Foreword: My intent for this article is to review recent events in the crypto market, starting with two data points that we encountered in the past week, and then reviewing the past year to understand what began and ended 2017’s parabolic bull run. We’ll then look at what happened to the last wave of crypto speculators, and who — if anyone — will replace them. Lastly, and most importantly, we’ll seek to understand what will need to happen before they enter.
Two events came to our attention this past week — one that we judge to be very good/bullish, and one that is most assuredly not.
Let’s get the bad news out of the way first.
First, the Bad News
Barring an unexpected and unlikely move, this week is going to mark an occasion that has only two precedents over the past six years, and has not happened since November 2015.
Unfortunately, you’re going to have to keep the champagne locked up in the cellar for now as this will be an event we would all just as soon forget. Why? Assuming that its price remains in the current range, then on November 1st 2018, for the first time in three years, Bitcoin’s 12-month trailing return will move from positive into negative territory. A Halloween horror show, indeed.
I’ll follow that up with this little gem of a table. I don’t think there’s a better way to illustrate the wild ride that has been crypto for the past five years, than this:
As you can see, anyone who bought their first Bitcoin in January 2013 had a very merry Christmas that year. Conversely, those who entered the market in January 2014 ended the year with a big lump of coal (or a lump of something else entirely) in their stockings.
You may ask, why am I bringing this up? It’s not because I enjoy dwelling on the negatives. After all, my parents always encouraged me to seek out the positives in any setbacks or disappointments. Maybe that’s because I was raised in the upper Midwest, where the weather is consistently terrible.
Nonetheless, the fact remains that we arrived at this milestone amidst a remarkably stagnant period. I didn’t start actively trading crypto because I expected it to be boring. Quite the contrary. After all, one of my favorite crypto quotes comes from Arthur Hayes, founder of BitMex, who recently argued that “for crypto, a decline in volume and volatility is deadlier than white wine and painkillers”. Yet, as the charts below demonstrate, here we are.
In fact, Bitcoin’s annualized volatility is now below or on par with that of many of the largest US tech stocks, including Apple (AAPL) and Netflix (NFLX).
Source: Kosmos Research, Coinbase, NASDAQ
Not surprisingly, this has coincided with:
(1) Bitcoin trading in an ever-narrower range over recent months. In fact, when I last checked the price an hour ago, the 24-hour change was precisely 0.0%. We try not to stare at the ticker all day, but that was a first for me.
(2) Exchange-traded volumes are falling off a cliff. To take BTC as but one example, see below a table showing the lowest 10 daily volumes of 2018:
Yes, you are reading the table correctly: four of the ten slowest days year-to-date occurred last week and nine of the ten came this month. To put this in perspective, over US$ 11 billion traded on January 1 of this year.
Great — so the market is stuck in an almighty rut. How does that help us as investors?
Hold that thought for a moment. First, let me tell you about a conversation that we had last week that brightened our mood considerably.
Now, The Good News
Amidst all the crypto doom and gloom (but definitely no boom, sorry Marc Faber) my partner recently caught up with one of his friends, a macro hedge fund manager based in London. The crypto market loves to obsess over when that “institutional wall of money” is going to arrive. Well, this guy is an integral part of that wall. So we’re always interested in hearing his thoughts on crypto, to the extent that he has any.
After all, like most macro fund managers he doesn’t have much time for an asset class where the capitalization isn’t measured in trillions of dollars. As recently as the fall of 2017 he had admitted to knowing ‘next to nothing’ about crypto, and lacked the bandwidth or incentives to spend time learning more.
But this time the conversation went differently. He told us that he has begun reading up on the space and had questions. And if he is working his way up the learning curve, we strongly suspect that he is not alone. Our friend is not the type to waste time or energy on a topic unless he has identified a compelling opportunity. To us, more than anything we have read on Crypto Twitter, this was a bullish market signal.
Most importantly, we found it interesting that this conversation took place just as Bitcoin’s one-year trailing return was about to descend into negative territory.
However it’s important to consider these two data points — one good, the other not so much — in the context of what has transpired in the past year. Let’s briefly recap what happened to the crypto market in 2017, and why.
Past Is (Not) Prologue
Like most greed-driven bubbles, Bitcoin’s historic 2017 move started slowly. BTC traded at less than $1,000 on January 1st, and was worth only a few dollars more at the end of March.
But something happened in the second quarter — by the end of June BTC’s value had increased by over 250%. Three months later, it had doubled in value again. And December, of course, is when the frenzy went into full swing. Prices doubled in less than three weeks, and nearly touched $20,000 before finally collapsing.
Now, some might argue that initial coin offerings (ICOs) are what sparked the market frenzy. To an extent, we agree with this position. After all, the ICO mania is what initially shone the spotlight on crypto and forced the mainstream investing public to take notice.
Looking more closely though, we would argue that a more consequential trend emerged in the second half of 2017. Rumors of — and seeming steps toward — institutional market entry were what ultimately drove Bitcoin into its parabolic end-game.
An Annotated (Recent) History of Bitcoin
Simultaneously, announcements of Bitcoin futures contracts, paired with headlines regarding Wall Street interest and breathless predictions of imminent change, conspired to fuel a self-fulfilling narrative of ever-higher asset prices.
CNBC, December 2017. Boo-yah!
The hysteria peaked on December 18th, 2017. Bitcoin had just hit an all-time high of $19,783 on Coinbase the day before.
Two weeks earlier the Chicago futures exchanges, CME and CBOE, had announced launch dates for their Bitcoin futures contracts. Predictably, the cryptoasset market went ballistic as new entrants flooded in ahead of the ‘wall of institutional capital’ that was widely rumored to be imminent and was going to propel Bitcoin to new heights. The price of Bitcoin doubled in the first two weeks of that month.
CBOE futures debuted on December 10th and traded 19% higher on their first day. Trading was halted twice due to exchange ‘circuit breaker’ rules. The market continued to buy, waiting with bated breath for the CME launch a week later.
The CME contract opened to much fanfare, and then…traded 2% lower. It was the embodiment of failed expectations.
And this was only the beginning of the pain. The institutional money never arrived in earnest and did not drive this bubble.
In short, 2017 was almost exclusively a retail-driven train, and the late-arriving punters got crushed in the derailment. The institutional capital has not yet joined the party.
Where Is The Proverbial ‘Wall of Money’?
Go to any crypto meetup or convention today and the same question will be asked. It will be repeated like a mantra — in the panels, during the keynote, and in the furtive conversations backstage:
“When are the institutions coming in???”
We’re like teenagers waiting by the phone, staring at it like Luke Skywalker stared at that X-Wing Fighter on Dagobah…just willing it to ring. Come on, Blackrock, show us some love!
There are an abundance of different but credible theories to explain what might push Bitcoin below the well-defended price floor of 5,800 that has been maintained since late June. On the other hand, the smart people we talk to in the space as well as the “crypto media” are fairly unanimous in their view that the next bull run will be driven by widespread institutional adoption — the “wall of money” — that in most permutations of this vision arrives on the back of a long-awaited Bitcoin ETF. While we love being contrarians, on this point we wholeheartedly concur.
For your average long-term retail HODLer, the initial reaction to this question is likely an eye-roll. Why? For a concrete example, take a guess at the dates when these headlines were published.
The first article, from the Financial Times, was written on 12 August 2018. The WSJ story was published a little over a year ago.
You see, we’ve been here before and we’re still waiting for the institutions to arrive.
We all know what the reaction was to the Journal article — see chart above. And how did the market respond to the more recent FT piece?
Ironically, the conviction that institutional capital is the rocket fuel needed to ignite another crypto moonshot is, if anything, stronger now than last year. So why did the possibility of institutional entry drive such mania in 2017, and why has it failed to move the needle this year?
Really it all comes back to the specific inquiry we received from our friendly British hedge fund mogul: “who is buying Bitcoin here and now?”
The Importance of Market Psychology
Some of the smartest people I have ever met are working day and night to develop effective valuation approaches for cryptoassets. This is a monumental task, since crypto is unlike any other asset in human history. Market capitalization (sorry, CoinMarketCap) is generally useless. Certain equations that we learned in Economics 101, such as MV=PQ, are better but also have their limitations.
So crypto doesn’t yet have a universally accepted valuation metric. But we do have quite a few proxies. One of them is the measurement of how many active users are in a blockchain’s ecosystem at a given point in time. We refer to this as Daily Active Addresses (DAAs), which records the number of Bitcoin (or other token) wallets that engaged in transactions on a given day. DAAs are easy to track on the Bitcoin blockchain.
Take a hard look at this chart. Let it sink in.
The number of active wallets is — literally — half of what it was just ten months ago.
Now, if you’re reading this in late October 2018, you have most likely been in the crypto market for awhile. You probably enjoyed some — maybe even all — of the 2017 bull run and you’re still sitting on top of significant gains, even after this year’s drawdown. You’re in this for the long haul.
But now, imagine you’re one of those poor souls who decided to join the Great Crypto Buying Frenzy of December 2017 — right at the top of that chart. Maybe you were smart and just invested a small percentage of your net worth. Or maybe you weren’t so smart, and you mortgaged your house to go ‘all-in’.
If you decided to #HODL, like all of those other amateurs on Twitter, you’re staring at an unrealized loss of 61%. What do you suppose your feelings toward crypto are by now? Are you buying more? Averaging down your cost basis?
Most likely not. You’re probably cursing the friend who told you to open a Coinbase account, and wondering how you will ever make that money back. And you’re definitely telling anyone who will listen to your rants that they should stay away, too.
While we acknowledge this is an imperfect measure, let’s assume that each of those new December 2017 DAAs equates to one late entrant. If so, then over 600,000 people were burned in the latest crypto crash, and have left the market with their portfolio in a smoking ruin.
For an asset class with a market cap below $250 billion, that is a LOT of people. And it’s going to take a lot of good news to bring them back — if ever. If anything, we believe this wallet count understates end users as many on-exchange transactions get netted before they are ever recorded on-blockchain.
The damage was compounded by the fact that these people could have served as crypto ambassadors to the next tier of risk takers. That misery is now being further exacerbated in real time because, starting this week, people who bought 12 months ago — even before the last parabolic push higher — are now underwater too.
In many ways this is an age-old story: an asset collapsed, people lost money and therefore are more cautious this time around. However the scale of the carnage, given the proportion of investors who have been burned, is nearly unprecedented.
“Who is buying Bitcoin here?” we were asked. The answer was immediate and obvious: No one.
The marginal retail buyer — the people who were trying to front-run “big institutional money” in Q4 2017 — do not exist. So who does that leave?
The Wall of Money… yet again
Are you as tired of this metaphor as we are yet?
We’re not talking about Chicago high-frequency traders here, or ‘Mrs Watanabe’ in Japan. This refers to the real allocators. Pension funds. Sovereign wealth funds. Endowments. Powerhouses with asset pools that run to twelve digits, or more.
These organizations are managed by inherently risk-averse people who know that investing into new and untested markets implies significant career risk. Portfolio managers rarely get fired for buying German Bunds or T-bills. Any fund managers who went long crypto in December 2017 are probably dusting off their CVs now.
With no retail investors and no genuine prospect of them returning again before a big-time upside breakout that reinvigorates the FOMO on which crypto has historically thrived, it is these institutions who will have to carry the water to get things started.
There is no crystal ball on my desk, and I won’t pretend to know when this will happen. The timing of this evolution depends on a host of factors that are both endogenous and exogenous to the crypto market. However, we do feel confident in saying that no other spark exists for the next crypto bull run.
Are we there yet?
Two conditions must be met before that spark can be lit:
(1) Institutions must have the ability to participate in the crypto markets
(2) Institutions must have the desire to participate in the crypto markets
Here’s the irony: in 2017, the desire was certainly there. Having worked on Wall Street, I can confirm that bankers and traders were watching this market intensely, and in many cases they personally participated. But they had no ability to participate professionally because the key building blocks — qualified custodians, trusted trading counterparties, and (in some cases) leverage — were simply not there. (Remember, career risk is one of the most powerful forces in nature.)
And now, less than a year later, the conditions have been reversed. Over the past ten months the crypto community has improved its infrastructure by leaps and bounds. From actual, live people answering customer queries (thanks, Coinbase! and what’s taking you so long, Binance?!?) to fully licensed custody solutions, this market is evolving more rapidly than ever.
And yet, even though institutions now have the ability to enter — desire has left the building as volatility, volumes and returns have all evaporated.
It’s a sad day when Apple stock carries more vol than crypto…
So where does that leave us?
We’ve already established that the retail investor will not rescue the crypto market from its current plateau, and that institutional capital will eventually provide that needed boost. However, something needs to get them off the sidelines and into this asset class.
And while it’s safe to say that a Bitcoin ETF certainly can help to increase market adoption, we don’t believe this is the deus ex machina that the crypto market really wants — or needs.
According to the World Bank, institutional investors in developed economies currently manage over $100 trillion of assets. Think about what just fifty basis points of that capital would do to the crypto market.
That capital won’t be allocated overnight — each institution needs to arrive at its own decision to do so. And in order to allocate, an institution must believe that cryptoassets have finally arrived as an asset class that is worthy of investment.
But other things are happening out there, far beyond the reach of crypto exchanges. Dark clouds are forming over equity and fixed income markets, for the first time since Satoshi’s white paper was released to the world.
What happens if Wall Street loses its appetite for equities or corporate debt? Where does that capital go?
In the right circumstances, could Bitcoin even be considered a safe haven?
I think it’s very possible, and in our next article we’ll take a close look at how that just might happen.
DISCLAIMER: Nothing in this column is intended as investment advice and you definitely should not interpret it as such. Don’t rely on my advice, or for that matter anyone else’s advice, when making investment decisions. Doing your own research is the key to success in any market.