Thank you for subscribing to The State of the Crypto Newsletter. Every two weeks I provide my insights and analysis of key technological, financial and market trends in the crypto asset space.
In this edition I discuss:
The paths to on-chain scaling
The importance of hedging between off-chain and on-chain proposals
What a German slowdown means for investors
The ability of Turkey to spark the next wave of crypto adoption
Major Technology Trends
In the previous edition, we looked at scalability and specifically how monetary projects like Bitcoin and Litecoin are planning to scale with off-chain solutions such as the Lightning Network.
Today though I would like to draw your attention to the on-chain scaling plans being pursued by monetary projects such as Bitcoin Cash and Digibyte. For a more detailed explanation of the importance of scaling and the challenges it presents, I would refer you to the last edition.
On-chain scaling simply means, making changes to the blockchain so that it can handle more data at any one point. In the context of monetary assets, this typically refers to the number of transactions per second (tps) that a blockchain can handle. Right now, there are three main approaches to increase on-chain scaling, namely: block size increases, block time decreases and sharding.
Block Size Increases
Block size increases as the term suggests simply means increasing the cap on the upper limit of a block. In the early years of Bitcoin for instance, as demand increased, developers simply increased the upper limit all the way until 1MB where an impasse was then reached. At this point, a huge debate ensued about whether to increase the block size further, ultimately resulting in the Bitcoin and Bitcoin Cash split. Block size increases typically return a linear increase in scalability, for example, a doubling of the block size typically results in a near exact doubling of scalability.
Proponents of this approach say it is a simple, well-tested and practical approach. Detractors object though that it will lead to the centralization of mining and full nodes since it leads to an increase in the blockchain size, thus enforcing very high data storage requirements on node operators and small-scale miners.
Right now, the two main projects pursuing block size increases worth mentioning are Bitcoin Cash and Digibyte. Bitcoin Cash is a serious project. The development team behind the project have already successfully increased the BCH block size from 1 MB to 32 MB with plans eventually to move up to 1 TB blocks. The Bitcoin Cash approach is to implement hard forks whenever they do such an increase. There is a risk though that these become contentious and lead to splits as has already happened between Bitcoin Cash and Bitcoin SV. Conversely, Digibyte, a lesser known project has actually included automatic block size increases as part of their protocol without any need for contentious hard forks. As such, the Digibyte block size doubles every two years automatically.
Block Time Reductions
Aside from block size increases, there is one other variable that can be tweaked to increase scalability, namely block time reductions. Block time simply refers to the frequency that blocks are added to the blockchain, i.e. a 10 minute block time, means that a new block is confirmed and added every 10 minutes. The one monetary project that has pushed the boundaries of this variable is Digibyte. Whereas Bitcoin and Bitcoin Cash use 10 minute block times, Digibyte uses just 15 second block times. As such, blocks are added 40 times more frequently, resulting in a corresponding 40x increase in scalability. Indeed, by innovating on two variables rather than just one, Digibyte has been able to achieve very impressive on-chain scalability, boasting an impressive 560 tps versus the comparatively anaemic 7 tps on Bitcoin.
Aside from tweaking these two variables, there is an alternative on-chain scaling approach that is far more radical and reimagines the very idea of a blockchain. This is called sharding. A blockchain is broken up into hundreds of smaller data sets called shards, each processing different transactions. As such, it is possible to increase on-chain throughput by up to 1000 times and theoretically, through something called quadratic sharding, achieve near-infinite on-chain scaling. Right now, only platform protocols such as Ethereum and Zilliqa are actively pursuing sharding.
Importance of Hedging
Anyone who has spent any time in the crypto ecosystem will be all too aware of the intense and at times belligerent debate between on-chain and off-chain scaling advocates. As I have said before, for now, this debate is all theoretical. The only way to know which approach will work best is for both to be tested in the real world against each other. We are now starting to move into that phase as both camps are reaching production level. My personal philosophy due to this uncertainty is to hedge my portfolio between the two approaches. This means allocating near equal amounts to on-chain scaling focused projects like Bitcoin Cash and Digibyte as off-chain focused projects like Bitcoin and Litecoin.
Financial & Market Trends
Over the past two weeks, as I am sure you are aware Bitcoin has surged, sitting at $6,270 as of today. However, during this move, we have for the first time this year seen a significant divergence between Bitcoin and the rest of the market. Last time I told you about the heavy resistance we would encounter for Bitcoin around the $6,000 level. In fact, the resistance really lies in a range of $6,000-6,700, in which we are now in the middle of.
We cannot call a true bull market in my opinion until we break above the upper limit of this range with respectable volume, retest the range and start another leg up from there. Until then, it is still possible, that this is a bear market rally. I think this scenario is unlikely, but it is still a possibility, for now, so please bear that in mind.
I do expect the divergence between Bitcoin and the rest of the market to shift over the next 10-14 days, however. Indeed, as per previous legs up in Bitcoin, capital will likely spill into the major altcoins and then the smaller caps.
For those unaware, we have had significant turbulence in the space over the past 14 days. Specifically, there have been major concerns about the health of the major stablecoin, Tether and its exchange partner Bitfinex. Secondly, the highly popular exchange Binance suffered a $40 million dollar hack this week. Despite the severity of both these blows, the market has been extremely resilient. This impressive resilience gives me much more confidence in the validity of this move.
To understand where the crypto asset markets are going, it is essential to have an appreciation of the global markets and macroeconomic climate. In order for the crypto markets to expand, there must be capital inflows from other asset classes and markets. Understanding the stresses elsewhere helps us understand when, where from and by how much the crypto market could move. Importantly for us, there have been developments in the past two weeks.
Hastening Demise of Europe
The slowdown and political turmoil in Europe have continued to worsen. During previous crises, northern European countries, specifically Germany have been able to compensate for the weaknesses in the Mediterranean nations such as Greece, Italy and Spain. What is particularly worrying this year, is the weakness of German economic data. German real GDP (inflation adjusted) was in decline in Q3 of 2018, flat in Q4 and marginally positive at 0.1% in Q1 of 2019. The most worrying part is that manufacturing, the linchpin of German economic strength, is contracting at a very alarming rate with March representing the fifth continuous month of declines in factory orders.
German industrial problems are echoed in kind by its banking problems. The beleaguered Deutsche bank’s merger with Commerzbank fell through at the end of last month. Deutsche has been under pressure for years due to low profitability, the effects of prolonged record-low interest rates, poor competitiveness and a myriad of scandals. Deutsche is particularly worrisome because it not only is Germany’s largest bank but also has one of the largest derivative books of all global banks. Indeed, a full-blown crisis would certainly have ramifications across the globe.
The Turkish Problem
Unfortunately, there is another prominent threat to European banks, one from just outside its borders. The problems in Turkey, specifically in regards to inflation, its currency and reserve assets presents a major threat.
President Erdogan's interference in Istanbul elections has set off renewed fears about the limitations on the leader’s power and reach. Investors are particularly rattled by his perceived increasing grip on Turkey’s central bank and its ability to set sound monetary policy.
The Turkish Lira has started to depreciate against the US dollar just like it did last year at a rapid rate. Turkey is experiencing a currency collapse. Simultaneously, Turkish debt has reached toxic levels both on the government and corporate side. Private debt to GDP stands at 170%. The real issue is that much of this debt is denominated in foreign currencies. The collapse in the lira, therefore, makes this a lot worse.
From a European perspective, this could be a real threat to financial stability as the majority of this Turkish debt is held by European banks, particularly Spanish, French, Italian and German ones, all of whom are already under significant pressure. In July, $179 billion of Turkish debt is due. If the fall of the Lira continues between now and then, we could see multiple major Turkish defaults, with European banks, left holding the bags.
Implications for Crypto
So what does any of this have to do with the crypto markets?
Put simply, a crisis in the Eurozone will undermine citizen’s confidence in the banking system and perhaps even the Euro, pushing them to seek alternatives to protect their purchasing power and any wealth. Please remember that during the last Eurozone crisis, there were actual bail-ins. This meant that people’s money was seized from their bank accounts overnight with no warning or choice whatsoever. Many European countries now have bail-ins as part of their legislation.
When the next crisis hits, we are likely to see mass financial instability and unprecedented government actions. In this scenario, crypto assets, especially those with a monetary purpose, should do extremely well.
My Outlook & Positioning
Given the strength of Bitcoin, I moved out of my positions last week in most small caps. I plan on staying in Bitcoin and the major altcoins (Ethereum, Bitcoin Cash & Litecoin) for the next 7-14 days right now. If my reckoning is correct these major altcoins present the best risk: reward opportunity currently.
I hope that you found this edition useful and informative. As ever, none of this is investment advice, please do your own research!
I would love to hear your feedback on these newsletters. If there is a particular topic or angle that you would like me to discuss, then do please let me know and I will be sure to tackle it in future editions.
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