TowerWatch #14: Demand is Coming
Welcome to the 14th edition of TowerWatch, a newsletter from BlockTower aimed at cutting through the noise of crypto markets. We have one purpose: be useful.
Three things you should know:
One: Drivers of Demand
We certainly live in uncertain times. There is only one thing that’s absolutely true — the future is unknowable. As investors, we make our best guesses as to what the future might hold, but one can never be too sure.
When you’re a cryptocurrency firm, your primary focus is typically on the cryptocurrency markets. With all the volatility and inefficiency in our little corner of the world, it almost feels mundane to turn your attention elsewhere — things seem bland. Well, I can say with confidence 2020 is really trying its hardest to change that. Starting with the Iranian “missile crisis” in early January, and rolling into the Coronavirus crisis the world has been set ablaze with volatility.
Historically a major concern for the crypto-curious were the nauseating price swings of Bitcoin, but with this new normal in mind the gyrations of Bitcoin are starting to look less worrisome. If the S&P can fall 30%, and Bitcoin falls 40% during the same time — is buying Bitcoin that much more of a rollercoaster ride? The market seems to agree and YTD Bitcoin is one of the best performing macro assets, reflecting real demand (even in the face of a crisis).
The pandemic and the ensuing pandemonium have highlighted some major flaws in our system, and people (at least those who have the bandwidth to care) are watching wide eyed at the steps that governments around the world are taking to mitigate subsequent damage resulting from those flaws. This is a unique point in time, as central banks globally are simultaneously providing more liquidity than ever before to a stressed system — and it’s unclear what the effects of that additional liquidity will be.
As part of the effort to fight the demand crush the virus has caused, the Great Monetary Inflation has begun. As Paul Tudor Jones noted in his May investor letter:
The depth and magnitude of the economic drop-off took modern monetary theory or the direct monetization of massive fiscal spending from the theoretical to practice without any debate. It has happened globally with such speed that even a market veteran like myself was left speechless. Just since February, a global total of $3.9 trillion (6.6% of global GDP) has been magically created through quantitative easing. We are witnessing the Great Monetary Inflation (GMI) an unprecedented expansion of every form of money unlike anything the developed world has ever seen.
Global debt was very elevated entering the pandemic, and this monetary expansion is funding additional large debt creation, for now, without provoking the disciplining response of rising market yields. So far, the result has been asset price reflation. A large demand shortfall will prevent goods and services inflation from rising in the short term. The question is whether that will be the case in the long term with a central bank whose central focus will be repairing the worst employment crisis since the Great Depression.
Now, we should be sure to sprinkle in a bit of nuance here. It’s hard to parse whether this rally from Bitcoin is a direct reaction to the expansion of the Fed’s balance sheet because individuals view it as a hedge. It’s entirely possible that Bitcoin is just acting as a risk asset, and we’re reading in between the lines a bit too much. Although in the end what matters is the narrative, and when enough people in the world agree that Bitcoin might act as an inflation hedge, or a put on central banks — it just might.
On a more adversarial stage, the US and China are back at it again rattling their sabers, threatening action due to the virus. The world is souring on what it views as an increasingly authoritarian China and steps are being taken to mitigate reliance on their supply chains. This dynamic could potentially move production lines to more costly locations, another driver of inflation.
As a hard capped, scarce asset, Bitcoin stands to benefit tremendously from worries about fiat debasement. There are now a number of countries around the world that are experiencing currency depreciation, and many more that may be on the road there. Bitcoin supply is set in stone, a fixed supply curve dictated by the original codebase, leaving demand as the only unknown variable to price.
We continue to see pockets of demand globally this year, as the macro uncertainty pushes markets to their tipping points.As individual countries continue to have crises, the portability of Bitcoin will shine through. In a country like Lebanon, with a collapsing currency and financial industry, where war is not a foreign concept but a close reality, the portability of Bitcoin makes it a potent tool for the dissident, and a useful insurance plan for those leaving that may have to leave physical wealth behind.
Bitcoin fits neatly into a picture of the post COVID-19 world. Looking at the stock market, the NASDAQ has dramatically outperformed the S&P500. The S&P500 itself is on life support, other than the thriving tech companies near the top of the list. The virus has forced the transformation of society into a digital first world, so digital companies are the ones coming out on top. With this transformation will come broader acceptance of the concept of digital money. Bitcoin after all, is the internet's first money -- a protocol for sending value over the pipes that make up the interconnected world. With increasing reliance on the internet, expect increasing interest in all the things the internet has to offer.
"History repeats ... first as tragedy, then as farce"
The erosion of trust in central banking is sure to play a role in eventual adoption as well. Quantitative easing, first introduced in 2009 — to stem the unthinkable from happening. To save the global financial system. It worked, and the Federal Reserve was able to reverse the course of the financial system. Eleven years later, faced with another crisis — QE was rolled out to an even greater extent…but failed to work. When the Federal Reserve initially cut rates, the market sold off. The second time rates were cut to zero — once again, a sell-off.
The markets did not buy that the Fed alone could stop the bleeding. The fallibility of the “Fed Put” was on full display during that fateful week — once a strong response, now a failed exercise. The market refused to bottom until Congress stepped in, revved up the money printer and distributed capital to individuals and companies alike. The Overton Window has shifted, and I would be surprised to find people still hold our central banking system in great esteem, knowing that it failed to stem the bleed this time around.
With all of these catalysts on the horizon, what’s become clear is that the macro case for Bitcoin has never been more obvious. In the past, people have postulated that Bitcoin could potentially act as a store of value during inflationary regimes, but there wasn’t inflation on the horizon. In the past there were theories that Bitcoin would appreciate in the face of central bank currency debasement — but there was a net decrease in money supply from 2009 onwards. In the past, there were claims that the digitization of the world would need an internet currency -- but things were going slowly. Heading into the back half of 2020, the future looks pretty bright...
Two: Lifting the Veil on Mining
Every 210,000 blocks (roughly four years) Bitcoin miners get put to the test. The feasibility and profitability of their businesses come under fire due to the Bitcoin protocol’s pre-programmed block reward halving. Unfortunately for their bottom line, the Bitcoin block reward is directly proportional to miner revenue, so cutting the block reward by half cuts their revenues by half (save for transaction fees).
Now, many look at the halving and see a fundamentally bearish event. General consensus going into the halving was that hashrate would decrease by about ~30-40%, as many unprofitable miners started to turn off their machines and leave the network.
The general theory is that those unprofitable miners (those who use mining machines like S9 from Bitmain) would then offload their balance sheets, leading to a sell-off post halving. Hashrate hit an all time high around 120 EH/s before halving. After halving, it dropped (as of 5/15/6:30pm) to 95 EH/s (25% drop). With this drop, blocktime has lengthened to 11.4 min from the expected 10, which indicates that difficulty will be adjusted lower on Tuesday.
Despite the calls for a post-halving sell-off, we got a pre halving sell-off (as people “sold the news” — see my post on halving as a marketing event). Price rebounded fairly quickly after the sell-off though, and we’re currently only 5% off local highs.
There are a few reasons why bearishness related to mining was unfounded. Generally, smaller miners more frequently sell off their balance sheet Bitcoin to cover electricity costs, meaning that the miners most likely to capitulate probably had the least amount of inventory to offload on the market. Additionally, “Black Thursday” washed out a decent amount of miners from the system, who likely sold into or directly following the major price crash, getting supply out of the way early.
This halving is the first halving with the presence of widely used sophisticated hedging tools like futures and options, which have allowed miners to be more conservative with their selling. The halving is also a known quantity now, and miners have been preparing for this moment for over a year. Many miners have spent a large chunk of their free cash upgrading their machines to more recent models (S9s to S17s) to maintain cost advantage.
Current estimates are that almost 62% of the hash rate produced is done so by S17s — the newest mining hardware model from Bitmain, the largest producer of Bitcoin mining hardware.
Overall, the loss of hashpower should prove to be healthy for Bitcoin in the long term. The “Miner Capitulation Roadmap” articulated by BlockWare Solutions suggests that the loss of inefficient miners is a net positive for the Bitcoin ecosystem (which we tend to agree with).
Go deeper: Read this fantastic report by BlockWare solutions that dives deep into the mining ecosystem.
Three: Tokenizing People?
If you read this newsletter you may be familiar with the hundreds of attempts at tokenizing every asset with an existing market such as currencies, gold, bonds, equities, real estate, and so on. What you may have missed though, is the trend of people trying to tokenize themselves…
A crypto entrepreneur, Alex Masmej, has decided to do just that. He sold 1,000,000 $ALEX tokens to 29 investors for $20,000. He claims the funds will be used to move back to San Francisco with enough safety net to begin work on his next company. Anyone holding his personal token is entitled to 15% of Masmej’s income for the next three years, capped at $100,000. The entrepreneur also promised investors voting in major life decisions, participation in the seed funding round of his company, and exclusive “sessions” with him (whatever that means).
Alex isn’t the only one focused on the concept of personal tokenization, Stake on Me provides a platform for users to create individual tokens that can be traded for favors, the person’s time, future cash flows or whatever the two parties agree on. Human IPO aims to be a marketplace and investing platform that connects qualified users (entrepreneurs, media personalities, and influencers) who want to IPO themselves and investors who wish to buy equity in their futures.
A similar model, the income sharing agreement recently popularized by the coding academy Lambda School, has brought the concept into the spotlight in the tech world as they’ve been successful in attracting students and generating a return for their investors.
Why is this attractive for investors and individuals?
Tokenized individuals allow investors to bet on the entrepreneur rather than an individual business that they may create. This gives exposure to all outcomes rather than betting on the equity of a single entity.
By directly receiving income/equity from their success, investors’ incentives are aligned to help the tokenized individual succeed regardless of the path they may choose. Aligned incentives typically lead to better long-term payoffs.
A successful entrepreneur may found 5 companies that fail before founding their multi-billion dollar winner.
The potential downside for an early-stage venture investment is 100% but with income sharing agreements the downside is bounded either by the agreement or the average income the asset issuer is willing to live on. The risk-reward is favorable as entrepreneurs that fail in one business can fall back on a well-paid job or start another company.
Entrepreneurs, students, or the average individual who wish to leverage their potential can get access to financing that was previously unavailable to them.
One of the more consequential aspects of these possibilities is that it challenges our societal notion of human value. We are trained to be well aware of the value of our labor, but having a tradable asset with a market cap is a very different story. We are used to being paid for our time, but not paid for our potential. The mainstream is likely unwilling to accept this idea any time soon (and regulators are sure to fight it), but it *may* become more normal in tech and finance circles in the years to come.
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Overall Market: Heading into the summer months, Bitcoin is starting to slow down and paint a range. Spot buying has slowed decently following the halving, and sellers have appeared at $9,800 and above, willing to take prints. A break of the $10,500 yearly high would be a great sign, and point towards new money demand for BTC (as long as leverage remain depressed). A break of that high, and the next target would be the 2019 summer high of $14,000.
Throughout the last month, altcoins have lagged Bitcoin — indicative of the fact that new money flow is coming into Bitcoin first. The usual market flow is Bitcoin —> Large Caps —> Midcaps and this cycle seems to be following a similar pattern. If Bitcoin volatility dies off and people roll their profits, one would expect altcoins to begin outperforming.
While equity markets continue to worry investors, Bitcoin continues to outperform. Despite equity markets trading down at the end of last week, Bitcoin traded up. This short term decoupling could be a sign of a larger trend, but an extremely sharp move in the S&P500 could be cause for some to sell out of Bitcoin. We’re tracking correlations closely, as continued decoupling in the face of equity weakness could be a huge driver for Bitcoin demand.
Key Data: Leverage in the system is lower when compared to March highs, but there continues to be consistent growth. The fact that we are still holding mid 9s with half as much leverage as before suggests that there continues to be a strong spot bid. Key levels have been held recently by spot buying — a bearish indicator would be key levels instead getting propped up by derivatives which would set up a scenario for some nasty stop runs.