Crunching the numbers, $100K invested at a discount of 45% of current price of $136 would buy 1337 locked SOL tokens at an average price of $74.5. By end of 2025 (20 months), you would have access to 841 SOL (accounting for fees, staking yield, unlock schedule etc). 584 SOL would remain locked (43.6% of the original purchase) for the next several years.

Screenshot 2024-04-29 at 8.38.59 PM

2. High Volatility makes it worth it to buy more expensive SOL in the open market

This is where a lot of sentiments can probably chime in. These are highly volatile assets. Buying the VOO index fund for half the current market value and locking it for 4 years, would’ve been a completely different decision. Crypto assets can fluctuate by 10% a day at times. I can’t imagine how much pain I would feel if the market hit Euphoria and I couldn’t sell.

In fact, I did a second calculation where I compared what the math would look like if the market price dropped only 15% to $115 and I invested the same $100k in a direct purchase in the market and staked everything. (Note: the price of SOL did actually drop to $115 two weeks ago, so this isn’t all that farfetched).

The result? $100k buys you 870 SOL tokens, and by the end of 2025, you’d have a total of 951 SOL (adding staking yield). This is 110 more liquid tokens than you’d have access to than buying at auction.

The reason I compare both situations to the end of 2025 is because many analysts believe this is the time when previous crypto cycles have peaked. Question for you: Would the extra 110 SOL sold at the market peak be worth more than the 584 SOL locked up and earning yield? With a 97% decline in SOL’s price last cycle from peak to bottom, I think there’s a case to be made that it would be.

3. Opportunity Cost

I’ve had assets locked up for 3 years before. It isn’t fun. Liquidity lets you to stay nimble and take advantage of opportunities. Locking your funds for 4 years is a mostly irreversible move. I tend to believe that tight monetary policy continues to apply pressure on the business cycle. My personality prefers to remain flexible and take advantage of opportunities as they come.

4. If it seems too good to be true, it likely is.

This one is more superstitious than anything else. But if opportunities to bid on major assets are presented to puny investors like me. To me, this means the hedge funds have passed them down. This is presented as an opportunity to buy something at 50% off, but its not. It’s really a bad opportunity, and those with access to billions know it.

Again, I could be wrong and this may turn out to be an amazing deal. I mean, imagine buying bitcoin at half the market price and it being forcibly locked up for 4 years. ($$$!)

Time will tell. You’re welcomed to disagree with me, and if you are an accredited investor and would like to participate in the auction yourself, do not hesitate to reach out and I’ll connect you with the VC firm investing in this.

karmcy
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Humanity of jobs has changed

Humanity of jobs has changed A perspective I wish someone would have given me.

Behaviors starting with interpersonal relationships ended in the labor market.

When I was a kid I remember life time relationships and friendships were all around me, then I heard about a 50% divorce rate and a trend towards nuclear families and the parading of independence by many. Eventually we ended up in the world where its commonly accepted to ghost one another, not keeping one’s word, and show an utter disregard for anyone outside of yourself – and we wonder how we ended up here.

In my opinion, the job market has always been 10 years behind social culture. It isn’t because the nature of jobs are changing (they are changing, but what we see is not because of AI), but because the value of humanity in the workforce has changed under the perhaps fair banner of business interests. Symptoms of this: being laid off after 5 years via email, or being ghosted after 6 rounds of interview. I remember in my last venture, one of my employees suggested we post fake job postings with no intention to hire. I couldn’t do it, but I see it all around me. Toying with the emotions of people in need has little value compared to the interests of the hiring companies, customers and so on.

Before I share what this means, I do have to caveat the understanding of the business cycle. I personally believe we are in a recession, but even if not, i’ve felt the uphill battle businesses feel against macroeconomic conditions – be it the pandemic, inflation, tight monetary policy, labor shortages – I’ve led companies in all those conditions. But there’s something remarkable to be said about what’s considered acceptable in how humans treat each other these days outside of the economy.

Anyway, it’s either a nobleman or a fools journey to try and change the entire world – and I am neither. The purpose of this note is to spread this awareness to someone else whom may not see things as clearly. Luckily, I was fortunate enough to do well in my career and develop financial discipline and some prudence as an investor – so that a change in culture or a dip in economic conditions has negligible impact on my life. I can afford to disappear from the corporate world if I so choose. However, I feel for the millions of Americans who were never exposed to these skill; whom spend up to their means and stretched their budgets to their limit in order to pay the most rent, and buy the most expensive luxury goods and experiences they could afford.  

In my opinion, the future of the labor market is – everyone is an independent actor. We always have been, but it’s just painfully more obvious now and more necessary for everyone to acknowledge than ever before.

If you’d like some help in developing your own financial strategy, feel free to reach out. I’m not a career coach but I can try to help you get to where I am via some simple financial planning and investing.

karmcy
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Inflation in a US millennials lifetime (an independant review)

Inflation is defined as the decline in purchasing power of a given currency in time. Typically this is measured by measuring changes in a spread of the price of a basket of goods and services – things like oil, corn, etc. But this is an independent review, so let’s see if we can look at this another way.

For me, very simply, the measurement of inflation is how far will my dollar go when it comes to buying me things I want. And there are a few ‘things’ I would want my dollar to buy me:

  1. The dollar buys me things I need – These are the traditional household goods and individual services typically associated with the ‘regular’ definition of the term. My car and a back massage among everything i consume to live.
  2. The dollar buys me a home to stay
  3. The dollar buys me more dollars – I do have an MBA after all, and investment and productive assets are important to me as they help me gain wealth and improve the quality of my life over time.
  4. The dollar buys me ‘security’ – what i mean here is that it allows me to buy assets or freedom to get through a rainy day. Security here could mean a savings account in case I get in an accident, or it could be a global use of the world, and includes security from a massive EMP wiping out the internet, or a monetary reset, or any of the other things that haunt me from The Purge movies I love.

Since these are the things I’d like my dollars to do for me (and for the purpose of this article lets say each is of 25% importance to me) –  If the price of my groceries are going up, but the cost of my home is going down – I’m overall OK. But to understand the net change of monetary and fiscal policy during my lifetime, I’d like to look at all of these first independently and then cumulatively to see what type of historic advantage or disadvantage I have. So let’s begin.

Things I Need Burgers, Cars and Back Massages

CPI

The Result:

The US Urban CPI has multiplied 3.2 times since 1980, at an average of 2.9% per year.

In the last 12 months, it increased about 5% (although admittedly a majority of this increase is related to the price of gas, which is manipulated by an oligarchical market, and used car prices influenced by a supply constraint for semiconductors)

A Place To Stay My Home-Office, Home-Gym, and Kitchen

Median Sales Price of Houses

The Result:

Median sale prices of houses have increased 4.2 times since 1980, at an average of 4.1% per year. .

We also saw an 8% increase in the last 12 months, (notably peaking at about 11.5% before coming back down). This is also heavily influenced by lack of inventory related to:

  1. New building construction reduced due to lockdown, staffing and high lumber costs.
  2. Evictions, foreclosures etc being restricted by law
  3. Frank and Mary not wanting to sell their home during a global pandemic.

More Dollars My Stocks and Bonds Portfolio

Things are about to get more complicated, so lets keep things as simple as we can and assume we are an average “defensive intelligent investor” with a 50-50 split between SP500 stocks and US bonds.

S&P 500

The price of S&P500 index has increased 32 times since 1980 at an average of 8.9% per year.

A large part of this would be corporate decisions to re-invest dividends which would add the  dividend yield into the price of the stocks – so after subtracting (lets approximate 4% as the difference in yields), we see an approximately 5% price growth per year.

Partially affected by the sell off in March ’21, the SP500 has risen 40% in the last 12 months (although in July ’21 the market had almost completely recovered and was only 8% lower than previous all time highs)

10Y Treasury Bonds

Since 1980, we see an 85% decline in bond yields, which would push the price of a 10 year $50 coupon $1000 bond (5% is approximately the average of the bond yield over the last 40 years) –  from $590 to $1340.

This shows that bond prices have more than doubled for similar coupon, or indicating a 2% growth in bond prices over the last 40 years.

The Result:

Putting it together, we have a total inflation for a 50-50 portfolio to measure at (0.5 * 5%) +( 0.5 * 2% ) = 3.5%

Security Savings and Valuables

Savings Rate

We need money in savings accounts for a rainy day, but savings/ money market accounts behave similar to bonds described above but for reference the MMAs dropped yield from over 12% to under 0.1%.

Gold

If not MMAs long term, perhaps we look at what many consider the “ultimate safe haven” aka gold. The Result:

Gold price increased from 555 to 1800. Price increased 2.2 times or at an average growth rate of 2.9% per year.

Putting It All Together Whats my score?

So what does this all mean? Well the first observation is that everything has gotten more expensive and that my dollar seems to be buying me less of everything that I want.

I realize this is intuitive, because we all “feel” it. But let’s put a few calculations together to try to accurately measure our feeling.

We’re not spending 100% of our dollars on corn, or on our houses, or on stocks or bonds so lets allocate the spend in each category to measure overall inflation. If we keep it simple, and evenly break down spend into each of the 4 – that is, we spend 25% of our dollars on things we need, 25% on a place to stay, 25% on making more dollars, and 25% on a safe haven of wealth – we see: (I realize there is lots of variability in this breakdown for each person.)

Total Annual Inflation = (0.25* 2.9%) + (0.25* 4.1%) + (0.25* 3.5%) + (0.25* 2.9%) = 3.35%

Cumulative dollar weakening felt by someone born in 1981 is about 74.5%. Aka $1000 in 1980 are worth $255 today after adjusting for the compounding effect of the inflation each year.


Wages since 1980 What's my score? (part 2)

Wages

The Result:

For reference, looking at the 30 year average of wage growth in the United States. Wages have grown by about 3%, slightly under our “true” measure of inflation.

In Summary It's safe to say that it has become more expensive for me to live, and harder for me to gather wealth and security. By about 0.35% each year.

karmcy
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US Sectors: Charts

When people buy the S&P 500, they buy the 500 largest US firms in ratio to their market cap. These firms spread across industries, and so the exposure of one’s portfolio to the various sectors depends not on the importance of a particular sector in the GDP, or its need in the current economy – but by the size of the largest firm(s) in the space. Still, markets are cyclical and one may choose to increase ones exposure to a particular sector in order to boost performance in certain times – or alternatively verify the current price of a sector with relation to the overall market in order to better understand public expectations and potentially risk.
The weightage of the S
The weightage of the S&P500 for each sector on May 23, 2021
At the time of this writing, the S&P500 has the largest weigtage in the technology sector – primarily driven by the fact that Aaple, Amazon, Microsoft, and Facebook are essentially monopolies in their individual spaces and have the largest market cap for individual companies in the US. The smallest market caps belong in utilities, energy, materials and real estate. Partly due to government intrusions when monopolies formed in these sectors and also the inefficiencies of scale in real estate. The charts below will show what the ratio of each of these sectors is in the current market cycle, with a historical perspective. Changes in this ratio over time may determine the importance of a particular sector in a current economy, or (more likely) speculation towards performance of a particular sector in a current time. A historically high or low ratio can never be a sole indicator as to whether to buy or sell a particular sector – but its always good to reference these charts, and personally – i would caution against a buyer from buying a sector at the peak of its speculation.

Nasdaq 100 (Technology Sector) / SP500 Ratio

Normally we would use the VGT, but due to the sizes of the leading tech firms, the Nasdaq 100 almost perfectly matches tech sector performance and offers a longer historical time frame
QQQ/AMEX Chart by TradingView

Communication Services / SP500

VOX/AMEX Chart by TradingView

Consumer Discretionary / SP500

XLY/AMEX Chart by TradingView

Healthcare / SP500

VHT/AMEX Chart by TradingView

Financials / SP500

XLF/AMEX Chart by TradingView

Industrials / SP500

XLI/AMEX Chart by TradingView

Consumer Staples / SP500

XLP/AMEX Chart by TradingView

Energy / SP500

XLE/AMEX Chart by TradingView

Materials / SP500

XLB/AMEX Chart by TradingView

Utilities / SP500

XLU/AMEX Chart by TradingView

Real Estate / SP500

VNQ/AMEX Chart by TradingView
karmcy
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Charts: Crypto

Just one rule so far in Crypto:

Bitcoin is King. Everything else comes and goes.

* Although ETH is starting to push that rule, and looks more like the Silver to BTC representing Gold.

Therefore, when looking into enter the market either in BTC or an Alt Coin, a few charts should be referenced first.

  1. The Ratio of Crypto Market Cap that is referenced by Bitcoin – when BTC’s share of the crypto market drops, typically it suggests that Alt Coins prices are artificially boosted due to speculation.
  2. When looking to enter a particular coin, the ratio of that coin’s price to BTC is essential. The higher that ratio, the less likely I would want to enter that particular coin.

Here are a few interesting charts below. But remember that this is a speculators game, and I would only participate in this market for “fun”, and restrict an overall allocation to crypto to – lets say- 10% or so? You decide. (And dont judge me because I’m already allocating more than that!)

BTC Dominance (BTC MarketCap / Total Crypto MarketCap)

BTC.D Chart by TradingView

ETH / BTC

ETHBTC Chart by TradingView

ADA / BTC

ADABTC Chart by TradingView
karmcy
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Charts: US Equities

The market ebbs and flows across time – driven by greed, and speculation on one side and fear, uncertainty and doubt on the other.

Yet, I do believe that the diversified portfolio of the US largest firms remain the safest asset class. Yet, that doesn’t mean they are attractive at any price. In fact, waiting for the right time to buy MAY actually be a great way to play the game IF you can find an adequate rate of return using an alternative method. (and with some creativity you can!)

So here are some ratios that remind you where the market is with relation to historical records.

SP500 / Gold Ratio

SPY/TVC Chart by TradingView

Emerging Markets / SP500

EEM/AMEX Chart by TradingView

Nasdaq 100 (Tech) / SP500

QQQ/AMEX Chart by TradingView

Mid Cap (Blended) / SP500

IJH/AMEX Chart by TradingView

Small Cap (Blended) / SP500

IJR/AMEX Chart by TradingView

Value (SP900) / SP500

IUSV/AMEX Chart by TradingView

Growth (SP900) / SP500

IUSG/AMEX Chart by TradingView

A few more things could be looked (in addition) at to evaluate BUY or SELL signals to manage risk.

1. PUT/CALL ratio : You’d like to not buy when the ratio is under 0.75 and possibly buy when its over 1.
2. Volatility : When volatility is at a low (especially around lines of support), the risk of downside is higher as volatility is expected to rise.

SP500 : PUT / CALL Ratio

PCC Chart by TradingView

SP500 : Volatility

VXX Chart by TradingView
karmcy
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AI Trading program placed #18 nationally (25.87% return in 4 weeks)

A few weeks ago, I wrote about a tool I created to keep a “peripheral eye” on the stock market, with plans to plug it into on online brokerage that could make trades automatically (without any involvement from me). This post seeks to share the results from that endeavor.

Between October 26 – Nov 20 ’20 Alpaca held it’s Annual trading competition that includes both active and passive traders across a multitude of strategy including Swing Trading, Day Trading, Shorts, Longs Options, Margins and so on. I decided to enter what I had made so far at the time, which was only the Swing Trading & Long only strategies. Besides being the easiest to implement, I treated my portfolio as a personal investment account, did not use margins to leverage my returns, and focused on buy low and sell high.

Obviously this came with its Pros and Cons.

PRO: the maximum risk was to lose the value of the stocks the program was holding.

CON: difficult to generate “high” returns due to 1:1 leverage and limited upside potential. (how much can a stock really grow in 4 weeks?)

So What Happened?

Market Performance

To start, we need to look at the market overall to get a better picture.

S
S&P 500: Mid Oct – Mid Nov ’20

The market during this time was mostly sideways, with small moves. It opened at $3,440.66 on Oct 26, 2020 and closed at $3,557.15. With a net growth of 3.38%.

The low was $3,230.69 on Oct 30th with a high of $3,645.20 on Nov 9th. Someone who would have perfectly timed the market and bought and sold between these two points would have made 12.8%.

Trading Bot Performance

Obviously the trading bot was not buying and selling the market overall, but was instead trading individual stocks. The trading bot performed better with an overall return of 25.8% in the 4-week period.

Portfolio Performance over Contest

Portfolio Performance over Contest

@karmcy on leaderboard

@karmcy on leaderboard

The interesting part about this is that I actually was a late entrant to the competition as I was working on a project for work, and so missed the best buying opportunities during the market low on Oct 30th. Still, the program started trading a few days after, and grew quickly amid a slightly bull market.

As you can see, the returns were generally positive, with little swing – which is something that was planned. At its highest point, the algorithm had created 27.81% of unrealized profit – and ranked #8 overall.

However, since this was a contest within a 4-week timeframe, an exit strategy became important as the strategy I was using required multiple weeks but I only had a few days. At this point, I took a very risk averse outlook with an emphasis on preserving and growing the capital instead of trying to buy new stocks (which would again need time to grow).

My modifications at this point were new to me, and I made mistakes exiting these stocks, losing about 2% of overall gains, and ending at #18 nationally with 25.87% profit (or $25,868.77 in profit from a starting balance of $100,000). 

Final Leaderboard at competition close

Final Leaderboard at competition close

Click To View Official Contest Results

Post Competition Thoughts

1. Margin/Leverage + Options vs Investment + Long-only

The first observation I had was that there was consistent fluctuation among the top 10 in the leaderboard. The top few rankings would consistently change between people who made a lot of money, only to lose it all and drop out of the rankings next week. In fact, several of the people who finished on top at the end of the competition had swung up over 300 places only a couple days before the competition closed. 

Logically, this makes sense, high risk yields high reward scenarios and a 4x leveraged options trading strategy can do just that. Still, this was acceptable to me and something I consciously chose not to do, but looking forward – I will consider ways to maximize some returns while keeping risk at a level that is acceptable to me. At the very least, I’m looking into an Artificial Intelligent strategy to short stocks on the way down.

2. Human traders vs Artificial Intelligent / Machine Learning Machines

Most of the people on the leaderboards were human traders (if you look at the leaderboard image where I was ranked #8, 9 of the top 12 competitors were active traders aka human beings who were “Active Daily Rebalancing” their portfolio). Besides the point covered above, I didn’t find any noticeable advantage or disadvantage of humans when compared to an AI trading program that incorporated statistics and machine learning in a way that humans are not able to do quickly. Still, I also don’t have a lot of data to make this inference as I didn’t see many AI bots on the leaderboards, so its hard to say.

3. On the spot changes to strategy / Quick Fixes

The final observation I had (more of a lesson) is that on the spot changes to strategy – regardless of how well-intentioned they may be, lose money. Most of the program’s success came from well researched concepts from other trading experts and industry leaders that were coded into it by me. However, when I started to tweak things based on “what made sense to me personally”, (as I did towards the end of the contest) – the program lost money. I’m confident that had I left things alone, the returns would have continued to grow until the last day, which goes to show that when trying new things, you have to try in the lab before putting it in the real world program. Luckily, I did view the whole contest as a lab anyway, and was willing to take the risk of a mistake.

So what’s next?

Overall, I was quite happy with the performance of the robot, and have since moved it to the real world, where it seems to be doing well so far (between 1-4% returns on some weeks, but too early to tell). However, I plan to take a break and build to it some more to be more intelligent and also prepared for outlying conditions (for example, a massive sell off). 

I’d also like to incorporate the Day Trading strategies, or at least test them out, which require data analysis in shorter periods.

If things go well, maybe this program can scale and I’d be happy to invite some of my friends to allocate some of their capital to this as well. But theres a long way to go before I feel comfortable to do something like that, and until then, you can look at the daily watchlist the program recommends below. And as always, suggestions and criticisms are welcomed.

Read Original Article
View Algorithm Watchlist
See Each Trade Made

*The stocks in BLUE are the ones I traded – but the program often bought them at an opportune time. Also, I may be playing around with my strategies in the future so use at your own risk!

karmcy
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Decentralized Finance – a house of cards (for now)

Im writing this article to spread awareness on the underpriced risk associated with the Decentralized Finance marketplace of today.

The decentralized finance system is a house of cards built upon one fundamental assumption – the base crypto asset, or the crypto market, will not crash.

There has been a recent breakout of DeFi apps, and with Coinbase announcing its integration a few months ago, it has grown to prominence even more. Decentralized finance works via unregulated smart contracts, processed by nodes (computers) spread across the world that immediately enforce the loan contracts upon specific events. One particularly powerful network might be the Etherium (ETH) network for example. It runs on over 8000 nodes and is the largest network (excluding Bitcoin). For the simplicity of this article, let’s limit this article to the ETH network only, as insights may be extrapolated (and magnified) from here unto smaller networks.

Technically 60% of the network runs on the cloud (and 25% on AWS) but for the purposes of this article, we will be ignoring a systemic risks of corporate boycott – or regulatory restriction that could bring down a large majority of the network. Instead, let’s limit our arguments to economic fundamentals – and banking 101.

Etherium Network

 

Scenario 1: The Borrower

We start with the story of Sam – an American everyday man. Sam heard about ETH and bought 20 ETH with $5,000 of savings a year ago (when the price was $250). The coins have doubled in value since then and he is now sitting with an on paper value of $10,000 worth of ETH. Sam is happy with his investment.

Recently, Sam’s wife asked for a kitchen remodel which costs $2,500, and in order to fund the project, he collateralizes his 20 ETH in exchange for $2,500 USD and a 2% interest rate (1:4 represents an extremely conservative debt to collateral ratio, and is used by Celsius). Despite the high collateral, this loan is easy to originate – requires no credit check, and the interest rate is great. In fact, Sam thinks to himself that his ETH will probably appreciate even more than 2% over the term of the loan – so he goes for it.

Unfortunately, the timing isn’t great for Sam. The price of ETH crashes for reasons not emphasized in this article* from $500 when Sam initiated his loan to $125, which causes Sam’s loan to automatically terminate, as the smart contract automatically kicks in, liquidating all of his collateral of 20 ETH to cover this loaned amount. When the dust settles, Sam has the $2500 of cash from the loan in hand, but nothing else to show. Sam is no longer happy, as he did not want to sell his ETH, which would probably have bounced back next month.

* Potential reasons include an economic event or news story that spreads a message eroding trust, or a market correction. Perhaps i’ll go into this in greater detail in a subsequent post.

This is not what we expect from the banks we have created. A loan from a bank would not be automatically terminated during a healthy repayment. While it may seem unlikely to encounter such a large drop in value, todays crypto lenders actively sell the collateral  at several price points to ensure they are holding a fixed ratio of collateral to loaned amount. So liquidation can be triggered as early as a 5% drop in value.

The only way I can think of to protect against this scenario is the convert to ETH into a USD-stablecoin, prior to payout in fiat currency so that the collateral is stable to volatility. But a deeper dive shows that this does not work any better for a consumer than selling a portion of ETH for USD to buy back into ETH later.

 

Scenario 2: The Lender

Zack went through the same market cycle Sam did, but differently. Zack is a crypto Enthusiast, and a HODLer (plans to hold his crypto until the end of time) and is sitting on a wallet of 100 ETH. He read somewhere that it’s smarter to earn interest on his assets instead of leaving them in cold storage, he participates in DeFi (Decentralized Finance) platforms earning 5% interest. In order to earn interest rates at that level, all of his ETH is converted to fiat currency and lent out on a more aggressive market which allow borrowing up to 60% of  collateral.

When a big price drop begins, the people Zack have loaned money to stop making payments because their borrowed cash amount is worth more than the value of their ETH they have as collateral. They also haven’t signed any legal documents holding them personally liable, and there’s no regulatory body that can make them. As the borrowers collateral is liquidated at lower value in order to pay back Zack, when the dust settles, Zack’s loaned ETH tokens are returned with diminished value. He has now lost a portion of wealth.

What’s scary about this situation is that willing default could start as early as a price drop of 40% of the underlying crypto asset’s value from the time the loan was originated. One has only to look to the housing market to see how it plays out – when mortgages outweigh the price of the house – people stop paying. This happened despite the hurdles of litigations, long lasting impact on credit scores, eviction and so on. 

 

Likelihood:

What are the chances that one of the two situations above or something like it might happen? Too high for comfort in my opinion. There are always people eager to exchange higher risk for a higher interest rate. But in my opinion, this risk is undervalued – as the average person believes these outlying conditions will not happen. These people might get burned, and spreading awareness of the commonality risks is why I’m writing this article. In the charts below, if you you visually scan the all-time ETH price chart, you can quickly visually see that this has happened at least a dozen times in the past.

ETH prices line chart
ETH Prices historical 2

While this article has limited its focus to ETH for simplicity, it is safe to say that these market effects would likely be magnified in smaller markets due to fewer participants and less liquidity at a particular price. Increasing the risks even more.

FYI, this is the state of the market today as I write this. Count the number of crypto assets that lost 15-30% of their value in the last 24 hours. What do you think happened to the borrowers and sellers in these markets? Which direction do you think the automatic selloffs from smart contracts liquidating crypto collaterals pushed the prices?

Nov 26, 2020 - Thanksgiving Day
Nov 26, 2020 – Thanksgiving Day

Most interestingly, nothing special happened recently. I assume some people wanted to cash out their earnings before Thanksgiving weekend – and the result was a massive market tumble. Here’s a closer look at what happened to XRP, the #3 market cap crypto behind BTC and ETH. It dropped 34%. 

24 hours price for XRP - Nov 26,2020
24 hours price for XRP – Nov 26,2020

 

Do you see the house of cards now?

Please feel free to leave your thoughts and comments. Thank you for your time reading this, and hope it helped you.

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