Professional Investor Report - December 2022

This was originally published January 10, 2023, and was part of a paid newsletter for professional investors interested in bitcoin or bitcoin credit facilities. The price of bitcoin was $17,500. This is being republished for archival purposes. They will also be referenced in future writings.

The fallout from the FTX collapse continues to affect the industry as major accounting firms who once serviced the industry distance themselves from any digital asset. Miners experienced troubles as operating costs overshadowed revenue from new coin. A new survey shows that institutional investors are bullish. The SEC provides updates on the GBTC lawsuit. Exchanges are continuing to lose bitcoin to self-custody.

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

• Armanino and Mazars left the digital asset industry following their association with FTX and other failed entities.
• Proof-of-Reserve attestations are worthless, and we show examples of why.
• 62% of institutional investors currently invested in crypto increased their allocations in the past 12 months.
• 70% of investors cited real-world applications as a top catalyst for growth.
• GBTC traded at a nearly 50% discount to Net-Asset-Value
• The GBTC v SEC lawsuit received new briefs from the SEC
• Core Scientific, which controls 10% of the total network hashrate, filed for bankruptcy.
• Miners purchased near their peak have fallen 80% from May 2021.
• Miners left Europe thanks to the high costs of energy.
• Midas went bankrupt with a $63mm deficit in its DeFi portfolio.
• Exchanges hold 30% less bitcoin than they did one year ago.

Continued FTX Fallout - Attestation Services Are Leaving

Accounting and advisory firms, Armanino and Mazars are cutting ties with the digital asset industry. The two firms are primarily known for their "proof-of-reserve" (PoR) attestation/statement/report that exchanges, yield providers, and custodians use to "prove" solvency.

Armanino audited FTX.US in 2020 and 2021 and is now named in a RICO class-action lawsuit. The firm does stand by its audits with the clarification that it was not engaged to audit internal controls. The firm was engaged to audit financial statements. FT reported the nine-person team that produces the proof-of-reserves is leaving to start a new company to service clients. Armanino also provided similar reports for Kraken, Gate.io, Ledn, and Nexo.

Mazars provided similar services for Binance, KuCoin, and Crypto.com. The firm paused all crypto-related work stating, "This is due to concerns regarding the way these reports are understood by the public."

A spokesman for the firm BDO said, "In common with several other professional service firms, we are currently evaluating our approach to this sector and the work we undertake for our clients."

I assign almost zero value to these proof-of-reserve statements.

Coyni has an attestation report for $3,108. That's right, $3,108.

Firstly, they are not an audit. Some companies imply that their PoR statement is like an audit when they refer to the company providing the PoR as an "audit firm." It's not a false statement; it's surface-level misleading.

Second, a PoR uses mutually agreed-upon procedures. The company paying for the PoR provides wallets and backend links to their assets on the blockchain or with a counterparty. Theoretically, a company could engage one of these firms for a PoR and simply not report certain positions or liabilities, and everything would look fine on the surface. A PoR also doesn't even begin to account for the creditworthiness of borrowers, interest schedules, counterparty risk, systemic risk, and so many more factors. The PoR is only the bottom line of a balance sheet, and sometimes only half of the bottom of the balance sheet, like when only assets are provided.

Cliché Movie Reference

Sounds like rating agencies and MBSs.
https://www.youtube.com/watch?v=9xZx1lf2tvs

Institutional Investor Survey

Coinbase Institutional, the prime services arm of Coinbase, published a survey of institutional investors and their appetite for digital assets.

62% of investors currently invested in crypto increased their allocations in the past 12 months. Billions of dollars in institutional money are buying into the bear market. Only 12% decreased their allocations.

58% of investors expect to increase their allocations over the next three years.

The reasons investors are getting into digital assets were expected and similar to the Fidelity/Bloomberg survey from our October Report. Investors reported their main reasons for investing in digital assets to improve funded status (55%), followed by yield opportunities (38%). This was surprising given the recent year credit markets experienced in the public eye, driven by retail-facing products, and that the Bloomberg survey showed only 23% were interested in yield opportunities. The Bloomberg survey reported 23% of investors have an interest in DeFi, while the latest Coinbase survey reported only 5%. I am not surprised by this one. DeFi is becoming less and less appealing to investors given the questionable legality and significant risk and learning curve compared to spot-long bitcoin or even bitcoin futures.

Also, as expected, and again similar to the Bloomberg survey, 52% of investors are most concerned about the uncertainty in regulation. Volatility is close behind at 48%.

The biggest takeaway for anyone involved with Bitcoin; 70% of investors cited real-world applications as a top catalyst for growth.

Developments in lightning, bitcoin core, and self-custody -> real-world applications -> catalyze growth -> attract more investor attention -> money gets to application development. This is infinitely better than the crypto flywheel.

GBTC v.s. SEC

The Grayscale Bitcoin Trust (GBTC) traded this month at a record 49% discount to Net Asset Value. The Trust has attempted to be the premier traditional investment vehicle for bitcoin exposure and has been trading at a discount since February 2021. Before its discount days, the trust traded at a hefty premium, peaking at 89% in early 2018.

This month's deep discount was thanks to two factors; fears that DCG (the parent company to Grayscale) is insolvent and an update from the Grayscale v SEC lawsuit.

Fears that DCG is insolvent continued as Genesis (DCG's second-largest subsidiary) has yet to honor redemptions, and communication from the firm has been sparse. Speculation regarding the security of GBTC's underlying bitcoin, in the event of a DCG bankruptcy, was called into question by much of Twitter and those with an elementary understanding of how financial products are structured.

If DCG is near bankruptcy, they can not seize the bitcoin held by GBTC and sell it to fix their problems. The GBTC bitcoin is custodied by Coinbase (a registered fiduciary) and regulated by the SEC, and its obligations to shareholders. Coinbase will not allow DCG to illegally take shareholders' bitcoin and sell it.

GBTC has been a mediocre means of gaining exposure to bitcoin. The Sponsor charges a 2% annual fee (for a passive fund!), with no redemptions, and has a 6-month lockup before shares are eligible to be sold in the public market. Grayscale could, and still can (to some extent), justify these wild terms because they are the leading option available to people investing through a traditional IRA or self-directed account. Advisors got an easy option when clients wanted to "buy" bitcoin. Instead of offering real bitcoin through a qualified custodian or a spot-long-based existing offering, then trying to ensure they still got paid on it, they went with the easy option. I don't blame anyone for choosing GBTC. The learning curve is steep, and advisors are cautious about anything new. The "it's too new" argument is quickly weathering.

Further contributing to the uncertainty of GBTC, the SEC filed a brief in the Grayscale v SEC case before the DC Court of Appeals. Grayscale sued the SEC back in June after the SEC rejected its application to convert GBTC to an ETF. The SEC rejected the application due to concerns of market manipulation, the role of Tether in the ecosystem, and a lack of surveillance sharing agreement between exchanges.

The SEC's argument relies on the lack of regulatory oversight for bitcoin spot markets. Grayscale has a brief due January 13th.

Pressure in Mining

Core Scientific, a mining host with over 243,000 machines (accounting for about 10% of the total network hashrate), filed for Chapter 11 Bankruptcy late this month in a prepackaged bankruptcy with their largest of creditors. The restructuring will result in the $544mm in outstanding convertible notes converted to a significant portion of the new entity equity.

Core Scientific is one of many miners experiencing troubles. Debt restructurings, requests to pause trading due to debt restructurings, and unplugging machines are only a few examples. The bitcoin miners, especially the institutional miners, have been hit hard due to the declining price of newly mined bitcoin. This is putting pressure on the entire business; hence, all of the debt restructurings. Miners (the machines) purchased near their peak have fallen 80% from May 2021. The Bitcoin ASIC Price Index shows a decline in all efficiency tiers of miners.

Miners have also sold some of their coin reserves over the last six months. I don't believe this is a strong capitulation event, as others have described it. Following the ATH in November 2021, miners accumulated for almost ten months.

During a more than 60% drawdown, they continued to hold their coin. In August 2022, miners shed some coins for liquidity, and they again did the same in November. If we see miners sell another ~7,000 bitcoin, I would agree it is miner capitulation as that would put miner holdings to pre-ATH levels indicating that holdings are almost certainly underwater. At that point, any miners still operational are very well positioned for the long term and unlikely to get removed.

💡 If this miner capitulation happens, this is where I would start to look at miners who are selling equity (private market). Bear market miners who are well positioned would provide a great return as the machines and the assets are expected to appreciate. The deal breaker is always the same; cost of energy.

The winter storm that swept across North America forced miners offline. Due to existing agreements or requests with power providers, bitcoin miners were the first to slow or stop operations to alleviate stress on power grids. The Texas Blockchain Council reported that 99% of miners had voluntarily curtailed their power consumption.

When the hashrate declined on December 24th by 30% from one week prior, the network did not stop. No transactions stopped, and the entire network operated as if nothing had happened. This is the incredible power and flexibility of the bitcoin network in the face of extreme circumstances. By December 31st, the network had fully recovered to pre-storm rates.

The United States hosts around 33% of the global bitcoin hash rate. This will only increase as miners are forced out of authoritarian regimes like China, as we saw throughout early 2022, and soon Europe. The European Central Bank has not been a fan of bitcoin, with the go-to false narrative that bitcoin is harmful to the environment. Fabio Panetta, a member of the ECB's Executive Board, doubled down on the anti-bitcoin arguments in a speech at the London Business School. Fabio can sleep easy knowing that Europeans are no longer contributing to the bitcoin network hash rate.

The energy cost in Europe has largely forced all miners out of business or elsewhere. The last remaining miners in Norway and Sweden have been taken offline. With energy costs of around $0.18 (USD) per kWh, the machines are deep in the red on any newly mined bitcoin. Looming regulation from the EU is likely to be met with little resistance as there is no longer an industry to defend against it.

Mining will likely concentrate in the United States, China, Russia, Kazakhstan, and Canada. The cost of energy is the single biggest factor in profitability, and countries with energy independence, a surplus, and a favorable (or lacking) regulatory regime will win.

Midas

Another one bites the dust. The centralized DeFi platform Midas announced it was closing operations due to a $63mm deficit in its DeFi portfolio. Iakov Levin, Midas CEO, said that this is partly due to withdrawals following systemic shocks like the collapse of Terra, Celsius, and FTX. Levin reported that outflows of 60% of assets over the last six months made it impossible to sustain a fixed yield model.

$25mm of the deficit is due to the incentive token issued or purchased to "boost" yield. This token also paid an insane 22% APY. Again, tokens created out of thin air for the purposes of incentivizing trading have contributed to the downfall of another industry player. The same happened with FTX, Celsius, Terra Luna, BlockFi, and now Midas. They all had a native token that provided benefits if it was held, locked, purchased, or traded on its parent platform.

From the November Report on FTT token:

"Native tokens/incentive tokens/exchange tokens, all create misaligned incentives for everyone involved. They are also ripe for fraud and manipulation."

Metrics + Options Market

December spot price was range bound with a quick rise and fall shortly following a lower-than-expected CPI print and a 50bp rate hike from the Fed. It's important to realize that the public equities market reacted in this manner as well; the bitcoin spot market did so faster and more aggressively. This was the seventh consecutive rate hike in a year and introduced the market to interest rates last seen in early 2008. Everyone is expecting a 5% fed funds rate in 2023.

The Bitcoin Volatility Index (BVIN), a measure of the implied volatility from the options market, reached near all-time highs and all-time lows in the same month.

Implied volatility increased, and thus the BVIN increased, as experienced and sophisticated market participants hedged their contagion (systemic) risk and the spot market volatility expected from the FTX fallout. As the demand for such options decreases, demonstrating hedges are in place, the IV decreases in conjunction with spot volatility.

Deribit, the largest crypto options exchange by both volume and open interest, reported a 20% overall volume increase MoM (October to November). Deribit settled 778,000 bitcoin and 8.9 million ETH options contracts in November.

Bitcoin spent its 9th year in a row with a 100% uptime. From a technical aspect, this is the most impressive piece of data. Compared to companies with billions of dollars spent on infrastructure every year, this is beyond fantastic.

Every month this metric continues to look more and more promising for the long term. The small-holders, those with between 0.1 and 1 bitcoin, have grown non-stop. Every single Pro Report this year has referenced this data, again, because as of today it is the single most important metric for long-term growth.

Exchange users have continued to withdraw. From the beginning of the year, more than 30% of coin on exchanges had left.

2023 is going to be a great year. We will see if the bitcoin "super cycle" continues. We will see the outcomes of a 5% fed funds rate. We will see how new credit market products are offered to retail clients and the appetite for such products. We will see regulators make strides in the institutional adoption of digital assets. We will see the small-holders continue accumulating coin AND removing it from trusted third parties.

If you found anything valuable here, please consider sharing it with someone who could benefit from this information.

Sincerely,
Johnny DeMaddalena