2020 Q1 Investor Update
The following is an excerpt from our quarterly letter to limited partners in Electric Capital.
Executive Summary
- We are more optimistic than ever about the emergence of a new programmable money infrastructure, with a non-sovereign store of value as its first killer application.
- Governments’ unprecedented monetary and fiscal stimulus is hastening the emergence of a world where cryptocurrencies and crypto infrastructure will thrive.
Dear Partners,
The question asked most often of us in March/April is whether we are surprised by Bitcoin’s performance relative to US Equities markets. We focus our Q1 letter on addressing this question, though our thesis around blockchain technologies is broader than Bitcoin.
In short, we are not surprised and have increased confidence that at least one cryptocurrency can emerge as a non-sovereign store of value, with Bitcoin being the leading candidate.
Are we surprised by how Bitcoin has reacted to the broader market? No.
In a hunt for liquidity, equities, gold, bonds, and Bitcoin all correlated. The USD liquidity crunch was a surprise to many, but short-term correlation during a liquidity crunch is not surprising.
In the case of Bitcoin, price movements can be exacerbated by the lack of circuit breakers. Unlike equities, unwinding levered positions can result in cascading margin calls. This likely happened on March 11, which spiraled to create a 50% drop in a few short hours. Once these levered positions were unwound, Bitcoin rebounded 25%.
Time will tell if Bitcoin and equities continue to stay uncorrelated long term.
One way to visualize correlations between two assets is on a plane, with a dot representing one day, and the (x,y) coordinate representing the returns on that day for the two assets. The following visualizations are from Electric Capital portfolio company Bitwise. On the left demonstrates positive correlation, the middle is negative, and the right is no correlation.
We can visualize the correlation between Bitcoin and S&P 500 using this scatterplot approach:
We see that prior to March 9, 2020, BTC and SPY were uncorrelated (black dots). From March 9 — March 16 there was a stronger correlation (red labels), and since March 16 there has been less correlation (green dots). With a recession looming, we will see whether Bitcoin remains as uncorrelated in a macro bear market as it has in the last decade’s bull market.
BTC is a potential store of value vs. USD, and may already be a SoV vs. other currencies.
Some say the short term correlation between Bitcoin and US equities undercuts the “Bitcoin as a store of value” narrative. This is a straw-man argument. As we regularly state: Bitcoin is not a store of value today relative to USD. It is a potential store of value, as it has many (though not yet all) of the characteristics of an excellent store of value.
Bitcoin and other crypto-assets are hedges against inflation, fiat devaluation, and government seizure. What we have presently seen in the US is a demand shock and government stimulus that may eventually result in inflation or currency crises. As this correction (or recession or depression) progresses, we will see whether Bitcoin evolves into a seizure resistant safe haven or inflationary store of value relative to USD.
At best, we can say that Bitcoin is a store of value relative to distressed emerging market currencies. There is evidence in Latin America and Africa, for example, where people stand more to lose by staying in local fiat currencies and do not have easy access to USD or gold.
We are optimistic about Bitcoin as a store of value because of long term trends in trust.
Stores of value require a fundamental utility, trust in that utility, and broad adoption.
A/ Utility — some fundamental properties that are useful for individuals or small groups.
B/ Trust — a reason to believe the utility will continue to be available and serve its purpose.
C/ Adoption — enabled because of utility and trust, and unlocks new network-effect based utility.
Utility + Trust enables Adoption. Adoption unlocks new, network effect based utility, such as people adopting fiat currency as a global reserve currency. However, if people lose trust in the fundamental utility of the asset, any existing network effects unravel and the asset loses its hard earned network-effect based utility.
For example, a fiat currency’s utility derives from its role as legal tender — all participants in the economy are required to accept the currency in exchange for goods and services. Trust relies on the government’s ability to levy taxes to fund itself to repay its debt, enforce the rule of law, and to credibly manage the money supply. If there is enough utility and trust to drive adoption, other countries may adopt the currency as a reserve currency.
If trust is lost, the asset loses adoption, which causes the collapse of the network effects. For example, if we discovered a new chemical process to extract gold, global trust in gold’s predictable physical scarcity would be undercut. The price for gold would crash and gold may no longer be a store of value, as we may now believe that future chemical processes may also emerge to further drive down scarcity in unpredictable ways.
The fundamental utility of crypto technology is not in question: Bitcoin has survived a decade, secures $125B of value outside of banks, and moves billions of dollars on chain every day.
What remains to be seen is whether the number of people and institutions that trust in Bitcoin and desire its utility is sufficiently large to drive adoption. Broad adoption would allow us to then assess whether Bitcoin is actually a store of value.
We believe recent market developments increase the likelihood of broader Bitcoin adoption because of two simultaneous trends:
- A long term collapse in trust in existing financial markets (including US markets) and existing fiat currencies (outside of the US Dollar, in particular).
- A long term increase in trust in cryptographic systems on which a new store of value and new markets can be built.
Trust in governments is at all time lows, a global recession looms, unemployment will hit historic highs, government debt-to-GDP is at all time highs, dollar denominated debt payments in emerging markets loom, and many are worried about the scale of government stimulus — data is in the appendix that follows this letter. In some emerging markets, many are actively searching for any exit out of their fiat system. In the developed markets, an increasing number of investors are open to the idea that the status quo may not persist for another 70 years.
At the same time, Trust in cryptographic systems such as Bitcoin continues to grow. 30% of Millennials would rather own Bitcoin than Equities, GBTC is the 4th largest holding in Schwab for Millennials, a record $500M flowed into GBTC in Q1, and 2019 was a watershed moment in the types of institutions that entered crypto. Institutional investors invested meaningfully in venture funds, Fortune 500 companies such as Fidelity and Facebook have invested $100s of millions in infra, and regulators in the US, China, and India have greenlit Bitcoin and blockchain.
Reduced Trust in Existing Systems + Increased Trust in Bitcoin Drives Adoption.
The impact of forward thinking institutions, endowments, and philanthropies entering the space in 2019 cannot be overstated. “Early adopter” endowments and philanthropies have opened the door for later adopting endowments and early adopter pension funds. As some pension funds invest in the coming years, sovereign wealth funds will consider investing, and so on. The bootstrapping of trust in Bitcoin (which unlocks network effects) is well underway.
What happens next?
In the short term, no one knows.
In the long term, the data suggests an ever increasing number of people around the world are worried our economic current paths are unsustainable. People and institutions are willing to consider new alternatives. As these people and institutions explore Bitcoin’s utility and the utility of other cryptocurrencies, come to trust in the underlying software, and consider the risk-reward palatable, there is an ever increasing likelihood that Bitcoin and other cryptocurrencies achieve broad adoption. And through broad adoption at least one will become accepted as a store of value.
There are still potential technical, market, and regulatory impediments to a non-sovereign, cryptocurrency as a store of value. But recent events make us more optimistic than ever.
Appendix: Trust Data
1. Collapse of Trust in Existing Systems
Data going back to the 1960s traces significant reduction in confidence in institutions of all forms — governments, the media, financial markets, banks, and more.
The current health crisis and economic slowdown further erode trust in existing institutions and financial systems around the world. For example:
- Which institutions do we trust to protect us from similar pandemics in the future?
- Will millennials’ trust in the stock market continue to erode because of 2008 and 2020?
- What happens to trust in banks and the government if the 30M SMBs who employ 50% of Americans are unable to get their PPP loan requests processed?
- Will the world trust the US can sustain a debt load of 250% of GDP, and what contingency plans will other countries make?
- What happens to the Chinese economy and social order as supply chains de-globalize?
- What happens to fiat currencies in emerging markets where most debt is denominated in USD but they are unable to service that debt in the coming years?
- Who benefits in any government stimulus and to what degree does it alleviate or accentuate existing global wealth gaps?
The world must grapple with issues that have persisted for decades — but with numbers that have grown dramatically in magnitude and consequence. To be clear, we are not fatalists. We do not believe existing systems are destined to collapse imminently (or ever). But it is undeniable that many have lost trust in existing systems and institutions, and we are on a path to further erosion of trust in the existing system due to the fallout of COVID-19.
2. Increased Trust in Cryptographic System
Bitcoin as a non-sovereign, fixed supply, bearer asset is the antithesis of the existing system. It requires trust in no existing institution, cannot be inflated away, cannot easily be seized, and is not mediated by an existing country or institution.
From the perspective of a peer to peer payment utility, Bitcoin as a technology does what it was designed to do. Unlike traditional markets, the long term trends measuring health in Bitcoin are positive. There is record hash power, a record amount of capital secured, more regulatory clarity, and billions of dollars being moved every day. These trends do not monotonically increase, but the long term trajectories in light of dramatic price drops are encouraging.
In parallel, there is increasing confidence in cryptocurrency ecosystems — starting with people in emerging markets who have lost faith in their fiat systems and digital natives in developed markets who have the least invested in the existing financial and political systems.
