Professional Investor Report - August 2022

This was originally published September 1, 2022, and was part of a paid newsletter for professional investors interested in bitcoin or bitcoin credit facilities. The price of bitcoin was $20,000. This is being republished for archival purposes. They will also be referenced in future writings.

We'll start by addressing the elephant in the room; The current bitcoin drawdown has lasted 294 days. We are currently down 72% from the all-time high. 2014, 2018, and 2019 bear markets lasted on average 330 days. Peak drawdowns during those times hit 85%. That being said, price action does not kill innovation and adoption. We will review some indications of such trends. Today we have investors accepting volatility and deploying capital into a down market. We will present some data to show why, based on historical trends, it might be a great time to do so.

TL;DR (Too Long; Didn't Read)

• BlackRock offers institutional clients a bitcoin trust. $10T * 2% = a lot
• The Federal Reserve sends letters to banks asking about "Crypto-Asset-Related Activities"
• FOMC meeting minutes show more interest in how digital asset markets affect traditional markets
• Well understood models attempting to predict the bottom of a bitcoin market cycle have hit, indicating a potential bottom
• Small buyers continue to purchase bitcoin and appear to be unfazed by price
• Lending Rates increase as illiquidity continues
• Large accounts that hold more than 1,000 bitcoin have been accumulating like mad
• Ethereum is updating and 245,000 bitcoin is locked on their network

I accidentally typed BlockRock too many times while writing this.

The Biggest Kid on the Block

BlackRock gets into bitcoin by offering a private spot-based trust to institutional clients. This is no different than other options out there, the significance is that BlackRock is doing it. The press release says, "Despite the steep downturn in the digital asset market, we are still seeing substantial interest from some institutional clients.." The private trust will use Coinbase to provide "trading, custody, prime brokerage, and reporting capabilities."

This makes total sense to use if you are an institutional BlackRock client with access to the Aladdin platform and only want spot-long exposure. If not, this doesn't affect you. The greater market effect will be a continued decline in available coins as institutions lock away large amounts of bitcoin relative to an individual. This is a big deal for adoption at the highest levels of finance. Other than that, BlackRock getting involved was eventually going to happen, and in our opinion, it was effectively priced into the market. BlackRock manages about $10 trillion in assets. Of the wealth managers we work with, we see an allocation of 2% on average to bitcoin.

The press release also mentioned strange language about "permissioned blockchains, stablecoins, cryptoassets, and tokenization." I have never heard the term "permissioned blockchains," and I think it was summed up nicely by Steve Sanders,

More cynically it means: "I want to fool you and control your money. My cabal will be in charge of the monetary database and use the buzzword 'blockchain' from the crypto community to fool suckers."

— Steve Sanders (@attorneysanders), August 12, 2022

Federal Reserve Letter to Banks

The Fed's Division of Supervision and Regulation sent a letter to all banks requiring notification to The Fed about current "Crypto-Asset-Related Activities" and before engaging in any such activity. The letter tells banks to ensure; their activities are "legally permissible," their Federal Reserve point of contact is notified before engaging in such crypto activities, and they are maintaining adequate systems, risk management, and controls.

Since the Executive Order from the White House earlier this year, The Fed and other agencies are getting to work executing the desired policy from the White House. The Fed and other executive branch agencies are in the data gathering phase. They want institutions to report their activity to gather a baseline to later determine what they might need to do or not to do. As much as it might brush up against individual small government ideals, no administration or government will sit by while a trillion-dollar market operates without what they believe is sufficient regulation.

Additional context about working in the industry...

After this letter, some claimed that due-diligence processes and related KYC/AML will become more rigorous and will find their way to the end user. If someone is writing that, they have not gone through such a process before. I can not imagine how much more difficult it could become. A business that plays by the rules and does everything correctly is burdened with redundant and intrusive requirements to simply access a bank account. If the system is not simplified, this market will end up with only two types of participants; large institutions holding assets on behalf of everyone else (while also ensuring no future competition) or those who go underground and do not comply. Both of those are bad for everyone.

FOMC and Stablecoins

Meeting minutes for the July 26-27 FOMC meeting were released this month. The main topic was controlling inflation and how high rates need to go to hit the golden 2% inflation rate. Aside from monetary policy, stablecoins and digital assets were mentioned. The minutes show concern for digital asset markets and "...vulnerabilities—such as runs, fire sales, and excessive leverage—similar to those associated with more traditional assets." It was noted that digital assets have a "rising importance and growing interconnectedness" with the financial system. Further mentioned was a "need to establish a robust supervisory and regulatory framework..." in addition to stronger oversight in "nonbank financial institutions."

The Committee knows that this market is not going away; it will get larger and, thus, more connected to traditional systems. The main takeaway is confirmation that the digital asset market, including stablecoins, is something members of the committee are increasingly watching, emphasizing how they affect traditional markets.

The Kansas City Fed knows a symposium in KC wouldn't be well attended, but Jackson Hole on the other hand...

The annual Jackson Hole Economic Symposium took place late this month. The major news was Jerome Powell's comments on the pain of fixing inflation,

"While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain."

Equity markets reacted and shed all the gains for August on the S&P and more than 1,000 points on the Dow. The bond markets were relatively quiet, suggesting they had accurately priced in "some pain." Bitcoin dropped about 8%, ending the day barely above $20,000.

Potential Bottom Signals

A unique feature of the bitcoin market is our ability to track (roughly) the cost basis of users on the network. This is thanks to the transparent ledger which holds all transactions. The network doesn't "know" what a dollar is, but we can overlay BTC/USD data in conjunction with transaction heuristics to draw conclusions on the cost basis of users. A few of these models or metrics have predicted a market cycle bottom in the past. One of the three metrics hit recently, leading some to believe we are either at or very close to a market cycle bottom.

I don't have much faith in anything claiming to predict the bottom of a market cycle. Especially when correlation to public equities is more pronounced than when these models were successful. But, the data behind the models provides insight into market participants and their activity. With models this public and well understood by so many, it does introduce a caveat for analysis. A collective understanding and acceptance of such models could encourage buyers and sellers to act upon such metrics, effectively making them true, but not for the reasons the models claim. The market could believe something into existence.

The three metrics/models are Realized Price, Balanced Price, and Delta Price.

Breakdown of the models...

Realized Capitalization & Price

This metric values every bitcoin at the price it was last moved, not the current price. Doing so gives us an aggregate cost basis which can then be measured against something like the market cap to provide insight into if the market is in a net state of profit or loss.

The Realized Cap can then be divided by the current supply to give us an aggregate price per bitcoin. This metric is referred to as the Realized Price. The Realized Price can also be viewed as the average price PAID for each coin. Thinking about it in this way instead of in the aggregate makes more sense to me, and it might also help you.

Balanced Price

The Balanced Price uses the Realized Price, discussed above, and Transferred Price. The formula is as follows: BalancedPrice = RealisedPrice - TransferredPrice

Transferred Price tracks the cumulative value of transactions while adjusting for how long each bitcoin was held. Factoring in the time of holding gives value to coins stored for a longer period of time. The assumption is that older coins are used as a store of value, and younger coins are used as a medium of exchange. The Transferred Price is only realized when coins move. For example, the movement of coins held for 2 years signifies that those holders feel the market is overpriced and are realizing profit by selling to younger holders.

When the market price reaches the Balanced Price, it is viewed that the market is at baseline due to the market price matching what was paid - what was spent.

Delta Price

This hybrid metric uses old-school price action technicals and bitcoin-specific on-chain data. This metric perfectly picked the bottom of the 2018/19 market cycle.

The Delta Price model is calculated as the difference between the Realized Price (on-chain) and the all-time Average Price (technical based). The all-time average price is a life-to-date, cumulative moving average that serves the entire history of the market. It is similar to a market cap moving average.

The three appear to indicate a solid floor. This does not mean they will hold up into the future. These models are affected by recent capital flows (movement of bitcoin) and price action to an equal extent. If there were some bifurcation, the models would break down as recent data is applied. We can see some of this after new all-time highs moving into bear markets where the models slope downward for an extended period of time. It is not unreasonable to believe that a black swan event or even another situation like Terra Luna could invalidate these models. You could call that temporary, but the model still broke.

Are these models something to keep an eye on? Yes, but more so how markets react around the models' prices. We will be watching the decision-making of price-sensitive market participants as that provides more valuable information. It's also important to realize that these are not total valuation models. For more on those: Valuing Bitcoin - Part 1.

Small Buyers Are Unstoppable

I'll keep this one short as I have been talking about this trend all year. Small market participants, as we define as less than 1 (one) bitcoin, are growing, and the growth has yet to slow down.

The number of holders of at least 0.1 bitcoin is growing as well.

This is significant as it shows that millions of market participants are unfazed by a declining price. Based on the recent growth, it's evident that depressed prices are seen as an opportunity. The bullish sentiment is screamingly obvious based on the number of new unique accounts.

In addition, exchanges continue to see coins leave. The last time exchanges were at these supply levels was in May of 2018.

The Market is in a Net Loss

Over the past few months, the declining price has been trending towards the average cost basis of the market. On August 19th, the market crossed the average cost basis, flipping to a net loss. This cost is about $20,200, measured by when coins were last moved and at which price, called Realized Price. Measuring a move of coin is not indicative of a sale, but it does mean that the network is active and might be adjusting to price by selling, buying, or preparing. All of which would result in the movement of coins.

For a quick breakdown of what Realized Price means...

Realized Capitalization

This metric values every bitcoin at the price it was last moved, not the current price. Doing so gives us an aggregate cost basis which can then be measured against something like the market cap to provide insight into if the market is in a net state of profit or loss.

The Realized Cap can then be divided by the current supply to give us an aggregate price per bitcoin. This metric is referred to as the Realized Price. The Realized Price can also be viewed as the average price PAID for each coin. Thinking about it this way instead of in the aggregate makes more sense to me, and it might also help you.

To put the net loss into context: ~40% of all bitcoin is in a state of unrealized loss.* ~$8.2 billion realized a loss in the month of August.*

Now that the market is in a net loss, it could mean a "reset" from the latest cycle, i.e. we are at the bottom as described above in Potential Bottom Signals. This could also mean we will soon see those in a loss shed their positions, further depressing prices while realizing a loss. While I'm not entirely convinced this is a solid "bottom signal," I also don't think this is a sign of impending doom. The new buyers and experienced market participants are both aware of the value of such relatively low prices, and aside from major macro turmoil, I don't see them going away anytime soon.

*based on network data which is an estimation and does not constitute a bitcoin transaction to fiat.

Lending Rates Increase

Illiquidity has driven rates up 50 basis points over the past 60 days (on average). In the fallout of bankruptcies and liquidity issues in credit market corporates, whale inflows (big buyers), and the continued accumulation from individual holders, the market has seen a lot of supply leave the liquid market. Demand for loans is now slowly starting to outpace supply. This shift is something we predicted in previous reports (Q1 & Q2).

At the low end, 12-month fixed unsecured loans are around 3%. Moving out on the risk curve (according to our risk assessments), we are seeing 4.5% APY.

Open rates are still sub 2%, with most desks not interested in open term.

What we defined as a more-than-moderately safe un-secured loan 60 days ago was paying 4.25% on bitcoin. That rate has not changed.

We have seen a similar trend with a handful of smaller borrowers (sub $100mm operations) paying attractive rates consistently throughout shifting market conditions. We see this as a combination of stronger and more flexible positioning, better borrowers, and more efficient operations.

Large Wallet Inflows

Over the past month (and since June), we have seen large wallets (accounts) busy acquiring bitcoin in a way seen only once before. Q1 inflows appear higher than usual due to a single-day move of 200,000 bitcoin.

The last time we saw an accumulation like this was at the bottom of the 2018/19 cycle. Those were the good ol' days of sub $4,000 bitcoin.

We primarily watch the wallets holding between 1,000 and 10,000 bitcoin. Above 10k is mostly custodians with hundreds or thousands of claims to each wallet. The 1k-10k wallets can either be self-custody (respect) or prime service custodians. Such services will offer segregated wallets to private funds or wealthy individuals. These accounts (wallets) would get picked up in the count for large wallets.

When the accumulation from large players slows, we will see the result of those who sold to strong conviction holders. Spot markets will be illiquid, credit markets will pay starvation rates, and volatility will follow as a mispriced asset is adjusted.

ETH Merge + Wrapped Bitcoin

Ethereum, bitcoin's much younger brother with big dreams and good network marketing skills, is going through a software update called the merge. This is an update, not an upgrade. The Ethereum (ETH) ecosystem is shifting to the long-awaited and controversial Proof of Stake consensus mechanism. I believe this model is flawed and will be detrimental to any digital payments network with an underlying currency intended to hold its value. My official stance on ETH is the following:

Ethereum has a more than moderate probability of appreciating in value (USD terms).

That being said...

— Johnny DeMaddalena (@JohnnyDeMadd), August 24, 2022

The Ethereum merge generally does not affect bitcoin. In the long run, Ethereum could affect the 245,000 bitcoin locked in the ecosystem. There is 245,000 bitcoin locked in a piece of bridge software on Ethereum called Wrapped Bitcoin (WBTC).

Bitcoin is sent to this system to be custodied by a third party. In exchange, you are issued a token that, in theory and thus far in practice, carries the value of real bitcoin. This token, called Wrapped Bitcoin (WBTC), can be used natively on the Ethereum network.

As we have seen in recent Celsius bankruptcy filings, it is likely that other custodians/lenders are using Wrapped Bitcoin to gain access to Ethereum-based yield generation systems. In the case of Celsius, bitcoin deposits appear to have been converted to WBTC. Effectively leveraging real bitcoin deposits to access risky yield products, loans on Ethereum, and on-chain derivatives. If there were a run on capital in such systems and WBTC saw secondary market selling pressure, would the arbitrage players be liquid, incentivized, and confident in the protocols to buffer volatility before it reaches spot markets? In addition to these complexities, the multiple layers of counterparty risk and newfound technical risks mean a higher likelihood of total loss. As horrible as it would be;

"Lost coins only make everyone else's coins worth slightly more. Think of it as a donation to everyone." — Satoshi Nakamoto

I hope this report is valuable to you.

Sincerely,
Johnny DeMaddalena