Bitcoin bubbles; the optimal distribution mechanism

Why planned fair distributions don't work for broad use cases - adapted from an internal memo drafted in May 2019.

Bitcoin’s volatility profile is - by now - the stuff of legends. Monumental, euphoric rallies give way to abrupt, violent crashes and proclamations of Bitcoin’s demise (380 and counting). Thus far, the cycle has repeated without failure, earning Bitcoin the “Honey Badger” moniker in the process.

As the current cycle is unfolding, behind the BTC/USD pair’s most recent gyrations, new types of participants are entering the market; traditional macro money managers (e.g. PTJ) and nation states (e.g. Iran) are becoming increasingly open about dipping their toes in the cryptoasset ecosystem.

With every new type of player that jumps on board, the likelihood of Bitcoin becoming a widely accepted store of value and the Bitcoin blockchain becoming a globally accepted settlement layer, increases. The “why” Bitcoin makes for a good settlement layer and store of value has been covered extensively. However, the “how we get there” remains somewhat elusive. In this post, I will attempt to unpack that.

Fair != Equal

Let's for a moment imagine what an optimal state of the Bitcoin network at maturity looks like; Bitcoin is a widely accepted global store of value and/or settlement layer; global institutions (e.g. central banks) are on board, co-existing with crypto-native actors (e.g. miners); market manipulation is too expensive to attempt, as are direct attacks on the network; BTC is distributed widely among holders, such that network participants extract maximum value by being able to settle with all other parties they may wish to, and that no party has disproportionate “bargaining power” over network outcomes, allowing participants in the network to be continuously incentivized to remain participants.

From the above, a “fair” allocation of BTC among holders seems to be a key underlying requirement for this future to come to bear. Note that “fair” is not the same as “equal”.

Fairness, in this case, implies that every participant’s utility function is maximized, subject to their unique constraints. Under that condition, “equal” is “unfair” and therefore, unsustainable.

If we assume the “fairness” condition as requisite, then while not necessarily an easy pill to swallow, the rollercoaster ride might be the *only* path available to get us there. To illustrate the point, an approach by deduction reveals why the competing approaches cannot work;

  • A centrally planned diffusion mechanism: this construct fails as the planner holds all the bargaining power - such that no other party would willingly opt-in. In order to be executed effectively, it would have to be orchestrated and delivered by a benevolent dictator (a party with perfect information and perfectly benign incentives), and for all participants in the network to trust that the allocator is indeed benevolent. In practice, impossible.

  • A diffusion mechanism planned by a “political” coalition:  this can’t be orchestrated in a multi-party explicit negotiation format, because there are too many conflicting interests at play in order to implement top down consensus. If it is sufficiently hard to achieve with structures where there is some cultural cohesion (e.g. EU and the Eurozone), it should be near impossible to achieve at a global scale.

Economic bubbles as a by-product of fairness

So if we agree that neither of the two are viable options, the only option left is a free market mechanism; a continuous game, that is played by individualistic agents with hidden preferences, in near infinite (and infinitesimal) rounds, that allows for each participant to opt-in at the valuation that perfectly satisfies their objective function (what they strive to maximize under given constraints), therefore covering the full utility spectrum of the population of agents.

Hidden preferences become revealed ex-post and as such competing agents cannot devise a strategy that creates a surplus for themselves that leaves others at a deficit ex-ante, resulting to an ultimately fair distribution. And in the process of revealing preferences in a continuous game with infinite rounds, bubbles are created. Competing agents with similar objective functions are forced to respond to the first mover among their counterparts and jump on the bandwagon. Under scarcity, the price rallies, until the reservation price of agents that opted-in earlier is met. At that point the distribution phase begins, as earlier participants divest and get rewarded for stewarding the network thus far, by locking in a margin. As painful as the process might be, it ultimately yields to a fairer allocation.

As the "rounds" of the tacit negotiation - come free-market-bonanza - game unravel, the very nature of the platform evolves, opening up to a wider possible utility spectrum. With time, the network becomes more secure as wider margins become available for miners (either through higher prices or through advances in operational efficiency) and more resources are committed towards Bitcoin’s Proof of Work. It follows that as the network’s security improves, it opens up to new types of agents that are striving to maximize value preservation potential, subject to the liability they have to their constituents (measured as risk). The more types of agents there are on the network, the better a settlement layer it becomes, and so on.

Therefore, there is sense to the idea that progressively larger agents would opt-in at a higher prices, as they are effectively buying into a fundamentally different - and arguably better - network for value store and transfer. And with every new type of agent unlocked, the bandwagon effect re-emerges.

Conclusion

Bitcoin might not have been a secure or wide enough network for Square (an agent to its shareholders) to consider as its future payment rails and settlement layer in 2015. It is in 2020. Similarly, while Bitcoin might not be a secure or wide enough network for a sovereign to opt-in in 2020, it might be in 2025.

So, not only should we not be surprised by the new type of participant that is emerging in the early innings of this cycle, but we should expect more of this as the network’s value increases and its security profile improves.

And in the process, we should learn to accept the nature of the game.

Covid-19 and the big unwind

Monday 5pm GMT: Since March 9th, financial markets are going through one of the fastest downturns in recorded history, as western economies scramble to battle the spread of Covid-19.

The macro view

On Sunday (16/03) the Fed announced a round of emergency rate cuts, down to a target of 0% to 0.25%, along with $700 billion worth of asset purchases, that include Treasuries and mortgage-backed securities. 

Global markets had none of it; the Dow is down ~9%, the FTSE 100 is down more than 10% on the opening, while Asian markets are hit less hard, though still down to the tune of ~4% - the MSCI Asia Pacific Index was down 3.8% at the opening. As global economies go in lockdown mode, the appetite for risk has vanished, pushing bonds and all the USD forex pairs higher as capital finds its way to safety. 

Mayhem in crypto

This past week was also the worst week for crypto since at least 2013. Amidst the global flight to safety, Bitcoin has also lost its uncorrelated status, and is moving in tandem with traditional markets, almost tick for tick. The drawdown in crypto was accelerated as highly leveraged positions on Bitmex started getting margin called, putting a liquidation cascade in motion. Since then, liquidity seems to have evaporated, as order books across most exchanges are much thiner than usual and open interest in futures is in multi-year lows. 

In all, we are now deep in bear country. Rallies are being sold aggressively, and as if everything else happening wasn't enough, with the halving coming up Bitcoin will see an additional set of natural sellers emerge; unprofitable miners. As the block rewards get cut in half, the effective cost of producing bitcoin will double. Reports have it that S19 and S15 miners are already shutting down, and that the greater mining community is in panic mode. As the BTC/USD pair edges closer to the $4k level, increasingly more miners will be shutting down and selling BTC to cover costs. Those with cash will survive this. Those without will be exiting. And as they do, prices will slide.

Bitcoin—still a risk asset

The week of March 9th 2020 was a strong test for cryptoassets; one which they failed to pass with flying colours. The narrative that Bitcoin is a store of value has been dispelled - at least for the time being. While it has the properties of one, this week put the debate about its current status beyond any reasonable doubt. Bitcoin is - still - a risk-asset, as are the rest 4,000+ cryptoassets in the investable universe. It will take some time before the global sentiment for risk returns. But, eventually, it will.

While sentiment and prices change, fundamental properties do not. As this downturn exposed the chronic pains that underlie cryptoassets (e.g. scalability, oracles, fragmented markets), I believe that over a longer time horizon this will be remembered as a pivotal point that served as a wake-up call for builders, investors and pundits alike - to ground expectations and re-focus attention on what really matters in order to bring this technology to a massive global audience.

It’s always darkest before dawn

From an investment standpoint, the weaknesses that were exposed over the past week represent investable opportunities. There are strong teams with ample runway that are working on solutions to the industry’s endemic problems, and cryptoassets that are economically tied to the success of those solutions. Many of these cryptoassets also happen to be priced a lot more favourably than they were just a week ago.

Over the coming weeks, it is highly likely that the pricing of these opportunities will become even more attractive.

As the global economy moves towards a recession and with interest rates being already at - or close - to 0, deflation will kick in. But then, as the effect of the coronavirus wears off, confidence will return. People will start spending again, interest rates will rise, and with all the liquidity sloshing around, eventually inflation will kick in. 

Bitcoin was never a hedge on a global emergency. It does though have the fundamental properties of an asset that can be a hedge on the debasement of fiat currency. And as growth - and with it inflation - returns and with the money printer already firing on all cylinders, Bitcoin will get its ultimate test. And I believe it will succeed.

But even if it doesn’t - it’s not the only game in town. We’re talking about retooling the financial system here. You surely can’t do that with a hammer alone.

I’m not a maximalist, but If I am anything in the “-ist” contingent, is an optimist. As an optimist - not a deluded one, I remain optimistic about the future of the asset class.

It’s always darkest before dawn.

Cryptoassets in transition

Taken from Decentral Park’s Annual Investor Letter for 2019

2019 has been quite a ride for global markets. The year started with a rallying S&P and confident markets which quickly transitioned into fear, uncertainty and doubt, as the Sino-American trade war took center stage and the yield curve inverted for the first time since 2008, summoning fears of an impending recession. In that environment, cryptoassets had a mercurial H1 2019, coming off of a brutal bear market in 2018.

Emerging cryptoassets within the cluster outperformed the average in Q1, passing the baton to Bitcoin in Q2, which led the way with a 230% appreciation, bottom-to-top, from April to July 2019. At the time, there were strong indications that the pent up demand for capital flight from China found a suitable vehicle in Bitcoin, as global economic uncertainty rose [1]. However, this did not sustain for long, leading the overall asset class to deflate by ~50% over the course of H2 2019.

Although Bitcoin failed to meet expectations set by the excitement garnered by 1H19’s run-up to $13k per BTC, the asset class overall is once again the best performing for the year, returning +90% beginning to end, whereas the NASDAQ returned +38%, the S&P +31% and REITs +27%.

Be that as it may, the sentiment among market participants - at present - is much bleaker than the absolute YoY performance implies, reminding us that biases are omnipresent in how sentiment manifests in markets. In this case, it is an anchoring bias, a recency bias and loss aversion in full effect [2].

As Bitcoin descended from July highs for most of 2H19, the trade war fears were dispelled and under the onlook of a dovish Fed, the Dow and the S&P both broke to new all-time highs. Considering the developments within the world of cryptoassets, we are - quite frankly - dumbfounded by the weak sentiment. While being cognizant and appreciative of the limitations of cryptoassets and the challenges that lie ahead,  we cannot help but continue to be optimistic about the medium and long term prospects of the asset class.

2019: a year of quiet infrastructure development 

 Our thesis has always been that there are two forces that charge adoption prospects for cryptoassets; 1. top-down adoption by institutions and legacy finance, and 2. bottom-up adoption of Web 3.0 and Open Finance innovations and primitives by the general public.  2019 was a year of steady infrastructure development and deployment in both of these areas.

Top down

2019 saw a continuous stream of innovation in institutional infrastructure, with cornerstone products such as digital asset custody and derivatives being delivered and further developed from both legacy players such as Fidelity, ICE and the CME [3], as well as crypto native players such as Coinbase, BitGo and Binance [4]. These advances are bringing mature and trusted prime brokerage solutions closer to the cryptocurrency industry, and will enable the deployment of ever more complex strategies at scale, while simplifying the complexity at the base layer of this technology, head-on. 

At the same time though, 2019 saw multiple rejections of applications for a Bitcoin ETF - and for good reason. The market is still fairly fragmented, small and immature for an ETF, with a prime example being the lack of a generally accepted and agreed upon true price of Bitcoin. Despite this, in December 2019 Charles Schwab reported that Grayscale’s Bitcoin Trust is the 4th most popular equity amongst Millenials in their customer base - more popular than Netflix or Berkshire Hathaway [5]. 

As progress in data pipelines is made and liquidity improves, the uncertainties around the asset class will become increasingly less, at which point we expect to see the development of products that will make Bitcoin’s inclusion into ISAs (Individual Savings Account) and IRAs (Individual Retirement Account), a matter of routine.

While we do not believe that this will become commonplace in 2020, we do believe we will see material progress in that direction, both in regulations, and in market structure/infrastructure.

Once that milestone is cleared, and the asset class has grown sufficiently to become even more generally accepted, the probability of it being included as an asset of pension funds and endowments increases dramatically. The most forward thinking of the largest allocators are already getting smart in and around the asset class, primarily via allocating to Venture Capital [7], while some have started dipping their toes in direct token purchases.

The last but perhaps most important piece of the puzzle for top down adoption is regulatory clarity - or, at present, lack thereof. Bitcoin’s Q2 ascent was accompanied by the announcement of Libra - Facebook’s blockchain-based stablecoin initiative, that would - upon launch - bring digital wallet infrastructure to Facebook’s massive user base.

Libra’s launch was soon put on hold by US lawmakers, with both Mark Zuckerberg and David Marcus (Libra CEO) having to undergo multiple rounds of hearings in front of the US Congress and Senate. The biggest result to so far come out of those hearings, was the lack of alignment among members of the House and Senate, which continues the uncertainty for entrepreneurs and managers in the space. 

Meanwhile, in October, Xi Jinping publicly labeled blockchain an important strategic focus for China, causing a flurry of activity in the market [9]. Amongst the most notable events to follow, the Bundestag issued a decree enabling German banks to sell and custody crypto starting 2020, the ECB announcing a proof-of-concept for anonymous transactions using central bank backed digital currency, and more recently a draft bill entitled “Crypto-Currency Act of 2020” was introduced in the US House of Representatives.

Given the sense of urgency that China’s aggressive move seems to have instilled in its counterparts, we believe that 2020 is going to be a pivotal year for a much needed regulatory framework that will de-risk the emerging asset class. 

Bottom-up

Even in the face of structural uncertainty, in 2019 the builders have been hard at work and their labour is already bearing fruit - with Ethereum (#2 public blockchain and #1 smart contract platform by market capitalization) the clear leader in attracting developer interest. Ethereum has been a hotbed for developer activity, with Open Finance (or DeFi) use cases finding notable traction.

There are now stable value issuers (e.g. Maker DAO), loan facilities (e.g. Compound), market makers and exchanges (e.g. Uniswap, Kyber) and derivatives facilities (e.g. Synthetix) that are fairly well established, while we are seeing use cases in insurance (e.g. Nexus Mutual), interfaces (e.g. Zerion), and payments (e.g. xDai) emerge.

These protocols and applications live purely on-chain, are largely software operated and have processed multiple hundreds of millions of USD in loans, payments and collateral value in 2019 [10]. 

Over the course of 2019, Ethereum became a lot more expressive. There are now more frameworks, IDEs and mature blocks of value within Ethereum that can be used as references for new applications, enabling developers to deploy a wider array of features, faster than ever before.

Given the product/market fit that the category is showing, Ethereum’s lead in developer mindshare and maturity of tooling, but also being cognizant of the platform’s scaling and governance limitations , we believe this to be the space where most value will be created and captured in the next 2-3 years.

It is indicative that in an indexing exercise exploring 2019 returns, DeFi has been the standout performer, primarily driven by the mercurial H2 performance of Synthetix (SNX) - a 30x run. Additionally, the money and finance related indices have strongly outperformed all other clusters in 2019 - a clear indication of where product/market fit can be found at present and how much it matters to the market. 

Some of the areas that we are excited by within the cluster, are synthetic asset solutions that will reduce collateral ratio requirements, allow for legacy assets (e.g. equities) to be printed on chain and transacted at a fraction of the cost of traditional brokerages, enable new forms of hedging risk for crypto native businesses (e.g. hashrate derivatives) and - well - new forms of leverage. After all, given the early stage we are currently in, speculation largely remains the main use case.

Concurrently, in 2019 we saw glimpses of the rise of domain specific chains. Different fee structures for platform resources and performance limitations and trade-offs across different chains create breeding grounds for fundamentally different applications. As such, while Ethereum has found traction in use cases that are described by low friction and high transaction value, chains like EOS - and more recently WAX - are finding traction in high friction and low volume applications (e.g. games) [11].

While - in theory - Layer 2 solutions can allow for such applications to work on slower chains, it is hard to argue that these solutions will provide a more compelling alternative to chains that are purpose built to withstand heavier loads. 

However, most of the aforementioned platforms are still in their infancy (e.g. WAX) and others are yet to launch (e.g. Telegram’s TON), as is the case with the interoperability bridges that will allow value to frictionlessly traverse through different blockchain ecosystems (e.g. Cosmos).

We see the next two years as the time when these platforms will prove (or disprove) their viability and pave the way for immense value creation from 2021 onwards.

Miners are not capitulating (yet!)

A tweetstorm looking at on-chain flows in and out of tagged miner addresses, at a time when the crypto-twitterati were snowballing into the narrative that the recent price action was instigated by unprofitable (or close to being unprofitable) miners selling down on their BTC stock.

 

The evolution of the Bitcoin mining landscape

A short twitter thread on the evolution of the mining landscape in Bitcoin. In the short space of 10 years, we have gone from cypherpunks and GPU’s, to pre-IPO behemoths and ASICs. Will it be sovereigns next?

 

Bitcoin is not a Giffen good

The narrative that Bitcoin is a Giffen good was proposed by Chris King of Morgan Creek as of late, and I thought this is a good time to take a look into it and see if if it holds ground (hint: it doesn't).

 

I get how one can fall into this trap - Bitcoin's reflexive properties, do give it some of the characteristics that Giffen goods bear. But Giffen goods are not the only types of goods that violate the law of demand. Everybody is entitled to their opinion, but nobody is entitled to their facts. That said, there seems an audience for everything...

 

A Giffen good is a product that people consume more of as the price rises and vice versa. Giffen goods are so strongly inferior goods (inferior goods are goods whose demand decreases, as the the income of consumers increases - e.g. broomsticks) in the minds of consumers (being more in demand at lower incomes) that the income effect more than offsets the substitution effect, and the net effect of the good's price rise is to increase demand for it.

The econ 101 example is that of potatoes in Ireland during the great famine - note that potatoes were not a Giffen good before the famine, but only became one as all substitutes became incredibly scarce.

Here are the conditions for a good to be considered a Giffen good: 

  • the good in question must be an inferior good,

  • there must be a lack of close substitute goods, and

  • the goods must constitute a substantial percentage of the buyer's income, but not such a substantial percentage of the buyer's income that none of the associated normal goods are consumed.

How many of the above criteria does Bitcoin satisfy? You guessed it - NONE ❌

Be that as it may, the underlying idea that Bitcoin becomes more desire-able as its price rises, does hold some ground. Here's why:

  • It attracts more hash-power and is therefore more expensive to 51% attack, and as such is a better store of value. Its fundamental properties improve, which in turn pushes the price higher.

  • Bitcoin's market cap is like votes of confidence - every dollar exchanged for Bitcoin is a vote towards BTC becoming established as a global medium of exchange. The more votes in favour, the more likely you are to be on the losing side if you don't participate.

  • Lack of proper valuation models, make Bitcoin more reflexive - there is no objective measure of value, and so people are more easily subjected to a bandwagon effect and a confirmation bias.

  • I will go as far as to argue that, given the amount of attention that Bitcoin has currently, and considering its deflationary schedule (artificial scarcity), Bitcoin more closely resembles a Veblen good, than it does a Giffen good. That is to say Bitcoin is more like the original Aston Martin DB5 from Goldfinger, than potatoes in the Irish famine - but really is like neither.