Sigil - Q2 2022 letter to investors<br>

Sigil - Q2 2022 letter to investors

Dear Investors,

We're happy to address you with a review of the second quarter of 2022 and the performance of the Sigil Fund over this period.

This quarter continued to be strongly affected by widely known macro events.

On account of the war, Ukraine and Russia are facing a decline in economic performance and its ripple effects. Europe is affected by shattered supply chains and energy crisis. Sanctions and disruptions in the economy keep impacting international trade and investment markets. World supply-chains are disrupted by the lockdowns in China, halted growth of the Chinese economy and tensions over Taiwan. These grounds are the underlying cause of the threat of imminent stagflation.

Inflation, largely driven by food and energy prices, recorded the highest price increase since August 1988. Hence, the closely watched Fed in June hiked the interest rate by three-quarters of a point to 1.50-1.75%. This was the largest single interest rate increase in almost three decades. At the same time, the Fed indicated another significant increase was likely to be necessary.

US inflation chart

On top of these generally volatile macro grounds, three high-profile events triggered a mass forced selling across crypto markets.

1. LUNA Death Spiral

In May, one of the most popular stablecoins, the algorithmic uncollateralized stablecoin TerraUSD (UST) with an $18.57b market cap lost its peg to the U.S. dollar due to strong selling pressure. Within 4 days, its value fell below $0.10. UST together with Luna (LUNA) were two native tokens of the Terra network.

The mechanism was well known: one could burn a dollar worth of LUNA (volatile asset) to mint one UST (stablecoin pegged to dollar), and vice versa to redeem one UST for a dollar’s worth of LUNA. However there was a potential risk of death spiral: if everyone starts exiting UST, the mechanism starts automatically minting new LUNA and selling it. In the environment without external buyers of LUNA, this caused the price crash of both LUNA and UST. Team behind Terra ecosystem was obviously aware of this risk and aimed to move from the bootstrapping phase to the next phase where UST was not only stabilized by selling LUNA but also by external assets (mainly BTC) via so called LFG reserves. However their efforts came too late and there were not enough external reserves available to backstop the crash.

UST collapse

Historically, LUNA has been one of the top performers and thus a significant part of the Sigil Core portfolio. Our thesis behind the investment was twofold:

1. Since 2019, Terra was one of the few crypto ecosystems that was trying to focus on real e-commerce use cases. Although recent investigations uncovered the fact that traction metrics behind Terra's flagship e-commerce product CHAI were artificially inflated, the traction in Korean ecommerce was the original fundamental reason why LUNA got traction among crypto investors.

2. Terra DeFi ecosystem was focusing on developer and user experience and there was a positive market wide feedback. We tested many of these Terra applications and found the technology very promising.

For these two reasons we formed an opinion that Terra had a potential to become a top10 crypto in terms of market capitalization, despite the known risks of death spiral. Our first purchases of LUNA were at around $0.3 which allowed us to build a healthy position over time as LUNA appreciated in token value.

However, as the Terra ecosystem grew in 2021 and early 2022, we started watching the situation around it more closely - especially the lending app Anchor, which used to pay out 19.5% in yield to lenders of UST. We believe one of the major mistakes Terra's team committed was to subsidize the Anchor yield. This yield was beyond competitive and it became extremely lucrative for market participants to acquire UST and put it in Anchor. This in effect inflated the supply of UST and created a bubble. There was funding for startups whose sole product was to build frontend and onboarding for the Anchor yield farm.

Sigil, as an early buyer of LUNA, has taken profits on several occasions to de-risk its position, the last time a few weeks before the depeg at $115. As a result of managing the position carefully, Sigil Core has overall been a big winner of the whole “LUNA trade”. We managed to protect the capital and generate great returns for our investors. However, the big Luna crash is a good reminder for everyone that crypto markets are highly risky and deep insights are required to manage portfolios.

pavel stehno

Sigil Stable was also farming yield in Anchor. We managed to withdraw the vast majority of our capital a few weeks before the collapse as the perceived risk grew too big. This resulted in ca. 2% loss in Sigil Stable fund.

There are some efforts to restart the ecosystem with a forked blockchain Terra 2.0, but we are not convinced that the current leadership is capable of saving the ecosystem. Sigil Core is focused elsewhere. The fate of LUNA is a cautionary tale of double edged reflexivity which some crypto economic mechanisms employ to bootstrap their liquidity and network effects.

2. Celsius Network and stETH parity

In June Celsius Network suspended all withdrawals and on July 13, it filed for bankruptcy with a $1.2 billion deficit on its balance sheet. Celsius facilitated asset lending and borrowing, offered yields as high as 18% per year, and had 1.7 million customers. As of May 2022, the company had lent out $8 billion to clients and had almost $12 billion in assets under management.

A core part of Celsius' strategy was based on staked ETH not losing parity with Ethereum. Staked ETH (stETH) is a derivative asset that represents ETH locked into the Ethereum 2.0 beacon chain, a network that will soon be merged with the Ethereum mainnet as part of a highly anticipated proof of stake blockchain upgrade. Celsius let its users to stake stETH to generate interest. Celsius then used stETH as collateral on DeFi protocols to borrow vanilla ETH.

stETH ETH

Before ETH 2.0 is live, there is no mechanism that ensures stETH trading with parity to ETH. However, many unsophisticated investors expected stETH and ETH to keep trading close to parity and treated stETH and ETH as almost the same. So, when some big stETH holders started selling stETH and dropped the price of stETH vs ETH, it caused a series of liquidations and panic sell-offs across the market. This posed existential problems for Celsius. As Celsius was on the brink of getting their stETH collateral liquidated.

However, the final nail to the Celsius coffin came a bit later…

Please note: neither Sigil Core nor Sigil Stable has and never had any assets in Celsius.

3. The downfall of Three Arrows

The third event that shook crypto markets was the bankruptcy of one of the crypto industry's biggest hedge funds Three Arrows Capital (3AC) which was filed on July 1. According to court documents, the Singapore-based company owed 27 crypto companies $3.5 billion. Three Arrows Capital was one of the biggest crypto native investment entities with a very good reputation. Thus, it could borrow extensive amounts of credit from institutional lenders.

3AC co-founders Kyle Davies and Zhu Su claim three factors are behind the firm's collapse: overexposure to Terra, Grayscale's Bitcoin Trust, and staked Ethereum. (Bloomberg)

Most of the major institutional lenders were affected by the downfall of 3AC: Celsius, Blockfi, Voyager among others.

It is worth noting that the interrelated factor that we can identify among the events described above is centralization and the associated administrative and risk management failures. Decentralized crypto protocols and DeFi lending platforms remained unscathed. We see this as a proof that fully collateralized, public and on-chain decentralized finance can serve as a robust backbone of a new financial system even without regulation, whereas opaque centralized entities will always carry systemic risk if left unchecked.

Sigil Fund does not use leverage, and although our performance followed the general market trend, we were able to avoid significant losses through strict risk management. Sigil Core's portfolio during this period maintained a defensive composition. Up to 40% of the portfolio was located in stablecoins of fiat currencies.

The above negative events successfully battle-tested some of our core values on how to successfully run a long crypto fund, especially the point about leverage and gradually taking profits from positions:

What to expect in the near future?

After such an eventful Q2 we expect (or rather hope for?) markets to consolidate. We have seen many forced sellers as a result of liquidations and we were able to add to our long positions near local bottoms of the current price range. However we remain careful as we don't predict a very quick and smooth recovery given the ongoing geopolitical and macro situation.

The biggest crypto event to watch out for is Ethereum Merge and change from Proof of Work (mining) to Proof of Stake (staking ETH) as a form of securing the network. This change will significantly reduce Ethereum's environmental impact, which is one of the biggest talking points of blockchain critics. However it can also lead to a contentious blockchain fork like in the case of Bitcoin and Bitcoin Cash in 2017, since many miners will probably try to keep the PoW chain alive. In short, we expect this PoW chain to carry little value and ultimately break apart, given that many tokens such as stablecoins will simply move to PoS, rendering their PoW counterparts value-less.

In Sigil Core we are actively looking to add to our positions for favourable prices and expand our portfolio more into the NFT and GameFi segments where we see the biggest opportunity for attracting retail users to crypto.

In Sigil Stable we are still looking for the best yielding and market neutral opportunities. Since the vast majority of the Stable portfolio is in USD pegged stablecoins, we were able to preserve the capital of our investors against the recent weakening of EUR. However, given the ongoing bear market and the reduced amount of yield opportunities, we can expect Sigil Stable to perform at the lower range of our expected returns.

Sigil Core Net Performance vs EUR Q2 2022

Sigil Core recorded a performance of -56.20% vs EUR, -3.92% vs BTC in Q2 2022

Sigil Stable Net Performance vs EUR Q2 2022

Sigil Stable recorded a performance of +2.86% vs EUR, -2.66% vs USD in Q2 2022

The market bottoms are an opportunity for the brave risk-takers who go by the saying "Buy when there's blood in the streets, even if the blood is your own". Was July 2022 the bottom of the crypto markets? It remains to be seen and it is generally hard to catch the exact bottom. However, buying around the perceived lows has historically been a successful strategy for investors, especially those with a long term investment horizon. We certainly believe the Q3 will offer a lot of “buy the dip” opportunities even if the immediate future may feel somewhat scary. 

Thank you for your ongoing trust in Sigil Fund.

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