Sound Money

2021, what a year! There is lots to be grateful for, in life, work and markets. Lots of lessons learnt too. In the past week I took some time to reflect on last years predictions, digest the learnings and contextualize where we are ahead of what will likely be another whirlwind year. Forecasts can be foolhardy because some of them will inevitably be wrong and if you get too precise you end up tying yourself up in knots. But they are useful to sharpen the mind, record the current state of the crypto markets, provide a vision of the future and create signposts to assess that future. TLDR: I think the market structure has changed and do not think we will experience a protracted bear market, which historically lasted about 18 months. Fed tightening could create a tougher year for crypto but capital deployment will still result in bright sparks as numerous new entities are compelled to turn towards this powerful decentralized technology. I will be watching the Fed, the SEC and US stablecoin regulation very closely to assess if we out/underperform these expectations.

Summary & Predictions

1. Market structure has changed
2. Historical 4-year bull & bear cycles are dead
3. More short-term volatility and less long-term volatility
4. Extended bear market unlikely but 2022 presents serious macro challenges
5. Consolidation and outperformance of BTC and ETH
6. Securities scrutiny places smaller crypto projects under pressure
7. Limited El Salvador followers
8. ‘Rogue states’ stealth bitcoin accumulation
9. US government legitimizes stablecoins
10. Politicization of bitcoin

2021 expectations were too bullish

In Jan 2021 I predicted that the year ahead would be characterised by “speculation and FOMO as Bitcoin price surpasses $100K” _{(all the Jan 2021 predictions are presented in blue boxes below)}

Bitcoin 2x’d rather than 3x’d in 2021 as we did not experience a FOMO-induced blow-off top in price that has happened in previous bull-markets. A FOMO-induced blow-off top could easily have taken bitcoin above $100K but the market structure has potentially changed in 2021.

Institutions have changed the Market Structure

I suggested that we would see further “institutional interest” in 2021 & “Bitcoin ETF approval”

These predictions were accurate - Tesla joined a host of other listed companies, adding bitcoin to the balance sheet. The SEC followed Canada as bitcoin ETF’s were approved in the US. Another sign of the institutionalization of crypto was the rise in derivative markets. Open interest on bitcoin and ethereum derivatives grew 3X.

While derivative markets and leverage may contribute to greater short-term volatility and bouts of liquidations, they have probably dampened the cyclical volatility. For example, numerous institutions have implemented the cash-and-carry strategy, buying spot bitcoin and simultaneously selling futures to earn the yield between the two instruments. This adds liquidity, supports bitcoin over the long-term but it also lowers bitcoin’s cyclical volatility.

Less bitcoin cyclical volatility and lower perceived bitcoin price potential also pushed retail activity into other segments of the market. Retail buyers are more likely to make impulsive purchases, supporting volatility in the wider crypto markets. But with less retail activity in bitcoin itself, lower cyclical volatility became a self-fulfilling prophecy.

More short-term volatility but less long-term volatility?

Going forward, we may see a continuation of this trend with more short-term volatility, but less long-term volatility. I.E. Lots of pockets are short-term volatility with rallies and corrections in 20%-30% being common place but fewer 100% FOMO-induced rallies and fewer 80%-90% bear market price corrections. In fact, the historical 80-90% bear market could be a thing of the past.

Extended bear unlikely but 2022 certainly presents macro challenges

I thought that, “2021 will surpass price expectations but will be followed by another bear market in 2022”

With more institutions and less retail we failed to experience a blow-off-top moment and a subsequent price unraveling that would have burnt new entrants and warded off interest for 12 to 18 months. This has reduced the likelihood of a protracted bear market where crypto completely falls off the radar. There is just too much interest at these low prices, too many institutions building in the space and too many others who have not even got their toes wet yet. There is a reported $25bn worth of venture capital that is waiting to be deployed.

2022 will not be plain sailing as Macro headwinds mount

That being said, there are clearly more risks at the start of 2022 than the start of 2021. The biggest risk remains the tightening macro conditions in traditional financial markets with the Federal Reserve at the centre. I wrote in the November Market Review (Macro headwinds build) “A stronger USD and flatter yield curve tell a cautionary tail”. Our macro indicator has taken a breather into year-end, but it is substantially lower than it was 6 to 12 months ago.

Tighter macro conditions create a more challenging environment for risk appetite across the board, equity, crypto, etc. Wintry seasonal conditions should be expected until the Fed is forced to reverse its tightening course and usher in a new round of stimulus. Will there be enough pressure on Jerome Powell from Congress by the mid-term elections in November 2022? Truth is, no one knows. We will have to wait and see and thus the range of possible paths this year is wide.

In terms of specific price ranges, I think it is going to be a choppy year. I think capital deployment from VCs and elevated risk appetite at the start of the year could generate a strong first quarter, taking us back into the $55-60K range. But macro headwinds could keep a lid on new all-time highs until the Fed changes its course later in the year. Unless the Fed really plays hard-ball and tightens aggressively, I find it difficult to see a sub-$30K bitcoin price for any length of time. As soon as the Fed changes its tune towards a looser stance, I expect bitcoin to benefit substantially from negative real interest rates.

Constrained by debt, Fed tightening will not last long

The Fed is currently trying to raise interest rates and tighten policy, but history tells us that they will not get very far. Deeply indebted economies cannot stomach positive real interest rates for any length of time because debtors become insolvent. The government is the biggest debtor of all so they would certainly prefer elevated inflation to insolvency.

During the 1940s and 1950s, when US debt levels were comparable to today, US real interest rates averaged -2.6%. Using this historical precedent, I expect central banks will return to loosening policy with vigour as soon as there is clear sign of softening inflation, in either consumer or asset prices. This necessity to loosen policy stands in stark contrast to bitcoin and remains a compelling case for holding over all time horizons

Market consolidation with BTC and ETH outperformance

At the start of the year I thought “rising transaction fees on BTC and ETH” would force the market to focus on “L2 solutions in 2021″.

This has been partially true and BTC has achieved a fair amount of success with Lightning. But retail activity has not waited for L2 solutions. Rather than allocate directly to BTC and ETH, retail has focused on alternative blockchains altogether. non-ETH layer 1 protocol’s like Solana and Avalanche have received incredible interest. These chains are less decentralised than ETH and BTC but allow for cheaper transaction fees, encouraging new users and developers.

Given that 2022 might be a period of less crypto froth, I suspect we could see market consolidation, appreciation of the progress made on scaling in bitcoin and ethereum and outperformance of these assets relative to 2021.

Regulatory mixed bag but widespread bans unlikely

At the turn of the year finCEN’s KYC proposal was a worry but, as expected, it did not pass before Mnuchin left office.

Despite all the regulatory worries, the trajectory in crypto regulation has been reasonably positive. Obviously there is more regulation than in the past, and not all of it is friendly, but widespread bans across the world have not been forthcoming. The only governments foolhardy enough to attempt widespread crypto bans are authoritarians like China, Turkey and Nigeria. I have said it before and I will say it again, “if you are worried about a bitcoin ban, then you need it more than you think.” I am sure Turks wish they had more bitcoin in 2021 as the Turkish Lira experienced a parabolic depreciation vs. the USD.

Crypto securities to come under SEC scrutiny

More regulation should be expected in 2022. SEC chair Gary Gensler wants to clamp down on securities law, which could place a number of smaller crypto projects under pressure. In truth, many Initial Coin Offerings (ICOs) contravene securities law by raising capital without being formally registered with the requisite securities regulator. The complicating factor for regulators is the decentralized and distributed nature of crypto projects. If the development team is globally distributed and the protocol is deployed on a decentralized architecture, who needs to file? And where should they report to? These questions are particularly challenging for regulators, which delays the timeline towards executing regulations. Nevertheless, I expect securities scrutiny is a high probability at some point in 2022, which could place additional pressure on smaller projects in 2022. In contrast to smaller projects, bitcoin is a one of the few cryptos where there is no chance of it being labeled a security. Bitcoin never had a pre-issuance of tokens to insiders.

Adoption path moves into the national realm with El Salvador

The biggest piece of news last year came from El Salvador which became first country to adopt bitcoin as a medium of exchange. El Salvador is a small country, so I understand why people gloss over this development, but this is a major step in bitcoin’s adoption path.

I certainly did not predict this decision, but if bitcoin is going to become a global reserve currency, then everyone will turn towards bitcoin as a primary monetary good. This will take time and it will not happen in a straight line. The process is incremental. Some individuals, families and organizations already live on a bitcoin standard. Now we have a whole country living on a bitcoin standard, which is a big leap in bitcoin adoption.

I think it is unlikely that we experience a flood of country’s following El Salvador’s lead. Why?

1. El Salvador is in the exceptional circumstance where remittances drive a major proportion of GDP and it is already dollarised.
2. Remittances are substantially cheaper on bitcoin so El Salvador boosted its GDP through adopting bitcoin.
3. Most governments use their currency as a tool to exert their economic policies and are unwilling to give up this privilege without a fight.

El Salvador’s incentive structure is remarkably different, opening the possibility of bitcoin adoption. Counties that are already dollarised and thus have a similar incentive structure to El Salvaor are: Ecuador, Zimbabwe, Guam, American Samoa, Palau, the Marshal Islands and Panama - hardly the G8 but if things go well in El Salvador, reporters will snap up the story. In fact, awareness of El Salvador has already gone through the roof and capital inflows from bitcoiners are pouring into the country.

I wish you well, El Salvador!

Rogue states to begin stealth bitcoin accumulation

Amongst larger countries, the best prospects for state-level bitcoin adoption lie in what are perceived to be ‘rogue states’ by the West. Russia, Iran and even China desire reserve currency diversification away from the USD because the USA uses the USD as a geopolitical weapon. It is unlikely that these ‘rogue states’ would publicly support bitcoin, but it is not out of the realms of possibility that the Russian central bank has started stealth accumulation already, for example. Russia was one of the largest accumulators of gold in recent years in an attempt to diversify away from the USD.

Note: ‘rogue state’ adoption of bitcoin says nothing about the technology itself. Business people adopt the best technologies to do business.

China entrenches centralized control

I thought China’s DCEP would “grab headlines in 2021 as central banks grasp for relevance.”

In reality the biggest news out of China was the bitcoin mining ban. While traumatic for bitcoin at the time due to the temporary drop in hash rate, this decentralizes the network and enhances security. The big looser is China which showed its true stripes, favouring centralization and control over innovation and freedom. I suspect that this could be the geopolitcal event of the decade and hamstring the rise of China.

Central bank digital currencies are not going away though. Now that China has driven mining out of the country, or underground, we could hear a lot more about China’s centralised digital currency solution, DCEP in 2022 as Xi Jinping exerts greater centralisation on China again.

US government to legitimize stablecoins

I do not think a central bank digital currency makes sense in the US, though. Stablecoins are potentially a powerful tool for US authorities and a much better option to achieve their goals that a separate digital currency.

1. Stablecoins support USD adoption and reserve currency status
2. Stablecoin issuers hold US Treasuries as collateral, creating additional buyers of Treasuries
3. Treasury demand allows the Fed to keep interest rates lower than otherwise, monetizing its massive debt stock.
4. Private stablecoins already exist and are in high demand, shortening the ‘time-to-market’ vs. a central bank digital currency which could take a number of quarters to develop.

The more I think about it, the incentives lean heavily towards US support for stablecoins so I expect legitimization in the current years. The major obstacles to this forecast are

1. Stablecoins could place pressure on the traditional banking sector if deposits rush from banks into crypto stablecoin issuers
2. US lawmakers struggle to pass law, even if the law is in their best interests.

So perhaps a piecemeal regulatory trajectory is likely where stablecoins are slowly legitimized but do not receive Congressional support and do not fall under FDIC insurance. Nevertheless, an important signpost to watch out for this year.

Politicization of bitcoin

US politicians have become sensitive to the growing lobby group represented by bitcoin, which is definitely a good thing for longevity. However, there is a risk in this trend. Conservative leaning politicians tend to be more favourable to bitcoin because they are receptive to free-market policy bias. For example, governors from red states like Wyoming, Florida and Texas have made explicitly constructive policies towards bitcoin. Left-leaning politicians do not have quite as clear a route to bitcoin. Sound Money is certainly supportive for their constituents but ideologically, may of these politicians like to exert control are in favour of utilizing monetary and fiscal policies extensively to actively pursue their goals, which is anathema to sound money principles. I certainly hope lobby groups will encourage liberal politicians to focus on the innovation, job creation and inclusiveness of crypto, but the Elizabeth Warren types will be difficult to convince. The politicization of bitcoin and the possibility that it becomes a partisan issue, is a big risk going forward.

There you have it. Here’s a recap of the 2021 summary and 2022 predictions

1. Market Structure has changed
2. Historical 4-year bull & bear cycles are dead
3. More short-term volatility and less long-term volatility
4. Extended bear market unlikely but 2022 presents serious macro challenges
5. Consolidation and outperformance of BTC and ETH
6. Securities scrutiny places smaller crypto projects under pressure
7. Limited El Salvador followers
8. ‘Rogue states’ stealth bitcoin accumulation
9. US government legitimizes stablecoins
10. Politicization of bitcoin

Wishing you a wonderful 2022.