Updated: Aug 25, 2022
Looking back, Thinking Clear
As those who’ve read my missives in the past may know, I’ve keenly followed both the progress and regress of blockchain technology, specifically the explosion of Bitcoin onto the financial scene. Every so often, I like to revisit past thinking and re-address some fundamentals. Is blockchain still a relevant technology? Does it continue to hold the promise its proponents have been touting? And is Bitcoin still a viable investment?
First let's take a bite out of FAANG
FAANG" is the acronym that Jim Cramer famously coined for the collection of the five most powerful internet stocks. These stocks (Facebook, Amazon, Apple, Netflix, and Google) have been paramount to the returns realized in the S&P 500 over the last several years. The aforementioned internet titans have grown so large that they now make up a whopping 11% of the total index of S&P 500. In recent years, Facebook, Amazon, Netflix, and Alphabet stocks are up about 30%, 29%, 28%, and 21%, respectively, year to date *. This compares to the 7% return of the S&P 500's over the same period. Furthermore, these stocks' big gains in 2017 extend to an extraordinary track record for each. Facebook's, Amazon's, Netflix's, and Alphabet's (Google) stock prices are up about 150%, 220%, 220%, and 80%, respectively, compared to three years ago. During this same period, the S&P 500 increased just 27%, which is in line with historical returns, however heavily dependent on FAANG.
Tech is wobbly
It seems that these companies have had a seamless transition from disruptive technology to established brands which, intuitively might make one believe that these stocks have had consistent returns. Nothing could be farther from the truth as FAANG stock's return profile more resembles the old Wall St. adage of taking the stairs up and the elevator down, complete with volatility spikes and rapid downward pressure on prices.
These moves tend to be painful to the majority of investors as the market's dramatic fluctuations punish and test their conviction about these technologies and their respective company’s prospects. For instance, Apple's Initial Public Offering took place in 1980. Since then the stock has returned an amazing 25,217% return at an annualized rate of 17%. However, in 2000, the stock dropped -71%, in 2008 -57%, and in 1993 the drawdown was -50% against a positive S&P return.
This is not unique to Apple. Amazon, Google, Netflix, and even Microsoft have had periods of extreme drawdowns. For instance in 2007-2008, Google lost -65% of its value. Facebook, whose IPO price was $38, traded down almost -48% just 4 months later before rebounding. What compounds the pain is the math behind getting back to break even. For example, a -33% drawdown means a 50% return to break even, a -50% loss would need a 100% return and in Google's case, the -65% loss would need a return of 135% merely to break even.
Gartner Hype Cycle
Parabolic moves and the resulting drawdown in stock prices of disruptive technology can be viewed through the lenses of the Gartner Hype Cycle Methodology (GHCM). It explains the psychology of the investor or general public around emerging technologies as it goes through stages of innovation triggers, inflated expectations, disillusionment, enlightenment, and final productivity (see chart above). The parallels between FAANG stock prices and the price of Bitcoin can be drawn and provide insight into future price movements. The chart above signals blockchain in the cycle of disillusionment, which certainly can be argued is reflective of the Bitcoin price movement from over $19,000 down to @ $6500 per coin. If blockchain technology flows according to the GHCM, we are in the early days of what could be a seminal technology benefiting multiple industries on a global level.
So What about Bitcoin?
Blockchain technology and cryptography are the underpinnings that have enabled the birth of a digital currency, in turn bringing along the innovation of a new, uncorrelated asset class. What is vital to understand is that blockchain is a decentralized, transparent and immutable software product where the growth is driven by a digital asset or native token. Bitcoin is the engine that powers the move from double-entry bookkeeping of the 15th century to the software efficiencies of decentralized ledgers. Another way to look at this would be to compare a centralized model like Microsoft, whose product growth is driven by tens of thousands of sales professionals, to a decentralized community where the token or coin is a de facto sales force. If we believe the premise that blockchain technology will be a multi-decade growth engine and tokens become common as a utility function, Bitcoin will most likely continue to be the barometer for all things crypto. When we apply GHCM to the blockchain (BITCOIN), from an investment thesis we can conclude not having exposure to this asset class in a portfolio increases the probability of underperforming early adopters and missing a FAANG type of investment. As any venture capitalist model will show you, picking winners is generally a low probability bet with a select few winners driving the majority of positive returns. So how does one gain exposure to the asset class or gain beta exposure to blockchain technology with the highest probability of a positive result? in a word Bitcoin.
Gartner Hype Cycle, Tulips and the South Sea
Is Bitcoin a bubble? The price action certainly has shown a lot of similarities to a bubble at various stages over the last ten years. But not all bubbles are the same and not all bubbles go to zero. The lessons learned from the price action of the FAANG stocks have taught us that bubbles in disruptive technology are more clearly identified as opportunities for a second or third bite of the Apple (pun intended). History has shown us that large swaths of portfolio returns come from these companies whose technology changes our actions and daily habits. Using traditional equity valuation methods, whose value is predicated by cash flow, therefore, does not pertain to Bitcoin. The value of Bitcoin is derived from several different use cases, therefore, is not synonymous with equities, however, a striking analogy comes in the form of the comparison to disruptive technology and the ability to reach critical mass adoption. Blockchain is a good, even powerful technology that can wring out inefficiencies across industries through its decentralized and immutable properties. Blockchain, however, has a symbiotic relationship with Bitcoin and when combined creates a truly transformative application that spans the global economy.
Mark Twain is quoted saying " history doesn't repeat itself but it rhymes". Disruptive ideas tend to be generational and in the 21st century, technology is the catalyst of change. It might be said that the optimal portfolio over the next decade will have a digital wallet (or its replacement) aligned with traditional assets. Prudence and precedence would dictate that disruptive technology be included in that portfolio and if blockchain is the catalyst of change then Bitcoin will be its champion.
What has changed?
Since Covid hit the US in March of 2020, markets have been prone to a lot of volatility, meaning price movements are sharper and larger. BTC has always been a highly volatile asset but interestingly has become more correlated (trades in tandem) to tech and FAANG stocks. Non-Correlation to traditional assets along with being an inflation hedge were attributed to BTC, but last several years leave these attributes in question. This is most likely the result to a larger macro investing environment (big economics), higher volatility across all markets as well as more adoption of institutional trading for BTC and cryptocurrencies.
Where are we now?
BTC is currently around 22,000** and has recently shown signs of consolidation at these levels. This corresponds to roughly a 66pct correction and mirrors FAANG stock drawdowns. While this return is a painful point for long-term investors, this also corresponds to the thesis that blockchain and BTC are emerging technologies and trade like the FAANG cousins. What else has changed? If we refer back to Gartner Hype Cycle chart, we may have slide further down the "Trough of Disillusionment". While the crypto and equities markets fall into a bear (down) market, building and investing around blockchain technologies has boomed behind venture firms like Andreessen Horowitz, Google Ventures, Fidelity Investments, and Blackrock to name a few. The world has gone through upheaval over the last 4 years and while BTC hasn't lived up to all the hype, the secular trend for blockchain and Bitcoin seems to be on Terra Firma.
* 10/1/18
** 8/22/22
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Is Blockchain the tool to gauge systematic risk?
My British colleagues in the world of rates loved to use the phrase "my word is my bond" as a way of conveying they could be trusted. Anyone who has worked on Wall St can tell you trust is hard won and often elusive. Banks and the financial industry as a whole have not done their reputations any favors since 2008 with some very public censors from libor rigging scandal to credit card stuffing. While this public shaming always seems so" in the rear view mirror", the amount of time and data regulators have to work through is daunting. The shear number of transactions along with derivatives trades that can be 10x the underlying markets, is a tangled web of risk exposures that can't be easily quantified.
Blockchain technology may finally provide regulators with the tools to effectively monitor and police the financial industry in real time. In fact CFTC Chairman Giancarlo has pointed to this as an effective way to protect the system from abuse and over leverage. Why is this this technology important to regulators? Because of the decentralization of this technology, it allows for immutability, accountability as well as greater transparency. Although the financial system would not be fully decentralized like say Bitcoin, a permission ledger between financial institutions and regulators would be vastly more effective in assessing risks to the financial system in real time. How so? Collateral is the engine that drives financial instruments and trading which allows risk to be be spread across all the different market participants. Healthy capital markets allow multiple participants with different goals and risk exposures to participate in driving business growth. History has shown that without proper parameters, this practice can get to a point of systematic risk such as mortgages turned into multiple IOU's claiming the same collateral.
Turning Equity into debt
Wall St is creative at stretching the most value out of any asset whether it theirs, yours or mine. For example those Apple shares that you own and have treated you so well are held in a custodial account. That equity stake you have becomes a debt instrument (an IOU) in the form that the custodian promises to deliver your shares upon request or trade. Those same shares are then lent out to short sellers or used as collateral several times over in a process called rehypothecation. This business practice , which very often sets up an account of commingled assets is one of the many ways that the financial markets create leverage but also possible systematic risk. Blockchain technology would give regulators an immutable record of where that asset is, who is basing a collateralized transaction on that asset and to identify abuse of over lending.
Where are we headed? A familiar road
NYSE parent ICE announced recently that a new division known as Bakkt will be offering a custodial solution for the digital asset space. While this has been cheered as another step in legitimizing bitcoin and the digital asset space, there comes the caveat of Wall St and their knack for financial engineering. Caitlin Long, President of Symbiont and co-founder of the Wyoming Blockchain Coalition, has argued that this is a double edged sword. As institutions embrace this technology and enter the market , the network affect and multiplier will accelerate growth for a new asset to emerge. The flip side she argues is bitcoin is alogrithmically engineered towards scarcity (21mm total that can be mined/printed) while institutionalization will lead to claims ( paper IOU's) with Bitcoin "being manufactured out of thin air" and therefore marginalizing the inelastic supply.
The paper fork
Blockchain technology has It's own way of upgrading software called “forks." In a soft fork essentially there is a consensus to upgrade an aspect of the protocol which is compatible with the technology which exists. Conversely, A hard fork happens when the changes necessary are not compatible with where the governing body wants to take the technology. It changes the rules going forward and generally speaking, creates a new protocol. If Bakkt and Wall St are successful with an institutional custody solution, could this possibly cause all these paper IOU's to look like synthetic Bitcoin or lets say a "paper fork".
Bitcoin is the phoenix that grew out of the financial crisis, emerging as a way around trusting centralization and the institutions. By design it creates immutable trust between parties rather than trusting a third party like a bank. The institutional custody solution and rehypothecation will lead to the development of financial tools of lending, forwards and option markets but just might also lead to a "paper fork". This whole idea seems some what of a anathema to the origins of bitcoin and it's community. However, the underlying blockchain technology which bitcoin is based upon should give regulators the ability to monitor the market and prevent any abuse. And perhaps, the HODL group might say no thanks to the "paper fork" making Bitcoin one expensive borrow.
*Bakkt CEO Kelly Loefner has recently stated that " Specifically, with our solution, the buying and selling of Bitcoin is fully collateralized or pre-funded. As such, our new daily Bitcoin contract will not be traded on margin, use leverage, or serve to create a paper claim on a real asset."
For more info , some interesting perspectives on the subject:
I want my ICO
So who can actually buy an ICO? If you're a US citizen, you maybe surprised to see private placements of many initial coin offerings exclude you. This is due to the confusion over US regulation and the classification of tokens. Arguably the crypto currency space has spent first part of the year in a bear market because of a cloud of regulatory uncertainty. I realize 6 months is a lifetime in the crypto space but in the world of regulation and compliance its a matter of course. Its been argued that US will be less competitive and is stifling innovation. However the regulators are doing a good job of patiently trying to understand the technology , how it affects markets and fulfilling their mandate of protecting investors, maintaining fair, orderly, and efficient markets while helping facilitate capital formation.
So where are we in the current regulatory regime? CFTC/SEC
The Commodity Fututes Trading Commision (CFTC) has claimed cryptos as a commodity (more precisely BTC), and has been generally a proponent of the promise and innovation of crypto assets. Arguably the CFTC has been in the forefront because of the commodity exchanges needed permission to roll out Bitcoin future contracts. The Securities Exchange Commission (SEC) in the meantime has recently gotten more active in issuing multiple subpoenas. While this may sound ominous, keep in mind that the SEC has said ICOs fall under the Howey test (what makes something a security) and the subpoenas are a way for the SEC to gather information and put bad actors on notice.
ABC's of reg
Given where the regulatory regime currently sits, lets look at what rules already apply to investors.
Regulation A: this exemption is for up to 10 mm and no more than 500 shareholders. In 2015 this was updated through the jobs act and included tiered exemptions which is essentially Reg A+
Regulation D — This is essentially an exemption with the SEC, but requires an electronic filing of “Form D” after the securities have first been sold. Solicitation is allowed to investors for an offering if they meet the requirements of Section 506c, which requires verification that the investors are accredited and the information provided during the solicitation must be “free from false or misleading statements.”
Regulation A+ — This is also an exemption that allows an issuer to offer a security qualified with the SEC to non-accredited investors through general solicitation for up to a total of $50,000,000 in investment. Due to the requirement to register the security, Regulation A+ issuance can take longer compared to other options. This regulation came directly from the jobs act as a way to even the playing field for smaller firms in investment management.
Regulation S — This is when an offering of securities is deemed to be executed in a country other than the US and therefore not subjected to the registration requirement under section 5 of the 1933 Act. Issuers of the security are still required to abide by the security regulations in each country where they offer their security.
Where are we headed?
Michael Piwowar, a U.S. Securities and Exchange Commissioner stated recently there are 3 buckets of securities. Bucket one: In this bucket are registered public offerings, or initial public offerings (IPOs). Bucket two: In this bucket are exempt offerings, and these include ICOs. Bucket three: In this bucket, are basically all the other offerings, which tend to be illegal. Piwowar said about bucket three that if the offering does not fall into the first two buckets, the SEC has said “we’re coming after you.
Certainly regulation is much deeper and more complex than I have mentioned here but regulators have made clear distinctions between BTC, Eth and the alt coins coming from ICOs. The point is that the regulators are pointing to the existing rules while acknowledging that there is a new and important technology emerging in finance. I believe they have essentially said we will work with you, not by sitting in the sandbox with developers but standing on the beach making sure investors don't get swept away with the tide.
for more info check out the sec post( https://www.sec.gov/news/speech/speech-peirce-050218)
