TowerWatch #3: The Silent Market

Welcome to the third edition of TowerWatch, a weekly newsletter from BlockTower that focuses on cutting through the noise in the cryptomarkets.

We have one purpose: be useful.

One: The Macro View

Many traditional fund managers that enter the Bitcoin world tend to view Bitcoin as a gold analog, for better or worse. The bitcoin vs gold analogy is somewhat useful as a tangible, surface level equivalent to aid understanding, but generally fails to present the whole picture.

While a main driver of value for gold is its use as an inflationary hedge, Bitcoins value has mostly been derived from speculation for the majority of its history. Interspersed throughout speculation have been brief periods where Bitcoin has reacted to isolated macro shocks, such as the 2013 Cyprus Bailout or the devaluation of the Yuan earlier this year. At a high level, Bitcoin is still a speculative instrument, but within its price action Bitcoin contains the potential for a fantastic macro hedge (in no small part because it's generally uncorrelated to equities, bonds and commodities).

From a broader macroeconomic perspective we can look at the growth of Bitcoin as being driven by combination of three things.

First, Bitcoin growth is a response an increasing Federal Reserve balance sheet. There is actually a synergistic flow between the two. Bitcoin was created by Satoshi Nakamoto as an apolitical, decentralized currency meant to be a hedge against mismanagement of central banks. A large part Bitcoin intrinsic value comes from its censorship resistance and resilience in the face of individual governmental failure. The unprecedented use of QE gave credence to this narrative, and helped justify Bitcoins success in the eyes of supporters.

Chart: BlockTower, data from CryptoCompare and Federal Reserve

In addition to narrative fodder QE introduced a technical reason for a price rise — the printing of “cheap” money. Cutting rates, and refusing to meaningfully unwind the balance seet has pushed investors up the risk curve over the last decade. The “risk-off” environment we’ve enjoyed for some time now has prompted some investors to bet on one of highest risk (but also highest reward) assets in search of returns.

Third, some amount of growth can be attributed to true demand emanating from macro shocks. As an apolitical and uncensorable asset, there is some demand for Bitcoin from those who live under regimes where their own particular currency or banks are untrustworthy. For people living in Cyprus in 2013, or Argentina in 2019, Bitcoin becomes a useful asset to hold. While it’s not clear whether individuals in these countries are piling in large amounts of money directly into Bitcoin as a consequence of currency depreciation (likely only a few are) — it doesn’t matter too much. What matters is that at the margin, individuals become more aware of the fallibility of their own systems during times of stress, and more knowledgeable about Bitcoin as a potential hedge.

  • For example, when the USDCNY peg broke in August, Bitcoin rallied. Whether this was entirely due to Chinese individuals entering is unknown, but the narrative of Bitcoin being a safe haven strengthened regardless.

Let’s entertain the question of how Bitcoin performs in a recession. There are quite a few proponents of Bitcoin who believe that it will outperform in a recession. Many others believe that a recession would be a death knell. To us, the clearest answer to this question is it depends. As a mostly risk-on asset it’s unlikely that Bitcoin does well if a full-on 2008 style recession happens in the next few years. Far too many people would flee to safe haven assets, which does not currently include Bitcoin.

The ideal scenario for Bitcoin is what seems to be happening currently. Idiosyncratic economic downturns and currency depreciation (Argentina, Turkey, Chile), while the broader world keeps on chugging. These individual downturns make the world more aware of potential failure, and as a result is likely to push individuals to explore potential hedges. As long as the broader markets remain strong, individuals will also be comfortable holding assets higher on the risk curve (Bitcoin). As time goes on, and money flows in, Bitcoins volatility goes down, and the narrative reinforces itself. In the end, it’s a matter of timing.

Two: What is Ethereum, Legally?

Ethereum is an odd case. Is it a security? Is it not a security? One of the reasons we can even entertain the possibility of Ethereum not being security is because the network is already launched and running. At the time of the ICO, Ethereum was likely a security because it was pre-launch and therefore almost by definition centralized and dependent on the work of a central group.

Back in 2014 however, no regulators were really paying much attention to the cryptocurrency world which let Ethereum fly under the radar. Cut to the present however, and you’ll find that similar but newer ICO’s are much less fortunate — the SEC is paying close attention.

Anyways. On October 10th, the Ethereum community got a welcome surprise from the Heath Tarbert (Chairman of the CFTC).

From Yahoo Finance:

“We've been very clear on bitcoin: bitcoin is a commodity. We haven't said anything about ether—until now,” Tarbert said on stage at Yahoo Finance’s All Markets Summit in New York City on Thursday. “It is my view as chairman of the CFTC that ether is a commodity.

Huzzah! The CFTC had never before directly addressed whether Ethereum was a commodity. While a director of the SEC (Bill Hinman) indirectly said Ethereum might be a commodity, it was not confirmed by any other regulator until that statement. The designation of commodity opens up a quicker path to Ethereum futures, and broader adoption for the cryptocurrency. All is good.

Wait a second:

Heath Tarbert, chairman of the U.S. Commodity Futures Trading Commission, sounded out a warning yesterday [Nov 12th] over the potential for staked tokens (i.e. the coins that support proof-of-stake blockchain networks) to be classified as securities.

“We are thinking carefully about it,” he said during a conversation at Coindesk’s Invest conference in New York City in response to a question about Ethereum 2.0, the blockchain’s next evolution which intends to use proof of stake (PoS) as a consensus mechanism.

Now this all just seems like a headache. If a cryptocurrency can move fluidly between being centralized and decentralized — then the SEC will constantly need to pay attention.

That’s exactly what the SEC believes though!

A digital asset may be offered and sold initially as a security because it meets the definition of an investment contract, but that designation may change over time if the digital asset later is offered and sold in such a way that it will no longer meet that definition.

I agree with Director Hinman's explanation of how a digital asset transaction may no longer represent an investment contract if, for example, purchasers would no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts.

  • Jay Clayton

It seems the SEC will need to have hard rules on what makes something decentralized vs centralized (which is not an easy task). How do you define a decentralized system? How often do you need to evaluate a system to ensure it’s decentralized? What happens to operators if something goes from being a security to not being a security and vice-versa? All of these questions need to be answered somehow.

Why this matters: Much of this particular issue may stem from the depth of understanding about underlying consensus protocols (i.e is PoS that much more centralized than PoW?). It also seems symptomatic of general overthinking from regulators, and underscores the importance of regulator education. If cryptocurrency is to go mainstream, there needs to be further concerted effort by the community to help educate regulators on the system.

Three: OpFi, DeFi, DAI and SAI

Open finance, decentralized finance, whatever you want to call it — it’s growing! Tomorrow, MakerDAO will open up transitions to multi-collateral DAI, and the great migration will begin.

  • This in many ways is the first major stress test of decentralized finance as it requires large coordination between exchanges, devs, and market participants in order to come out the other side successful.

  • Exchanges such as Coinbase and Kraken have announced support for multi-collateral DAI, illustrating broad community support (still no BSV on Coinbase / Kraken…)

Here we’ll be watching closely to see how the transition plays out, as we believe that the success or failure of multi-collateral DAI has major implications for the future of decentralized finance. One of the major worries about DeFi is the lack of portability. What happens when there are major changes to a protocol? When you’re dealing with peoples money, everything has to go perfectly, otherwise you can irreparably damage reputation and trust.

Why this matters: Historically confined to the Ethernet community, we’re seeing more widespread discussion about open finance. Over the next year, there are quite a few new protocols launching that may look for DeFi as a potential source of usage.

It’s not too far-fetched to imagine that we will see many different competitors to the current Ethereum DeFi stack on different protocols, with small tweaks to the system based on observed inefficiencies. Dfinity, Cosmos and Harmony all have incentive to help port over DeFi if they think it will allow them grow a userbase. There is already a MakerDAO competitor in existence (Kava) that is based on Cosmos, and we suspect there is more to come.

General News:

Capital Markets:

Market Outlook:

General Outlook: The Market is Silent

Bitcoin is continuing the grind lower with implied and realized volatility continuing to fall. While the options term structure is still very steep, we’re seeing weekly vols at levels not seen since April (mid 40’s).

Bitcoin price grinded lower since our last letter, settling in a tight range between 8350 and 8650. Despite ranging with low volatility, we’ve seen a few significant attempted range breaks that have failed quickly, indicating significant indecision from both buyers and sellers.

Funding rates and futures curves have flattened as well, but open interest remains elevated ($840m) compared to Sept and Oct lows. It seems as though both longs and shorts are positioned relatively well and there is no large imbalance between longs and shorts, which is what often causes sharp movements in either direction. Volume has also reached multi-month lows, setting the stage for a large movement.

Key Levels:

  • Resistance: 8640, 8800

  • Support: 8350, 8200

Overall Market: Ethereum too has seen a significant drop off in volatility, but also is seeing widening spreads on options indicating market markets are reluctant to play aggressively in this low-vol market. Bitcoin dominance has stayed relatively flat, but select altcoins continue to outperform on shorter time frames. In some ways, this market is similar to the February - April market where Bitcoin volatility trended down, giving altcoins room to breathe. The fact that alt coins are still moving upwards in this market lends credence to the idea that some part of Bitcoin under performance is due to altcoin rotation.

What We’re Reading:

This week, we’re taking a look at the cryptocurrency derivatives market. Over the last year, the derivatives market has exploded with a variety of new upstart exchanges and products hitting the market. Looking at just BitMEX vs spot volume, one can see that derivatives are in the drivers seat of this market.

Chart: BlockTower, data from CryptoCompare

Emmanuel Goh, of Skew, wrote a great article on the state of crypto derivatives, and we’d like to share an excerpt from that article:

Victims of their own success, derivatives venues were hit in 2019 with a first-world problem.

As trading occurs on margin, derivatives exchanges have been careful to design a spot price index derived from the price of what were, initially, much larger physical exchanges. The index is used to settle the contracts at expiry, and decide when to initiate margin calls. It was a smart way of preventing manipulation of the then not-so-liquid crypto derivatives contracts.

However, as the derivatives market has grown exponentially, we have now entered a period where the underlying physical exchanges are much smaller than the derivatives exchanges – only 10% of total volumes in aggregate. It has become tempting to try to manipulate the less liquid underlying exchanges to yield some profits trading the derivatives.

This was most visible earlier this year in May when a relatively small-size order on physical exchange Bitstamp triggered a wave of liquidations at BitMEX and took the entire market down.

Exchanges seem to have been increasingly aware of the problem and have been attempting to strengthen their indices – sometimes with unfortunate consequences, as with a recent miscalculation at Deribit costing the exchange $1.3 million.

With the CBOE officially out, expect the competition between CME and ICE to be heating up in 2020 as the two exchanges roll out their options offering.

It would be particularly encouraging to see corporate hedging flows taking off, led by mining companies and supported by physically delivered and options contracts. The Mexican government is said to have spent $1 billion on put options this year to hedge its 2020 oil production. Still some way to go for crypto derivatives.

Cryptocurrency derivatives have undoubtedly become bigger than the spot market — but what are the implications of this?

  • Markets becoming more dependent on Bitcoin. Individuals tend to aggregate around liquidity. Seeing at Bitcoin derivatives are now by far the most liquid instruments, they will continue to attract demand. Despite having periods of altcoin mania in the past, it’s possible that the derivatives market will drain those altcoin speculators and refocus them on Bitcoin derivatives. More generally this is a bearish thesis for altcoins, as individuals who would previously speculate on altcoins move over to leverage BTC products.

  • More sophistication in the Bitcoin markets. Wit derivatives comes sophisticated players who see the potential inefficiencies in the market. One would actually expect long term volatility to dampen (although short term may be exacerbated by increased leverage).

  • The rise of structured products. With derivatives will come products. Covered call portfolio, accumulators and more. Derivatives offer specialized ways to invest in the Bitcoin market, and offer investors ways to invest that were previously unavailable. This should open up the market to both the skittish and the bold.

All in all, suffice to say we’re quite excited for the next chapter.

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