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Bitcoin Down; Most Everything Else Up… Again

Jeff Dorman, CFA
Jan 25, 2021
What happened this week in the Digital Assets markets?
Week-over-Week Price Changes (as of Sunday, 1/24/21)
 
 
WoW
YTD
Bitcoin
-10.2%
+11.2%
Bloomberg Galaxy Crypto Index
+6.8%
+43.8%
S&P 500
+1.9%
+2.3%
Gold (XAU)
+1.4%
-2.4%
Oil (Brent)
-0.4%
+7.5%
Source: TradingView, CNBC, Bloomberg
 
Do You See a Pattern Here?
The digital assets market is off to a great start again this year, but week-over-week, Bitcoin (BTC) suffered another violent correction and at one point completely erased its 2020 gains before bouncing off the lows. This was already the fourth 10%+ sell-off of the new year.  “Crypto stocks” suffered a similar fate, posting weekly declines of 5-30% (with the exception of “crypto banks” SBNY and SI which performed well on the heels of strong earnings).  
 
This was in contrast to traditional markets, where equities once again flirted with record highs and the VIX fell considerably (-10%), as the market favored COVID stimulus talks and forthcoming vaccine distributions over less-than-stellar global economic numbers and the sobering reality of global COVID statistics.  The market’s favorite tech stocks boomed as the US Dollar weakened further, down 0.62%.  
 
Are retail investors simply giving up on digital assets in favor of stocks?   Not so fast...
 
“Crypto stocks” suffered last week even as tech stocks boomed and the dollar sank
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Source: Bloomberg

Last week we took some heat for our writeup suggesting that Crypto Indexes are a farce.  As is always the case, after I write something, I think about ways I could have written it differently.  In this particular case, I would have added the following if given a second chance:
 
"These thoughts have nothing to do with the quality of Bitwise, Galaxy or Grayscale as fund managers.  Nor does this suggest that these index products are not investable.  They most certainly are.  Both BTC and ETH are exciting investments, ones with which I believe should be in every investors' portfolio.  My issue is that these “diversified indexes” are not representative of the asset class.  If an investor just wants to own BTC and ETH, these passive “index” products are fantastic.  If, however, an investor wants exposure to the asset class and/or to monitor the asset class to better understand how it is performing, these indexes do not come close to painting an accurate picture.  Blockchain is a wrapper, in the same way that the ETF is a wrapper.  What we put inside the wrapper is most important.   You would not look at an "ETF Index" because it wouldn't make sense -- each ETF contains entirely different underlying assets.  In the same vein, looking at BTC and ETH and assuming that they are related to other digital assets simply because they share the same blockchain wrapper is woefully insufficient."
Despite pushback, we’re going to double-down on this, as this past week certainly didn’t disprove our theory.  For the second week in a row, Bitcoin, and thus “Crypto indexes”, failed to capture the true strength of the overall digital assets market, as once again, every sector other than “Cryptocurrencies” had an amazing week led by DeFi, smart contract platforms and Web 3.0.  The majority of “pass-thru” tokens that accrue real economic value via cash flows and dividends, and asset-backed tokens that have tangible intrinsic value, continue to rise at breakneck speeds despite Bitcoin’s struggles. If you don’t fully understand the difference here, wait until you see the returns of actively managed hedge funds in January -- the difference between those that do actual research on tokens versus those that just trade Bitcoin will be quite dramatic.

7-day Returns by Sector

LAST WEEK (ending 1/24) 2 WEEKS AGO (ending 1/17)
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Source: Messari
 
What Actually Caused the Rise in DeFi and Web 3.0?
As has been the case for much of the past 18 months, the gains seen across the broader digital assets market were caused by real traction and news.  Gone are the days of “Bitcoin vs alts” -- the depth and complexity of this asset class were on full display last week as the drivers of gains were completely idiosyncratic.  To highlight just how much happened last week, below is a snippet from an actual recap distributed internally by Arca’s director of research, Katie Talati: 
 
  • Centralized exchanges (CEX) fell 5% on average as trading volumes fell off slightly, but FTX outperformed, rising +6% as they continue to tokenize equity shares, listing Galaxy Digital shares. FTX’s user growth and web traffic has followed product announcements closely.
  • Meanwhile, decentralized exchange (DEX) volumes remain robust leading to continued growth in annualized earnings for the DEX space led by Uniswap and Sushi.  Overall, DEX's continue to see healthy growth in DAU, TVL, and capital efficiency.  UNI rose +46% as its grants program officially launched with their first round of funding, focusing on improving the user experience and building out dev tooling.  SUSHI, meanwhile, rose +28% after holding an AMA that provided detail on their 2021 roadmap. Their next release is BentoBox, a borrow and lend platform built off of the liquidity of their AMM.  DeFi has been so strong that on certain days, fee generation for Ethereum and Uniswap have outpaced that of Bitcoin, the difference being that in DeFi, the fees accrue to token holders and customers not just miners.
unnamed (43)

Source:  Arca Estimates

  • Decentralized insurance company Nexus Mutual (NXM) had a busy week, as the staking period was revised and reduced to 30 days from 90, and the capacity on several of the most popular contracts was increased allowing for more cover to be purchased. There was an increase in cover rates on a number of smart contracts which can be attributed to the shorter staking lock periods. A positive research report from Delphi Digital pushed NXM higher as well, along with an increase in cover purchases including the largest cover ever purchased  ($8.9 million cover on Uniswap for a premium of $19,000).  NXM rose 58% week-over-week.
  • Axie Infinity (AXS) rose +22% after the team teased the release of Ronin sidechain and provided instructions on how users can prepare for the migration. Ronin will allow a lot of activity on Axie to happen at a much faster pace.
  • Arweave (AR) jumped +28% as data usage spiked in December. This was mainly driven by the launch of a new product, ArDrive, a permanent Dropbox solution. ArDrive allows users to upload files of any size to the permaweb for a nominal one time fee.
  • Thorchain (RUNE) rose +38% mainly driven by anticipation of next week's Multichain testnet launch (BNB - BTC - ETH - LTC - BCH). In addition, the team released an updated website. TVL is about the same as last week, however, RUNE staked to earn liquidity fees has dipped slightly.
  • Chiliz (CHZ) rose +6% after the company announced that AC Milan has been signed following the Locker Room campaign and the token will launch "in the coming weeks".
Clearly, none of these events have anything in common with Bitcoin or macro investing.  This asset class has evolved.
 
Breaking Down the 2 Reasons Bitcoin Tanked
So why did Bitcoin tank when most other digital assets and tech stocks soared?  Three reasons:  Leverage, Leverage, and Leverage.  Before the much needed correction, the perpetual swaps funding rate was at 6-month highs, meaning longs were paying shorts almost 25 bps per day for the right to stay long (the funding rate is meant to incentivize participation on the other side to restore balance).  Skew was also at all-time negative lows, meaning calls were 40% more expensive than puts earlier in the week, as the put/call ratio sunk to recent lows.  Leverage and euphoria itself does not take markets down, but it exacerbates price action when something organic does cause sell pressure, and that’s exactly what happened last week. The selling pressure caused cascading liquidations to the tune of billions of dollars.  Heading into this week, the market appears to be on much healthier footing following the leveraged unwind.
 
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unnamed (46)Source:  Skew / Bybt
 
Of course, that still doesn’t explain what caused the selling in the first place.  In our opinion, two bogus and misleading headlines spooked market participants, even though each was thoroughly dismissed.  
 
Headline 1:  Janet Yellen says cryptocurrencies are used for illicit purposes
Janet Yellen seemingly set off a witch hunt over Bitcoin, as she commented that Bitcoin is often used for illicit funding.  Ironically, this clickbait happened on the same day that blockchain forensics firm Chainalysis published a report that showed that cryptocurrency-based criminal activity actually fell to 0.34% of total transaction volume, down from 2.1% in 2019.  But the headline damage was enough -- many Bitcoin naysayers and media outlets refused to let the facts get in the way of a good story.  Even after Yellen backed off her original statements, later clarifying them with a more balanced tone, the damage had already been done. 
 
The message is simple.  Don’t use Bitcoin for illegal activities because that’s what the government will focus on.  Sounds like a reasonable take despite the journalistic malpractice that ensued. 

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Headline 2:  The Bitcoin Double spend
As originally documented here, many believed that this supposed double spend would invalidate Bitcoin and blockchain.  Arca blockchain expert Sasha Fleyshman explains what really happened, and why this is a non-factor event.
 
What happened with the "double-spend" wasn't even a double spend - a double spend occurs when a sender of BTC has that block reorganized, which invalidates the transfer. The sender of BTC then resends that BTC, thereby paying for services twice with the same Bitcoin. What happened here is what's called a blockchain reorganization (reorg), which happens quite frequently. This is due to the competitive nature of Bitcoin mining and algorithmic based block discovery - all miners are competing to find an output lower than the target hash. Sometimes, two miners (or pools) both find outputs below the target at the same time - the lower output wins out and the other block is orphaned, creating a stale block. This happens around every two weeks (on average), making it a common occurrence. To protect against this, Bitcoin was created with confirmations, which works like a fly trapped in amber: when a block (A) is mined, it is published to the network of nodes. At this point, it has 1 confirmation. When the next block is mined and broadcasted, the original block (A) now has 2 confirmations. In the Bitcoin whitepaper, it was determined that 6 confirmations was the accepted value for a probabilistically irreversible transaction/block, at which point it becomes safe to consider the Bitcoin safely transacted - this usually takes 20-30 minutes (varies based on network congestion and pool luck). Transactions with no confirmations are subject to Finney/Race attacks, and each confirmation secures the transaction due to the Gambler's Ruin problem. The fact that $22 was sent is irrelevant. The only important thing is the following: if the receiver of the BTC transaction in the orphaned block accepted the payment early (at 0 confs), they lost out by not understanding the finality of transactions in the network (99% of wallets have 6 confirmations preloaded into the system, you would have to manually overwrite that input). If the payment was for a good/service, they most likely lost that good/service since the payment was never officially received.  Though there is a significant chance this was a nonfactor, and the receiver didn't lose out at all. So, the "double spend" information circulating is misconstrued. This is normal, happens frequently with 1-block reorgs, and would be the fault of the receiver. The Bitcoin Network operated as intended, and the receiver learned a lesson on why finality is a sliding scale.
What’s Driving Token Prices?
In Russian culture, it is considered bad luck to discuss success as bringing attention to it will just as soon rid one of it. That superstitious vow of silence is prevalent in the market as we look to avoid discussing the current ‘alt season’ - a colloquial (yet completely outdated) term used to describe a market where the rest of the digital asset market outperforms both Bitcoin and the dollar simultaneously. In a stereotypical ‘alt season’ lifespan, Bitcoin leads the market (December 16 - January 3, BTC.D +12%), retraces  as the trade becomes crowded intramarket (January 4, BTC.D -3%), then goes stagnant and cedes the market to Ethereum and the rest of the space to rally as assets rotate (January 5 - present). 
 
Two indicators of this trend shift are Bitcoin Dominance (BTC.D) and the ETH/BTC pair. Since January 3rd, BTC.D is down 12% and the ETH/BTC pair is up 75%. The last ‘alt season’ happened from June-September of 2020 (DeFi Summer), where BTC.D fell 11.5% and ETH/BTC jumped 67%. These sporadic spurts of growth in the rest of the digital assets market are usually paired with organic interest - in 2020, Decentralized Finance went through a Cambrian Explosion, and this time Layer 2 (ETH 2.0) growth was the spark that lit the powder keg. To illustrate how drastic these moves can be, let’s look at price moves from January 3rd:
 
  • Bitcoin (BTC): flat
  • Ethereum (ETH): +75%
  • DeFi Index (DEFIPERP): +114%
  • Exchange Index (EXCHPERP): +13%
  • Altcoin Index (ALTPERP): +52%
  • Midcap Index (MIDPERP) +44%
What We’re Reading this Week
 
 
 
 

And That’s Our Two Satoshis! 
Thanks for reading everyone!   
Questions or comments, just let us know.  

The Arca Portfolio Management Team
Jeff Dorman, CFA - Chief Investment Officer
Katie Talati - Head of Research
Hassan Bassiri, CFA - PM / Analyst
Sasha Fleyshman -  Trader  
Wes Hansen -  Head of Trading & Operations
Alex Woodward- Analyst
  
To learn more or talk to us about investing in digital assets and cryptocurrency
call us now at (424) 289-8068.
 

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