Crypto: Rally or Inflection Point?
The past 12 months set into motion a very bizarre combination of events which will be discussed for years to come. These events also set the stage for crypto’s real world value to be simultaneously demonstrated across all major narratives. Narratives (or memes) are critical to the adoption of new technologies as they explain not only what to do with a new technology but why.
“Buy bitcoin to hedge against inflation,…, but also to tell your government to f*ck off. Buy ethereum to secure the fledging decentralized financial system, …., but also to tell your bank to f*ck off.” — Ryan Selkis, Founder of Messari¹⁹
The price of bitcoin and ether, as well as other cryptocurrencies, and on-chain activity have blown past previous all time highs.¹ Total crypto market cap is now greater than $1T dollars. Accordingly, many people have been asking, “How real is this rally? Is this just another hype cycle?” In order to answer these questions, I had to break it down by the four distinct narratives that support crypto:
- Sound Money
- Financial Inclusion
- Web 3.0
I went in skeptical, but after evaluating the drivers of each crypto narrative, I came to the conclusion that this is not just another rally. This is an inflection point.
1. Sound Money
Sound money is costly to create, maintaining reliable mechanisms for restricting supply growth and making it less subject to currency debasement. This narrative posits that bitcoin, which has a capped supply, is a store of value and inflation hedge.
Tl;dr: Institutional acceptance of bitcoin is at an inflection point.
Bitcoin commands ~60% of crypto market share and its main narrative is that of “digital gold.” Bitcoin is an algorithmically scarce store of value that should benefit from the same drivers that gold traditionally has; namely, as an inflation hedge.
“Bitcoin is the equivalent to the dollar in the fiat currency system. That’s a pretty exalted role.” — Cathie Wood, Founder of ARKinvest ⁴
Given bitcoin’s fixed supply of 21M, halvenings (programmatic events in which miner block rewards are reduced by half) are believed to drive demand. While there was little price action following the most recent halvening in May 2020, Pantera Capital has found that the market peaks 1.2 years after a halvening.⁵ Pantera’s analysis indicates that bitcoin could peak in August 2021, at ~$115,000.⁵ I struggle to accept “the halvening” as a real driver given it’s an anticipated event and analysis is done on only two historical data points. That said, what it really comes down to is supply and demand. The argument is that the halvening reminds people of bitcon’s fixed supply, increasing demand.
“It’s fair to say we have never observed money supply growth as high as it is today.” — Mike Wilson, U.S. Chief Equity Strategist, Morgan Stanley¹⁷
The main argument I hear is that the attractiveness of an asset like bitcoin (with a verifiably fixed supply, outside the purview of global monetary policies) has increased due to inflation concerns following trillions of dollars in stimulus spending. I remain skeptical that this is a large driver (markets don’t incorporate this type of information this quickly and the economists I’ve spoken with aren’t actually concerned about inflation.) However, bitcoin inflows do seem to coincide with the progression of the pandemic (and corresponding stimulus), driven primarily by investors rather than traders.
Famed investor, Paul Tudor Jones, wrote a letter in May expressing the view that if, under certain economic circumstances, one would otherwise buy gold, bitcoin is a relatively more attractive option in terms of upside potential. He did not say he believes bitcoin is a superior store of value or asset. Instead, he indicated it was undervalued relative to alternatives with ~50x bitcoin’s market cap. Other investors have made similar comments about the attractiveness of bitcoin’s liquidity relative to its upside potential. Even at today’s levels, compared to other perceived stores of value, bitcoin’s market cap represents just 33% of private-sector gold investment ($2.7 trillion), 5% of the M2 money stock ($19.1 trillion), and 2% of global institutional-grade real estate ($45.3 trillion).⁴ Some argue that the market cap of bitcoin should be larger than that of gold since it has superior properties. One step at a time.
Paul Tudor’s Jones commentary was also important in that it effectively granted permission for other Wall Street investors to take similar positions. Since then Stanley Druckenmiller⁸ and Bill Miller⁹ have also been outspoken about investments in bitcoin. Even long time skeptic Ray Dalio has recently taken a more positive, although still cautious, view.¹⁰
After years of intense criticism, financial institutions are jumping on board. JP Morgan, Citi, and Guggenheim, all cover bitcoin and have forecasted six-figure price targets.⁴ Bank of New York Mellon has said it will hold and transfer cryptocurrencies. Goldman Sachs is expected to announce plans to launch custody services. Blackrock has granted at least two funds the ability to invest in bitcoin futures. The CME recently launched cash-settled ETH futures. Mass Mutual purchased $100M in bitcoin and acquired NYDIG equity. Guggenheim disclosed that it holds the right to invest up to $530M in the Grayscale bitcoin trust. This isn’t just talk. Large investors acquired 1M bitcoin from Oct-Jan 26³ (~5% of supply) and Coinbase Institutional helped “a number of endowments, institutional family offices, and leading wealth management platforms buy and store crypto assets for their investment portfolios” in the second half of 2020.⁴ Harvard, Yale, Brown, and the University of Michigan all disclosed that they’ve been buying crypto for their multi-billion dollar endowments. Grayscale’s Bitcoin Trust (GBTC), reportedly saw $1.2B in fresh investor funds between January 15–21 and has plans to launch 5 more trusts. NYDIG, which manages bitcoin for institutions, private clients, and banks, expects to hold $25B in bitcoin for institutional clients by year end, up from ~$6B.
Yes, some of these inflows were financed by whales and miners offloading to newbie investors. Some funds took some risk off after BTC hit $40,000. But more and more traditional finance (TradFi) institutions, ranging from hedge funds to venture funds, are developing crypto strategies and planning to dedicate significant capital to bitcoin. I know, because I’ve talked to them. We haven’t even seen those inflows yet.
A fund cannot decide to hold crypto overnight. They must change mandates, hold board meetings, and get approval from LPs. That takes about a quarter.
How much of the >$90T¹¹ under institutional management globally could flow into bitcoin? Coinbase’s efficient frontier calculations suggest a ~10% allocation to bitcoin is optimal.⁴ A similar analysis done by ARKinvest found that a 2.55% allocation was optimal, when maximizing returns and minimizing volatility, and 6.55% was best for maximizing the Sharpe Ratio, a measure of risk-adjusted returns. Coinbase calculated a rolling annualized Sharpe ratio of 2.54 in 2020, or 1.54 over a five year period, spanning the most recent bear market.
Corporate treasuries are also buying bitcoin. Payments company Square announced that it would put $50M, or 1% of its assets, into bitcoin. Microstrategy holds >70,000 BTC in its corporate treasury and Morgan Stanley took a 10% stake in MicroStrategy to gain indirect exposure. Tesla bought $1.5B in bitcoin and will accept it for payment. RBC believes that Apple could be the next Fortune 500 to make a similar allocation. Even if you believe Tether has been artificially inflating the price of bitcoin, these are real inflows, converted from USD. Tether may be a fraud, but if so, it’s also created a self-fulfilling prophecy.
Regardless of which underlying driver dominates, we are at an initial inflection point in terms of institutional adoption of bitcoin.
2. Decentralized Finance (DeFi)
DeFi aims to create a highly interoperable financial system with greater transparency, equal access rights, and little need for intermediaries, as these roles are assumed by smart contracts.¹³ This narrative posits that DeFi is an alternative (open, transparent, and automated) financial system.
Tl;dr: The run up in DeFi seems more like a rally, but there are signs that it will either become integrated with, or replace elements of, the traditional financial system. That would ultimately be an enormous inflection point.
Centralized financial markets prevent fair access and are vulnerable to counterparty risk, censorship, a lack of transparency, and manipulation. The recent events regarding $GME and Robinhood, while ultimately driven by regulatory requirements, poignantly illustrate these flaws. Well before $GME, DeFi emerged in an attempt to correct these flaws, ensuring the infrastructure that supports markets for programmable assets is just as decentralized as their underlying technology. While just over two years old, decentralized exchanges (DEXs) hit $60B in total volume in 4Q20 while outstanding DeFi loans reached $4.5B.² Nearly $1.6 trillion USD in stablecoins and ETH transacted on the Ethereum network in 2020.² This is unignorable.
The implementation of liquidity incentives over the summer, drove a mostly speculative frenzy complete with yield farming, fork wars, and food tokens. “Degen capital” flowed en masse in search of higher yielding assets. While speculation may be the main driver, it is also resulting in productive usage and technological advancements. The focus in DeFi has moved from acquiring liquidity to retaining it. There is talk of tying air drops to vesting schedules or on-chain KPIs. Over-collateralization requirements persist but there is innovation (smart contract covenants, zk proofs for underwriting, and social credit delegation.) Since practically the entire DeFi ecosystem is competing for resources on Ethereum, gas fees have gotten out of hand, driving Layer 2 R&D (state channels, zero-knowledge rollups, and optimistic rollups.) Still, as more liquidity enters the market, and risk is reduced, it’s hard to believe current interest rates are sustainable.
Just as introducing interoperability into technologies tends to result in the commoditization of base layer protocols, more efficient/liquid markets also result in narrower spreads and lower yields over time.
DeFi is not immune to recreating TradFi fragilities (rehypothecation, excessive leverage, tranched lending, etc.) Composibility results in dependencies which causes systemic risk, by definition. However, the transparency afforded by DeFi changes the risk equation. The systemic meltdowns in TradFi markets have been, in part, the result of opacity (in 2008, nobody actually knew who held what risk.) Instead, DeFi’s transparency allows for the real-time pricing of risk and an auditable collateral trail. Protocols are also community owned and operated, meaning fees are split among users rather than hedge fund managers. Those are both meaningful reasons to use DeFi even after yields normalize.
A New Financial Infrastructure
Bitcoin was invented in 2009. DeFi came into being in late 2018. It is still experimental and users are more or less beta testers. While its potential is vast, and more investors are beginning to realize it, it’s not quite ready for mainstream yet. Outside a select group of VC funds and family offices, Coinbase did not see significant investment in DeFi assets from institutional clients in 2020.⁴ For now, DeFi remains primarily retail-driven.⁴ That’s not to say there isn’t institutional interest. The St. Louis Fed recently published a research paper on DeFi and Dr. Manmohan Singh, senior financial economist at the IMF, has acknowledged the potential benefits of DeFi. While there is talk of DeFi replacing the traditional financial system, I think it’s more likely that DeFi will integrate with TradFi than replace it. Many of the commonly cited reasons for needing a new financial infrastructure (multi-day settlement, for example) are not actually technology problems. 24/7 markets are possible now; it’s convention, not technological constraints that prevent innovation. A more compelling value proposition is the new financial instruments or capabilities that can’t be realized without a public blockchain, such as atomic swaps, autonomous liquidity pools, decentralized stablecoins, and flash loans.¹³ Don’t forget transparency.
DeFi is still relatively early in its development and is driven primarly by a search for yield. However, DeFi offers real improvements over the traditional financial system in terms of transparency, value accrual, and novel financial capabilities. It’s not at an inflection point yet, but it is absolutely unignorable.
3. Financial Inclusion
Cryptocurrencies are permissionless and less costly than their traditional counterparts, eliminating barriers to access for the ~1.7B globally unbanked,¹⁴ and the countless more underbanked. This narrative centers on lower fee remittances, “banking the bankless,” and mainstream adoption. 1.1B people are unbanked,¹⁴ at least in part because they lack a legal form of identification, and therefore this narrative depends on digital identity.
Tl;dr: Mainstream adoption is headed towards an inflection point. Whether or not the technology improves financial inclusion will not be answered in this cycle.
Starting with lower fee remittances, while there have been exciting advancements, they remain tricky as regulatory barriers, capital controls, and factors outside the banking system create much of the friction and cost in cross-border payments. Moving onto the unbanked population, while this population has been shut out of the financial system for decades, the pandemic demonstrated an urgent need for inclusion. While a large portion of the U.S. population can receive funds via direct deposit, there is still a sizable unbanked population that cannot. For those people, stimulus checks were sent by mail, reinforcing inequity. The delivery of funding to SMBs was also challenging, in part, due to lending practices that require loan officers, in-person identification, and faxes. While a proposal for a “digital dollar” was included in the original stimulus bill, better digital ID and digital distribution channels are still desperately needed.
It’s important to note that digital currencies can potentially lessen financial inclusion, depending on their design. The original announcement of Libra (now Diem) raised national sovereignty concerns for developing nations given the risk of something akin to inadvertant dollarization. It also appeared to create something very similar to a reserve bank, sounding alarms about global financial stability. Shortly thereafter, the pilot issuance of the DCEP by the People’s Bank of China raised concerns about threats to existing reserve currencies. Whether or not these concerns were well-founded, the result was a huge increase in central bank digital currency R&D.
Retail Central Bank Digital Currency (CBDC)
86% of central banks are working on CBDCs, according to a Bank of International Settlement survey from January 2021. The Sand Dollar in the Bahamas is live and the PBOC has launched DCEP trials in the Greater Bay Area, Beijing, Tianjin and Hebei province. Notably, the ECB announced that it will make a decision about whether it will launch a digital Euro pilot by mid-2021. The private sector is preparing for CBDCs as well. Mastercard has announced a proprietary virtual testing environment for central banks to evaluate CBDC use cases. Visa published a proposal for an Offline Payment System (OPS) protocol that would enable CBDC to have cash-like properties. Diem has proposed compatibility with CBDCs, as has PayPal. If designed well, CBDCs will integrate with Ethereum and the DeFi ecosystem too.
CDBCs are imminent, in my opinion, the only questions pertain to their design. WEF’s CBDC Policymaker toolkit outlines major design choices and policy issues. Both will be critical to whether or not CBDCs improve financial inclusion.
There have been significant developments in mainstream distribution with a path towards broader acceptance of crypto payments. PayPal launched new capabilities allowing users to buy, hold, and sell cryptocurrency. That’s 346M users and 26M merchants.¹⁵ Visa announced it is connecting its network of 60M merchants to USDC. Mastercard will begin allowing cardholders to transact in certain cryptocurrencies on its network. Square generates over $1B in quarterly Bitcoin revenues.⁴ Coinbase has more than 43M users.⁴ BlockFi has originated more than $5B in retail loans. This is not a fringe technology.
“Over the long run, I’m very bullish on digital currencies of all kinds.” — Dan Schulman, CEO of PayPal¹⁸
Public market liquidity events are on the way, with Coinbase expected to go public at a valuation ranking it among the top 10 financial institutions in the US. Other exchanges may follow suit, possibly via SPAC, followed by “CeFi” lenders. As institutional adoption increases, we might see consolidation in custody providers.
Of course, some mainstream adoption is driven by speculation (Dogecoin.) PayPal CEO, Daniel Schulman, has noted “everyone who signed up for crypto is opening up their app two times as much as they previously did.” That’s about price. In any event, as consumer fintech CAC continues to increase, a large number of fintechs are looking for ways to offer their customers higher yields, and crypto integration is looking more attractive by the day.
Mainstream adoption is heading towards an inflection point with new crypto products and services from major private sector players and, potentially, central banks. Whether or not this improves financial inclusion is a matter of policy and design.
4. Web 3.0
Web 3.0 refers to the use of blockchain technology to create an alternative to our current Internet, dominated by large, centralized platforms supported by extractive business models. The narrative posits that Web 3.0 grants users access to a stateful web, thereby reducing platform risk, empowering users, enabling new business models, and aligning incentives among network participants.
Tl;dr: While there is huge potential in Web 3.0, we probably have to wait another cycle until we start seeing an inflection point.
Web 2.0 is stateless, an architecture that has resulted in extractive business models and megacap platforms that act as centralized gatekeepers. All network participants are subject to platform risk. I know this well because I used to cover megacap Web 2.0 companies as an equity research analyst at Barclays. Regulators are trying to remedy this situation, but regulation is rarely the answer. What about rearchitecting?
Web 3.0 proposes a new Internet architecture; one that operates on a blockchain infrastructure, supports native identity and payments layers, has native governance mechanisms, and allows for privacy preservation. Contracts between crypto networks and their participants are enforced via open source code. There are built-in mechanisms for voice (governance) and exit (forking.)¹⁶ Web 3.0 allows for new business models based on scarcity rather than ubiquity. Web 3.0 also creates a different relationship with data. One could imagine a world in which Web 3.0 infrastructure providers generate value equivalent to their Web 2.0 analogs such as AWS (compute and storage), Google (indexing and search), and Okta (identity.) Web 3.0 is comprised of several sub-narratives, outlined below.
Censorship Resistance: D’Apps
Recent events have placed platform risk front and center, although it’s always been there (Zynga, eBay, etc.) While I do not condone the activities that were taking place on these platforms, the actions taken by AWS, Apple, Google, Twitter, Facebook, and Discord all highlight the power of centralized Web 2.0 platforms. In contrast, D’Apps can’t be shut down or censored by a single entity. Will recent events dramatically increase the usage of D’Apps? I think it will take more time.
Privacy: ZK Proofs, Self-Sovereign Identity, and Personal Data Stores
The recent flock to Signal and, to a lesser extent, Telegram, Horizon, and Zcash all indicate a newly heightened awareness of privacy. Web 3.0 architecture allows users to own and control their data via privacy preserving infrastructure and personal data stores, and to control their identity via SSI. Zk proofs are a key enabling technology and they are becoming operational at scale. Privacy has always been a hard sell, but the associated trade-offs are diminishing.
Digital scarcity: Non-Fungible Tokens (NFTs)
Individual units of fungible assets, like ETH or USD, are indistinguishable from each other. In contrast, each non-fungible token is unique. This digital scarcity makes NFTs uniquely suited to represent collectible items or art. Dapper Labs has seen early success with the launch of NBA Top Shot and Microsoft recently launched a browser game that rewards players with NFTs to be used inside Minecraft. NFTs are definitely gaining momentum but it’s probably another cycle before they hit mainstream. One could argue that NFTs aren’t specific to Web 3.0.
While I strongly believe in the importance of Web 3.0, I think we’ll have to wait another cycle until this narrative gains enough momentum to turn into a movement.
Regulation: The Anti-Narrative
Ray Dalio has been outspoken about regulation posing an existential threat to crypto. Regulation is still a non-trivial risk, but it does seem to be lessening by the day. The OCC made headlines by clarifying that federally chartered banks can legally provide custody of crypto assets. They also issued a letter clarifying that national banks and federal savings associations are allowed to operate blockchain nodes and use stablecoins for payments. These decisions seem related to the potential launch of central bank digital currencies, but they benefit the entire ecosystem. The EU’s recent regulatory proposal on DeFi, the Markets in Crypto Assets Regulation (MiCA), is generally seen as a positive as it has created a path to EU-wide regulation of crypto. That seems preferable to navigating the current maze of regulations across 27 different countries. DeFi creates unique regulatory challenges as regulation usually applies to intermediaries and the point of DeFi is to eliminate those.
That’s not to say that regulatory risk doesn’t remain. It does. Proposed regulation on requiring Stablecoin issuers to register as banks and midnight rulemaking by FinCEN that would regulate self-hosted wallets proves that. However, the more widely crypto is adopted, and the more revenue it generates for private corporations, the harder it will be to regulate it out of existence.
The Next Narrative?
Prices will go back down. The path to adoption for transformational technologies is non-linear. However, in each cycle, developer activity, startup activity, innovation, and adoption increases. World class research institutions will continue to push the technology forward. Top tier talent is re-entering the industry as broader adoption decreases career risk.
We are at an initial inflection point. While not every narrative is at this point, once an initial inflection occurs (Sound Money, driven by institutional adoption of bitcoin), the rest will follow more quickly. Immense value can be generated in the 10–20 years following an initial inflection, due to “after-shock” inflection points and the development of supporting ecosystems.⁶ Notably, the Sound Money inflection point benefits from unique dynamics. Bitcoin is perceived as less risky the higher price goes, the broader adoption becomes. It’s scarcity increases with demand.
“It gets less risky the higher it goes….That’s the opposite of what happens with most stocks.” — Bill Miller, Founder of Miller Value Partners ⁷
After reading this, imagine thinking crypto isn’t important. Imagine thinking it will fade away or go to zero. Imagine thinking this is not an inflection point. Yeah… I can’t either.
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