 February 21, 2020  Weekly insights, news and analysis for the professional investor Sponsored By:  By Noelle Acheson Director of Research If you were forwarded this newsletter and would like to receive it, sign up here. PRICES (02/21/21 @ 12 p.m. UTC): BTC - $56,968.66 | ETH - $1,944.91
Hi all,
This week we landed a rover on Mars. We watched Congress grapple with memes. And just when it felt like things couldn't possibly get more surreal, bitcoin's market cap broke through $1 trillion.
It's just a number, sure. But it's a symbolic number, and even if the market cap corrects from here, the overall mood of vindication across the industry will not go away.
But wait, things can get even more surreal from there. In THE BRIEFING, I write about decentralized finance, which I didn't expect to need to tackle until later this year. But things are accelerating and professional investors are getting interested, especially after the market-infrastructure dramas of the past few weeks.
Read on to find out why …
– Noelle
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The Briefing (Note: We use Bitcoin with uppercase when referring to the protocol, and bitcoin with lowercase, or BTC, when referring to the asset.)
GameStop boost to investor interest in DeFi
One of the most iconic moments of the past week was when Keith Gill, otherwise known as Reddit trader DeepF**kingValue, testified in front of the House Financial Services Committee: "I am not a cat." All who enjoyed the video of the meeting in which a frustrated lawyer struggled with Zoom settings (who among us hasn't experienced Zoom awkwardness?) immediately knew what he was referring to, and some of us may or may not have spluttered coffee all over our keyboard.
It wasn't so much the power of memes that made his remark feel important, nor was it just the humor that made us sit up. It was more the deadpan delivery, staring at the screen, addressing some of the most powerful people in the world. To me, it synthesized a loud shift in attitudes toward authority. With that throwaway remark, Mr. Gill demonstrated loyalty to his tribe rather than to the establishment, a sentiment we see playing out not only across social media but also in classrooms, culture, startups and even in the intimidating world of finance.
The surge in value of "anti-establishment" bitcoin, which broke $1 trillion this week, as well as of meme coins such as Dogecoin, are to a large extent an extension of this. The lack of trust in the establishment's judgement, and the visible weakening of its influence, make alternatives more viable. This goes beyond individual crypto assets. The congressional hearings highlighted a growing awareness of structural risks in our capital markets. This, combined with recent industry trends, points to strong potential growth in an area of digital assets we have not yet talked much about in this column: decentralized finance, or "DeFi."
The concept is about so much more than high investment returns, although there are potentially plenty of those to be had for those willing to take on high risk. It's about the emergence of a new type of financial market, not created with professional investors in mind, but which will end up benefiting from their interest. This week, that got a strong boost.
Under the hood
The GameStop drama awakened a greater interest in financial market plumbing, something that very few had bothered to care about before. When we see what looks like institutions trampling on the retail investor, we have questions. Few congressional hearings have been as eagerly followed as this one, in the hopes of getting answers and of seeing the beginning of change.
This is happening at the same time as an explosion of interest and development in DeFi applications.
The term "DeFi" refers to self-executing programs that fulfill the functions of centralized financial services such as borrowing, lending and trading, but in a decentralized, peer-to-peer manner (here's a more detailed primer if you need it). This week, Bloomberg reported that approximately $359 million worth of GameStop shares failed to deliver on Jan. 28. In the world of automated crypto asset trading, that couldn't happen. Also, trades can't be frozen, all traders have equal priority, and there is no authority who can change the rules or middleman who can prioritize some orders over others.
The concept started a few years ago in an experimental corner of the Ethereum ecosystem, with open-source "smart contracts" deployed to execute trades, interest payments and collateral swaps. Last year saw the rise of "yield farming," which refers to hopping from platform to platform in search of the highest yields. These sometimes reached triple digits, at a time when official interest rates were near zero.
The returns were significant, but so were the opportunities for things to go wrong. Many platforms were constructed on hastily written code, and last year we reported on numerous bugs and losses that had no recourse. Mistakes are not unexpected at the start of an innovation spurt, however, and the creativity and output were (and still are) astonishing.
Given the high yields, it was only a matter of time before institutions started to take notice. In its Q3 2020 report, Genesis Trading (a subsidiary of DCG, also the parent of CoinDesk) reported that much of its lending growth was to institutions looking to finance yield opportunities.
Fast forward a few months, and the ecosystem feels different.
The economic value riding on DeFi platforms has almost tripled since the beginning of the year, to $41.9bn at time of writing. These platforms are usually powered by tokens which confer access and governance rights – the aggregate value of the 100 largest tokens by market cap currently stands at $83 trillion (yes, with a "t"), with over $16 trillion in 24-hour trading volume. The DeFi Pulse Index, which tracks 10 of the largest tokens by market cap, has risen over 260% year-to-date.  Source: defipulse.com
What's more, Ethereum, the base blockchain for most DeFi applications, has entered a new phase of development with the launch of the first step in the migration to a more scalable and less energy-intensive consensus system. This will solve for the soaring fees on Ethereum which threaten to choke off some of the transaction volume. It will also give DeFi applications a viable platform from which to one day integrate with traditional finance.
Institutional onramps are spreading. Coinbase Custody has offered institutional clients trading and custody services for DeFi tokens for some time now, and has listed four new DeFi tokens so far this year. BitGo facilitates the conversion of bitcoin into a DeFi-friendly token. Digital asset custodian Trustology helps its institutional clients vet DeFi projects. But so far access to the potential returns has been largely limited to buying individual tokens. This is changing.
This week, crypto fund manager Bitwise launched a DeFi fund, which tracks the weighted value of a basket of tokens. And some U.S.-listed trusts may be on the way: over the past few weeks, Grayscale Investments, the largest fund manager in the industry (owned by DCG, also parent of CoinDesk), has filed for authorization of investment trusts based on tokens for DeFi protocols such as yield optimizer Yearn Finance, money market Aave and data oracle Chainlink. (Note that filing for authorization does not indicate intent to launch, but the possibility is there.)
New territory
The returns on DeFi assets may be high so far this year, but so are the risks. There's the possibility of a technological glitch, or a hack – we've reported on a few just this month. There's regulatory risk: the controversial FinCEN proposal presented in December of last year, which suggests that exchanges require identifying information for receiving addresses, would dampen DeFi innovation and make some functions unviable. There is also liquidity risk: even a small institutional order could distort the market, and it may be difficult to exit when necessary. What's more, the high volatility of DeFi assets means the downside could be brutal.
Nevertheless, given the public support for examining structural inefficiency and fragility in traditional capital markets, and the increase in DeFi activity and innovation, the growth in mainstream interest is likely to accelerate.
This will be positive for those building the capital markets of tomorrow, and for those that invest in these projects. So far this month, we've reported on three new venture funds targeting DeFi startups.
More institutional money flowing into the DeFi ecosystem, either in the form of token investment or venture capital, will boost liquidity and legitimacy. Institutional support will also guide the ecosystem through the shoals of regulatory acceptability and the gradual adaptation of current market infrastructure.
Smart money will hopefully understand the risks involved. But getting in early on a transformational innovation rewards the brave. And current market infrastructure is getting ready to help this along.
Macro currents
The reflation theme is a key backdrop for both traditional and crypto markets. This week, the 10-year Treasury yield rose near 1.3% – the highest level since March 2020. Generally, rising yields reflect market expectations for stronger growth and inflation.
But will investors allocate to risk assets, including cryptocurrencies, if yields rise too far?
The U.S. economy is entering a post-recession phase, which is typically good for risk asset performance. And Fed officials are forecasting rock-bottom rates through the end of 2023, which is far from the typical tightening bias seen during the late stage of an economic cycle.
Further, the spread between the 10-year Treasury yield and the two-year Treasury yield steepened to its highest level since 2017. This reflects market expectations that the Fed will continue to support the economic recovery, which has been very kind to asset price inflation.  Source: Federal Reserve Bank of St. Louis Chart shows the 10-year Treasury yield (reflects market expectations for future economic growth) versus 2-year Treasury yield (expectations for movement in the benchmark funds rate).
And rising yields were no match for cryptocurrency performance this week. BTC is now outperforming ETH over the past week and month. In traditional markets, gold ended the week in red despite the pull back in the U.S. dollar.  – Damanick Dantes
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Chain Links Investors talking:
Bank of America's February survey of fund managers revealed that "long bitcoin" has slipped from the most crowded trade in January to the number two position, behind "long tech" and just in front of "short dollar."
"We believe the trend of transactions, bitcoin investments, and blockchain-driven initiatives could surge over the coming years as this bitcoin mania is not a fad in our opinion, but rather the start of a new age on the digital currency front." – Wedbush Securities, in a research note.
"Bitcoin may be The Stimulus Asset. Doesn't look like gold is." – Jeffrey Gundlach, CEO of DoubleLine Capital
"Having some bitcoin, which is simply a less dumb form of liquidity than cash, is adventurous enough for an S&P500 company ... Bitcoin is almost as bs as fiat money. The key word is "almost"." – Elon Musk
"For now, the bitcoin boom may best be viewed as a canary in the coal mine." – An interesting take on bitcoin's boom by the FT's Rana Foroohar
Takeaways:
The Ontario Securities Commission (OSC) has approved the Evolve Bitcoin ETF, making it the second to list on the Toronto Stock Exchange. TAKEAWAY: U.S. regulators, the pressure is on …
Elsewhere in ETFs, the Purpose Bitcoin ETF (BTCC) started trading on the Toronto Stock Exchange on Thursday, and accumulated almost $422 million of AUM in two days. TAKEAWAY: This is a strong signal that there is demand for this type of product.
Speaking of which, NYDIG, Stone Ridge Asset Management's bitcoin spin-off firm, has filed with the U.S. Securities and Exchange Commission (SEC) for a bitcoin ETF. TAKEAWAY: This follows bitcoin ETF applications from VanEck and Valkyrie, and signals that fund managers are feeling more optimistic about the prospects for approval. Notably, the filing lists Morgan Stanley as the initial authorized participant, which adds a blue-chip name to the process – as far as I know, the other two ETF filings have not specified who their initial authorized participant will be.
Cryptocurrency exchange Coinbase, which is preparing to trade publicly in the next few months, is being valued at $77 billion, based on trading of the company's privately held shares on a secondary market. TAKEAWAY: This is higher than the CME Group, ICE (parent of the NYSE), the London Stock Exchange … the list goes on, but you get my drift.
MicroStrategy, the business intelligence firm now better known for the 70,784 BTC on its balance sheet, intends to raise $1.05 billion via the issuance of convertible senior notes due in 2027. The bulk of the proceeds will, you guessed it, be used to buy more bitcoin. TAKEAWAY: This makes MSTR the closest thing to a bitcoin ETF in the U.S. market, while layering a level of corporate risk on top of bitcoin market risk. This is yet another nudge to the SEC to approve a bitcoin ETF soon. A reasonable question is: what will happen to the MSTR share price when that happens?
A survey released by Gartner this week showed that only 5% of business executives intend to invest in bitcoin as a corporate asset this year. TAKEAWAY: "Only" 5%?? That seems like a lot to me. In mid-June non-financial corporate cash was at $2.12 trillion, according to Moody's. And the non-financial companies with the largest amount of cash on their balance sheets are Apple, Microsoft, Alphabet, Amazon and Facebook – tech companies that are more likely to be interested in BTC holdings than your "average" corporate.
A look at why the CME ETH futures matter for the market. TAKEAWAY: It's a way for a broader range of investors to take a broader range of positions. It's also a necessary prerequisite for the development of a lively ETH options market, which will offer even more hedging and directional bet opportunities for investors of all types.
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