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“That’s Our Two Satoshis” —  Is Crypto’s “Bear Stearns” moment upon us?

Jeff Dorman, CFA
Jan 14, 2019
What happened this week in the Crypto markets?

The January Effect couldn’t hold
After a strong start to the year, the crypto market did what the crypto market does — falling almost 20% week-over-week on the heels of three separate sharp declines, beginning in the middle of last week and continuing through the weekend. Prior to the selloff, the market actually seemed fairly orderly. Some tokens were trading up; some were trading down — and those tokens that outperformed or underperformed the market generally had reason for doing so. Even the crypto “sellside”, notorious for adding little to no value beyond just trade execution, came out of the woodwork with some bullish data on their order books. Coupled with a rising global equity backdrop, there seemed to be reason for cautious optimism.

Then Ethereum Classic (ETC) experienced a 51% attack.
For those who read this column regularly, you know we don’t often get into the weeds with crypto jargon or technical blockchain speak. But suffice to say, a 51% attack exposes an insecure blockchain that does not have enough miners securing the network, and in doing so, allows the attacker to “double spend” by rewriting certain transactions. Essentially, it is a form of theft (though in this case, the whitehat hacker actually returned the money — which is pretty awesome). When you hear about hacks in crypto, most of the time it is an exchange that is hacked (a centralized third party), not the blockchain itself… but in the case of a 51% attack, it is a direct hack on the blockchain.
This is obviously a bad outcome for crypto, even though the actual losses were small and only affected well capitalized exchanges, not individuals. Yet the price of ETC itself actually had a muted response to the news, only falling 7% that day, and even outperformed many other tokens week-over-week.
In November, it was the contentious Bitcoin Cash (BCH) fork that ultimately tanked the market, causing a 40% decline. But at the time of the fork, few people really thought about the broader market repercussions (and only assigned blame after the fact). This past week, as soon as the ETC 51% attack was revealed, we immediately began to think about the effect on the broader market. While it’s impossible to know for sure, we believe the 51% attack on ETC is what ultimately triggered the 20% market correction. In fact, we spent most of the week trying to figure out if the losses announced by Coinbase and and other exchanges were actually contained, or if this was the beginning of a larger problem.
Bear Stearns redux?
Most people recall the ultimate JP Morgan bailout of Bear Stearns in March 2008 for $2/share (from a high of $171/share in 2007), but don’t forget that the problems first surfaced in a rather innocuous way back in June 2007. At the time, the problems were deemed to be caused by a few rogue traders, and it was assumed that they were completely isolated. In retrospect, we now know that the problems at the two Bear Stearns hedge funds were not at all contained at Bear Stearns, and foreshadowed the entire mortgage crisis that culminated 12 months later. Further, not only did it take another 9 months for Bear Stearns to ultimately collapse, but the S&P 500 actually traded UP from July 2007 to October 2007 following the initial Bear Stearns news, reaching an 8-year high in October 2007 before falling 50% over the next 18 months through the March 2009 lows.
Let me get to the point. We tried every way possible this past week to uncover the spillover effect, convinced that the announced losses at Coinbase and were just the beginning. We anticipated that the losses were going to grow and some major institution like Coinbase or Kraken or Binance was eventually going to announce a massive loss related to this hack. But alas, we not only couldn’t prove our theory, it was actually disproved. This is what is so great about blockchain as it relates to financial services. Instead of completely opaque rumors and hidden losses that has become a staple of Wall Street banks, because of the transparency of blockchain transactions, we not only know the EXACT amount of the double spent crypto caused by this ETC 51% attack, but we can see and trace every single transaction. This problem is completely contained, isolated, and is now public record — it is over. Of course, it still resulted in a 20% market decline, but the fact that this problem has now been exposed, and will lead to tighter security in the future, gives us great comfort. In some ways, this is actually a positive event as the constant risk inherent in crypto is also what drives the community to ensure it’s ultimate protection.
All investors should proceed with caution — after the lessons of 2007 we have a feeling that this attack is not the last one we’ve seen, and there may still be more reported losses coming. But the transparency is real and that is something that investors are not accustomed to, but should be.
Notable Movers and Shakers
What We’re Reading this Week
“Bond King” Gundlach Adds Bitcoin to 2019 Predictions
Jeffrey Gundlach of Doubleline Capital predicts that Bitcoin will hit $5,000 or rise 25% in 2019, among other outlooks such as increasing volatility.

From Joke Token to Legitimate Use Case: KodakCoin One Year Later
KodakCoin may sound like a joke, but KODAKOne raised an ICO in early 2018 with the goal of putting photography rights on the blockchain. Despite many considering the token raise a publicity ploy, KODAKOne’s progress less than one year later is nothing to laugh at. Recently in a beta test of their Post Licensing Portal (PLP) the platform generated more than $1m in licensing claims for photographic rights. As a token that has created a loyalty-reward model, versus the utility token model, KodakCoin may come out on top over the multitude of ICOs that raised at the height of the hype cycle.

Spray and Pray
In Kraken’s annual Transparency Report, the exchange reported that it saw a 3x increase in inquiries from law enforcement agencies, two thirds of which came from US agencies, although only 20% of its customers are US-based. Kraken hypothesized that “it wouldn’t be surprising to find that the same subpoenas go out to everyone in the hopes that a match will be found.” While the exchange is currently valued at $4b, the resource and monetary costs of responding to subpoenas is still quite high.

A Potential Run on French Banks
The unrest in France continued this week with protesters now suggesting a run on the banks to destabilize the country and uproot President Macron. The Decentral speculates that with lots of cash floating around, the French may look to put their money into crypto as a censorship resistant asset

Will the Pendulum Swing Back?
In this op-ed, Chris Dixon of Andreessen Horowitz explores the various stages of the internet and its development. He discusses how at the dawn of the internet most technology was open source and community controlled. Slowly over time corporations rose in prominence and power and began dictating data usage and access for the public. As such we’re now seeing a return to open source, community-driven projects starting with a move to “cloud-based” systems and blockchain technology.

Why Voting Rights Matter for Security Tokens
Voting rights will become the next wave of important feature upgrades in the crypto ecosystem as this sector develops. As of right now, voting can be split into two categories: native voting rights (board seats, dividend payments) and crypto voting rights (burning/minting of tokens, exchange listings).

Crypto Sees High Usage in Latin America
Cryptocurrencies are seeing mass adoption in Latin America as only half the population has access to traditional banking services but almost everyone owns a smartphone. Venezuela and other countries hard hit by inflation have turned to non-government controlled cryptocurrencies as a payment method. Brazil has embraced cryptocurrencies with BTC, BCH and LTC accepted at supermarkets. Maybe a trip down south will show us what a future world of crypto payments looks like.

More 2019 Predictions:
Predictions for the year ahead abound all our newsfeeds. Carlos Domingo of Securitize and SPiCE VC is calling 2019 the year digital securities become the new ICO. In addition to predictions about the US government and wider global economy, Fred Wilson predicts that large projects in crypto will ship(Filecoin, Algorand), Ethereum will deliver many updates, and sectors such as stablecoins, NFT/gaming, earn/spend opportunities will grow.

Arca in the Press & on the Streets
  • Arca co-founder and Head of Legal & Product Structuring, Phil Liu, spoke on the “Impact of Blockchain on Finance Services & Regulations” panel at the Global Finblock Forum this weekend.
  • The launch of the Arca Digital Assets Fund was written about in Hedge Fund Alert.
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 — Portfolio Manager
Katie Talati — Director of Research
Hassan Bassiri , CFA — Junior PM / Analyst

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