Weekly Thoughts #14: The popular narratives


AUGUST 23, 2018

At press time, the price of bitcoin is around 6400 or roughly flat to yesterday at the same time. Oddly enough, this is where the price of bitcoin was when we wrote last week’s note. That fact alone should illustrate the relative lack of conviction this market is currently feeling. Outside of a few extremely short term blips in price on Tuesday (we dive more on that below), the price of bitcoin has been trading extremely range bound in the past week with little inspiration. The popular narratives this week have revolved around the market’s allusive desires for more volatility – a Bitfinex triggered short squeeze causing the market to go higher and the SEC denial on the ProShares Bitcoin ETF proposal causing the market to go lower. What does this tell us? The market is not only hungry for more volatility, there is a growing percentage of retail cowboys that are now sophisticated enough to punt their ideas both to the upside and to the downside. All that’s necessary now are binary events to trigger short term vol. In any case, on this week’s note we touch on a couple of these narratives indirectly but tried to highlight a few of our thoughts that we feel have been undercovered lately.

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1. Playing a short squeeze is very likely a crowded trade. ​In the past, this strategy had edge. Why? Because one could stealthily enter in a long position as the price of bitcoin was trending higher toward the projected “squeeze trigger” price. They could then single handedly move the market with a relatively small amount of crossing the spread and lifting continuous offers. Why else? Because the data was hard to come by as was the knowledgebase to interpret the data as was the communication amongst other traders. In classic trader speak, it was easy to position “right way” as the rest of the market was “wrong way”. Fast forward to today and what we have is the complete opposite picture. Markets are more efficient. The notional amount that moved the price of bitcoin +/- 1% a year ago would likely have little to no impact on the price action today. All the bots and market maker algorithms that are now nickel-and-diming one another would very quickly scope out a large buyer and dampen any undue impact by beefing up the offer side. Why else? Because data at one point that was hard to procure is now nearly ubiquitous across the crypto trading community (read: everyone is looking at the same data sources to make their decisions). When that happens in the traditional markets, 9 times out of 10, the trade that used to be profitable turns into one that loses money. That is because short term speculators are positioned and then waiting for the first sucker to move the market in their favor. Problem is that everyone is waiting. So some get tired of playing this game of chicken with other speculators and end up dumping their positions ahead of whatever event was supposed to occur. That’s where we are right now. Everyone is talking about the short positioning on Bitfinex (as of today, roughly 39k bitcoins or $250m using current prices). Everyone is speculating on a short squeeze. Everyone is positioning a future long with stop-limit orders (hopefully). And everyone is just waiting. When everyone is going the same way on a trade, it can effectively be deemed a crowded trade and there is a heightened risk that the price will move “wrong way” to expectations because of some exogenous factor that nobody predicted for. That happens in the traditional markets and that is likely what will happen here.

2. A cryptocurrency ETF is a horrible idea (and will be for the foreseeable future). ​Yesterday the big news of the day was the SEC rejecting the ProShares Bitcoin ETF. That was largely expected. What was a surprise however was that they also rejected all pending derivative-based bitcoin ETFs. For a succinct legal opinion as to why they may have did what they did, check out the ​following tweet storm that’s been making the rounds. Legal opinion aside, we have a very strong psychological opinion on this matter. We believe the notion of a bitcoin ETF (or any other retail distributed cryptocurrency vehicle that follows an index for that matter) is a bad idea that will do more harm than good for this marketplace in the short term. We have no agenda here or conflicts. Our views are informed of course by some fundamental and philosophical realities (ie, ETFs were never mentioned in Satoshi’s white paper) but they mainly stem from the fact that the digital asset marketplace is still too nascent of a marketplace for such a powerful derivative. ​Mom and Pop are not ready to, nor should they be buying or selling bitcoin exposure in their Schwab account. ​There is a big distinction between a traditional market retail investor and a traditional market institutional investor. We believe institutional investor interest in bitcoin is driven more by its relative uncorrelation to other assets and the potential for outsized returns far out in the future, not the opportunity to make a quick buck. Using some of the conversations we’ve had with the more educated and affluent members of our own family members as a data point, its clear to us that the majority of traditional market retail investors (both accredited and unaccredited) are likely still largely uninformed on the value proposition of a blockchain, the concept of bitcoin as money or how the fair value equilibrium price of a bitcoin should translate to some measures of adoption across different constituents in the ecosystem. They will buy a bitcoin ETF because 1) its super easy and 2) because they had a friend of a friend make a lot of money in the past and well, FOMO. However they will not be able to stomach the 70% annualized volatility much less the 5% daily swings that are more than appropriate for such a nascent asset class. We believe a bitcoin ETF (physically backed of course) may help fuel some good adoption well in the future and we are all for that…well in the future. Right now, as long as the market remains the way it is, we firmly hold that a bitcoin ETF should not be brought into the mainstream just yet.

3. The mainstream theory that the breakeven cost of mining provides support for prices is wrong.There is a belief adopted by many in the industry that the breakeven cost of mining for bitcoin creates a support for bitcoin prices. Fundstrat, for example, has been particularly vocal in this view​, and their price targets for bitcoin are based on the relationship that bitcoin has historically traded at 2.5 times its mining costs.

The majority of mining costs consist of electricity needed to run the miners and cooling units while costs associated with payroll, maintenance, and rent are secondary. Fundstrat estimates that the breakeven cost for a single bitcoin is about $6,000 to $7,000. Arthur Hayes of BitMEX also recently ​invoked this narrative by saying that “my hunch tells me that similar to the 2015 bear market, the price at which the average miner turns off their ASICs will be the local bottom” – around $5,000 according to his discussions with one of the largest miners.

The narrative, as explained to us, is that miners are one of the primary net sellers of bitcoin because they are required to constantly liquidate some of their bitcoin to cover the costs of operating a mine. They are also some of the strongest believers in the future of bitcoin and so when the price declines, miners tend to hold on to more of the bitcoin they mine in anticipation of higher prices and profits in the future. Thus, as prices decline and get close to the breakeven cost, miners want to accumulate as many coins as possible so that they will be worth more when prices recover. Prices declining to the breakeven cost may also be a signal that the “maximum pain” threshold has been reached by market participants.

On the surface, this theory seems to make sense. But we think this theory represents a fundamental misunderstanding of the fundamental factors that drive the bitcoin bubble and crash cycle.

●  First, while analyzing the breakeven cost of production makes sense for traditional commodities (such as oil and gold), it cannot be applied to bitcoin. Commodity prices tend to follow long-term bubble cycles because low prices make producing the commodity uneconomical. This reduces the supply and drives up prices. Higher prices then attract a lot of capital expenditures in production which requires a long lead time. Eventually, too much capacity comes to market, results in an oversupply, and the cycle repeats. But for bitcoin, the current price has no impact on the supply of bitcoin, even if prices make mining uneconomical. Regardless of the price or network hash power, the bitcoin protocol will adjust the mining difficulty such that on average, a fixed amount of bitcoin are produced every 10 minutes. Currently that amount is fixed at 12.5 bitcoin every 10 minutes. The amount of coins that are available for miners to sell is independent of the price.

●  Second, we believe that sell pressure from mining actually increases when prices fall, and can accelerate even further if prices reach or go below the breakeven cost of mining. Miners incur large fixed expenses that consist of electricity, server maintenance, internet service, payroll, benefits, legal fees, rent, and so on. These business expenses are fixed in fiat terms while a miners revenue is in the form of coins. Therefore, in order to cover the reoccuring fiat business expenses, miners must sell some of the coins they mine for fiat. When bitcoin prices are high, this means that miners need to sell less bitcoin to cover these fiat expenses and that they are actually saving more bitcoin as the bubble inflates. When bitcoin prices are low, this requires miners to sell more of the bitcoin to cover their fiat business expenses which remain relatively independent of bitcoin’s price. If bitcoin prices goes below the breakeven cost, miners may even be forced to sell more than 100 percent of what they are earning in order to survive which accelerates the decline. This is why the theory that miners save more coins when prices are low is wrong.

 Eventually the less economical miners will reach the point of capitulation and at some point will exhaust their inventory of coins to sell. So the breakeven cost of mining may in fact be a support for prices, except that the impact it has on prices happens on a delayed schedule and in a way that is not common understood. We should be looking at the point of miner capitulation when they liquidate their inventory of coins they mined in the past to find market bottoms.

How can we use this understanding to form a market view? The economics of mining suggest that miners are a major reason that bitcoin and other cryptocurrencies form bubbles. Momentum investing strategies that buy as prices trend higher and sell as prices decline should perform well. Tracking the inventory of large mining pools and movements of bitcoin to exchanges can yield important insights. Analyzing the rate of change of network hashrate may give an indication of whether uneconomical miners have exhausted their inventory and been squeezed out.

Thanks for reading everyone. Questions or comments, just let us know.

Portfolio Management Team

Thejas Nalval  | Kevin Lu


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