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The Bull Case for Crypto Assets Despite Carnage

Jeff Dorman, CFA
Mar 9, 2020
What happened this week in the Crypto markets?
Five days of gains, gone in an instant
Had this writeup gone out Sunday morning instead of Monday morning, it would have been titled “Boring crypto is a blessing”.  From Monday through Friday last week, most digital assets were stable, and more importantly, remained liquid, which was astonishing considering equities traded up or down 3% each day, corporate credit markets began to freeze and free-fall on little to no volume, the VIX was all over the place, and oil had an intra-day drop of 10% (which of course now looks mild relative to Sunday’s 25-30% decline).  
But for most of last week, the crypto markets actually grinded higher.  There was no panic, volatility remained at 9 month lows, and the market felt healthy as some tokens traded higher, while others traded lower.   News and events specific to individual assets had real effects on its token price, and relative value mattered. Basically, it was the opposite of equities, as digital assets seemed to show little interest at all in the outside world. 

But alas, the weekend was not kind to digital assets.  The sell-off began on Saturday with a mild 3-4% drop, followed by Sunday’s swift decline of 10-20%, erasing all of the first week of March’s gains (and then some). 
Could this move have been sparked entirely by the unwind of OPEC relations and the anticipated oil price wars?  Perhaps, though Bitcoin has never shown a statistically significant correlation to oil in the past (see chart below).  In fact the only real tie between oil and Bitcoin is the type of traders who are interested in these markets (via commodities futures exchanges).  A more simple answer would be that all risk assets are now for sale indiscriminately, but that seems odd given market participants had all week to reduce risk and it would make little sense to wait to sell until markets became slightly less liquid over the weekend.  Another rationale could be that as more traditional Hedge Funds show interest in digital assets, Bitcoin has turned into a leading indicator rather than a safe haven, as the crypto market's  24/7 trading availability makes it the perfect vehicle to front-run a giant risk-off Monday open. The problem with that theory of course is that most traditional hedge funds use the CME to trade Bitcoin, and there is now a sizable gap between Friday’s close and Monday’s expected open.  Or maybe Bitcoin falling 10% has nothing to do with any of the news last week or this weekend. We’ve seen plenty of 10% moves (up and down) in Bitcoin’s young history, with just as many random moves mixed in with explainable moves. Bitcoin is still up 10% for the year even after the 25% drawdown from YTD highs. 
As always, explaining hourly or daily moves is challenging, but we should see more definitive long-term answers over the next few months as money either continues to flow into the digital assets space, or abruptly leaves.
Bitcoin Has Shown No Correlation Versus Oil
Bitcoin Crypto Assets Shows No Correlation Versus Oil
The 10-year Treasury at 0.50%
We’ve been on record saying rates will likely never go higher, because the US government can’t afford higher rates on $23 trillion of debt.  Significantly higher rates would immediately make the government insolvent unless it comes with impossibly high tax receipts or crushing inflation. But we certainly weren’t calling for a 150 bps move lower over the course of just a few weeks.  A move like this affects an uncomfortable amount of the world’s investments, not to mention all of the financial models tied to risk-free rates, discount rates and expected return on assets.
Duration in fixed income markets is tricky, especially when you’re managing duration at historically low yields (if you happen to get quarantined, I recommend reading all 1400 pages of Fabozzi’s Fixed Income bible).  While plenty of investors believed that buying long duration Treasuries was a good trade recently in the face of negative yields abroad and a Federal Reserve hell bent on emptying its remaining ammo into anything that moves lower, how many people do you think actually want to own a 10-year bond that guarantees long-term income of no more than 0.50% per year?   
Even a stock like Tesla (TSLA), which may seem mispriced to most, has an outside chance of making you a fortune because the upside is uncapped.  You may disagree with an owner of TSLA stock, but you can rationalize their decision. Bonds, however, are clearly different. The buyers of Treasuries today are simply traders expecting further collapses in yields, or short-term thinkers focused more on current yield (the coupon payments) at the expense of yield to maturity (the actual annual yield on their investment).  Of course, the unthinkable could happen too and rates could rise. Duration is incredibly dangerous if/when yields go the other way and prices fall. 
As such, the “Safe-haven” narrative has to be questioned.  Other than “because it always has been”, can we really say that a 10-year US Treasury yielding 50 bps, with massive duration risk, backed by a government that has lost credibility and no longer collects tax receipts anywhere close to expenses is a safe haven?  

It’s a bit unsettling when even Treasuries have become nothing more than trading vehicles rather than sound investments. This changes the way investors think, and may completely dismantle the traditional 60/40 portfolio.  While very few investors are thinking long-term right now -- during market panics, the focus is on getting onsides and riding out the storm, not long-term asset rotations --  I do believe pockets of growth, like digital assets, will become more attractive once the dust settles. This lack of income has to be offset by gains somewhere else. It will be interesting to see where money flows when portfolios begin to rebalance over the next few months. 
10-year Treasury Yields
10-Year Treasury Yields
Source: Macro Trends
Actually, You Could Not Write a Better Script for Digital Assets
The next few days/weeks are going to be challenging for everyone.  But longer-term investors will begin to think about the longer-lasting impact over the next few years.  Peter Cecchini, Global Chief Market Strategist at Cantor Fitzgerald, writes one of the best daily macro notes to clients.  I took the liberty of highlighting the passages from one of his notes last week, with annotations (in orange).
While Cecchini does not explicitly mention or endorse Bitcoin or digital assets, most of what was written was 100% outright bullish for Bitcoin or other digital assets.  
From Cantor's morning note (annotated by Arca in orange):
Now it’s time for some Fed talk. In our view, the Fed’s 50 caliber bullet hit its own foot. While we (and rates markets) expected it at the March meeting, there was absolutely no need for an emergency cut. The signaling was poor (BULLISH CRYPTO - no trust in governments), and the belief that the Fed can keep the economy out of recession indefinitely by preemptive action is simply naïve and does not square with historical experience. The Fed appears to be playing checkers when it should be playing chess. Or perhaps it is playing extremely high level chess, and it simply sees quantitative easing (QE) as its next logical move (BULLISH BITCOIN - money printing). Does it no longer fear the Japanification of U.S. monetary policy? Seemingly not. QE is the only next move once funds go to zero, and they are already at 125bps. Long rates are moving there as well... of their own accord (with the 10-year at ~1%). The Fed does not like seeing funds above 10-year rates… and they are still there as of today by about 10bps (BULLISH CRYPTO - non productive assets are more attractive when rates are low and opportunity cost is low).
We’ve been writing about the trend towards zero rates as early as our 2018 Outlook, but the coronavirus outbreak has accelerated this ostensibly unavoidable abomination. Our expectation for this year was the 10-year at 1.25%. We are indeed seemingly trapped in the Cycle of Addiction about which we wrote in November 2019 (BULLISH BITCOIN - moral hazard and no end in sight). The Fed knows a flat yield curve is bad for the banking system. What’s bad for banks and non-bank lenders alike is also bad for the economy (BULLISH CRYPTO - many digital assets are replacements for banking and lending). Money creation happens through lending… not by the means of some magical printing press. Lending slows on flat or inverted yield curves. Without robust lending, an economy reliant upon it for growth is likely to stall (BULLISH CRYPTO - VC like risk/return profile but entirely outside traditional markets).
The banking system is the Fed’s monopoly. It price fixes capital costs towards a social agenda masquerading as an economic one: inflation at a level not too high or low and ‘full’ employment. It appears this goal is being pursued towards a short-term result without much regard to long-term outcomes. Even worse,  it is apparently being pursued without regard to the preservation of the very capitalistic system that it is designed to preserve (BULLISH CRYPTO -- Much of decentralized finance is being built to compete with traditional banking and lending). It’s important to recognize that the Fed’s monopoly and ability to set interest rates is a price control experiment that we have made illegal in every other industry but banking. It has been tolerated and even encouraged in the name of the public good, but we fear not much good will ultimately come of it (BULLISH CRYPTO -- The need for decentralization and less Government and Big Corporation power).
And lastly, there’s the election. It now appears to be a two man race between Joe Biden and Bernie Sanders (BULLISH BITCOIN -- socialism = more money printing) as CNN exit poll questioned indicated many voters were most concerned about having a candidate that could defeat President Trump.
The biggest financial firms (State Street, Fidelity, JPM, KPMG, BNY, Nomura, etc) are all explicitly talking about digital assets now.  Meanwhile, some of the best investors (Ray Dalio, Howard Marks, etc) are implicitly recommending digital assets via their global outlooks.  It's only a matter of time before morning notes, such as the one above, are too.
Notable Movers and Shakers
Bitcoin dominance finished the week up 1%, as Bitcoin continues to carry better downside capture compared to the rest of the digital asset space. With the sharp movement on the tail end of the week, we look to two regulatory related events that sparked token movement:

  • Matic Network and WazirX (MATIC/WRX) were the main beneficiaries of the Supreme Court ruling in India on Tuesday that removed the curbs set by the Reserve Bank of India on banks and NBFCs, which prevented them from providing services to crypto companies (as well as dealing with digital currencies in general). In a sea of red, MATIC (+11%) and WRX (160%) stood out.  WazirX is an up and coming Indian digital asset exchange, with an investment from Binance.
  • Icon (ICX) was the beneficiary of legislation passed in South Korea Thursday, in which an amendment was made to their Financial Information Act to include Virtual Asset Service Providers (VASPs), shoring up AML/CFT policies. This amendment should bring more legitimacy (and more regulation) to the digital assets space in South Korea. While ICX (2%) does not directly benefit from the legislation, the market picked up on the India trade from Tuesday - the short lived rotation trade had ICX peak with 30% gains on the week.
What We’re Reading this Week
Regulation Gives Crypto a Boost
Regulators made positive progress in two of Asia’s largest markets, India and South Korea. First, India’s supreme court ruled to reverse a ban on crypto trading instituted in 2018 by India’s central bank. Lifting this ban means that crypto businesses can interact with banks, and exchanges can once again act as on-ramps (accept fiat in exchange for crypto), opening the crypto market back up to Indian residents. In South Korea, lawmakers voted to institute new AML procedures on cryptocurrency exchanges. The new rules require exchanges to register with regulators, partner with a single bank, and have users’ accounts match the names on their bank accounts. The rules are designed to comply with FATF rules and assist authorities with tracking illegal funds. While the requirements will crack down on those operating in the grey areas of the market, it will wipe out scams and lead to a rise in legitimate crypto business. 
State Street explores Bitcoin and digital assets’ history and potential future heading into 2020. According to their 2019 Growth Readiness Study, 25% of respondents said they were invested in digital assets compared to 5% from 2018, with an additional 25% saying they intended to invest soon. Despite the rising interest in the asset class, there are still a large number of concerns for institutional investors surrounding investability. 41% cited cybersecurity as their top barrier to investing in digital assets.
After many believed it dead, Facebook’s Libra project is looking to make a comeback after rounds of appearances on capitol hill and a number of central banks warning against its launch. The project is currently considering adding the ability for its network to accept multiple currencies from central banks. The move would make its launch much more palatable to regulators and would even encourage some central banks to work with Libra on the design and launch of their currencies. According to sources, Facebook and the Libra Association still intend to launch its own digital currency, but the Libra network may become something more akin to a payments network than a global currency. 
According to crypto security firm Chainanalysis, out of $1 trillion transacted in crypto in 2019, only 1.1% of transactions were illicit. The firm cites multiple reasons for the decrease including a reduction in darknet activity along with an increase in mainstream adoption, and better coordination among exchanges and law enforcement agencies to thwart hacks. “Digital assets are only used by criminals” is the oft-cited reason for lack of adoption by institutions but that is becoming less and less the case as the industry matures.

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
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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