It has been four weeks since the previous edition of State of the Crypto. Please accept my apologies for not being in touch during this period, however external circumstances meant I was unable to write a full edition.
Since we last spoke, the crypto asset market has been on an absolute tear. Prices, especially those of Bitcoin are up significantly and animal spirits have returned with a vengeance. The strength of this uptrend has surprised me and I am extremely positive about the remainder of 2019.
In this edition I cover:
The impact of Facebook’s new Libra coin
The relevance of the Hong Kong protests for crypto assets
My market outlook for the summer
Libra - The Start of Mass Adoption?
The media has been in awe this week covering Facebook’s new Libra coin. To be honest though, for a company as disruptive as Facebook I was expecting something much more innovative and exciting than this. The Libra coin is essentially a quasi-cryptocurrency, backed by fiat currencies and government bonds, aka debt. Facebook’s attitude is that fiat currency and bonds have intrinsic value, while most cryptocurrencies do not, hence the need to back up the coin with these traditional assets.
The Value of Crypto
This viewpoint is of course diametrically opposed to the entire economic premise of crypto assets like Bitcoin.
Bitcoin’s value is driven by its network effect, i.e. the size of the network that uses it. However, this is simultaneously underpinned by its technical and monetary properties. It is limited in supply, disinflationary, censorship-resistant, highly divisible, portable, borderless and somewhat fungible.
In contrast, Libra shares few of these essential properties. Libra is essentially a redesign of PayPal. Although Libra’s White Paper states that it will utilize a blockchain, it will cost up to $10 million to run a node and participate in the network. As a result, only major corporations are likely to participate and secure the network. The network will be a centralized, corporate-owned blockchain with censorable digital currency running on top of it. Why they even use a blockchain in the first place is questionable, and I suspect the decision is driven more by PR and marketing than a fundamental appreciation of the value of blockchain technology.
One Among Many
It is highly likely, that over the next 24 months we will see a wave of other technology companies unveil their own ‘cryptocurrencies’. In addition to any success they enjoy, they will also serve as free marketing for genuine crypto assets as the general public is introduced to this technology.
Of course, there is no guarantee that their attempts will even be allowed. US lawmakers are already pushing back against Libra. They are suggesting that this will lead to further monopolization, increase Facebook’s political power and undermine user privacy by binding transactional activity to the swathe of personal information the company already holds. Given that there are also investigations by regulators into the monopolization of Facebook and other technology companies with antitrust movements brewing, these attempts at digital currencies might end being false starts. Either way, they certainly do not pose a threat to existing cryptocurrencies. The real victims of these moves, if successful, will be banks, money transmitters and payment providers like Visa and PayPal.
A Win for Open Blockchains
The most bullish scenario for real crypto assets in this scenario is another privacy scandal. Despite remarks by Zuckerberg that Facebook will be focused on protecting user privacy, there has been little substance to validate these commitments. It is highly likely that more abuses of privacy are waiting to be uncovered. This situation would then likely spark a debate about the monetization of user data and the data mining practices that the company performs while discussing the advantages that open and public financial systems like Bitcoin provide.
There is clearly a lot of potential for large scale transactional volume to occur on social networks given the attention they capture. However, there is no inherent reason that value has to be captured by proprietary services as opposed to decentralized and open ones. Open and public blockchain projects that are able to leverage the existing attention of these social networks could be the largest benefactors of all.
In the last edition, I covered the weakness of the Chinese economy and the impact that the Trump administration’s tariffs will have. There has since been more data showing a continued weakening within China.
Simultaneously, the world has witnessed the demonstrations in Hong Kong regarding a proposed extradition treaty. This treaty is hugely important for the strength of China, relations with the West and the move towards crypto assets from the Chinese public.
Portal to the West
Since the British rescinded control over Hong Kong in 1997, the West has recognised it as an autonomous region independent from the totalitarian controls of the Chinese mainland. With this, a series of rights and privileges have been afforded, including open access to Western financial markets. These rights have in turn been a very convenient route for the Chinese authorities to raise dollars and maintain diversified and plentiful reserves.
The catch is that these rights are neither guaranteed nor open-ended. Every year, for instance, the US president, at the recommendation of the State Department has to decide whether to continue this relationship with Hong Kong. The advice consented by the State Department is determined by the degree of Hong Kong’s autonomy and its accordance with Western norms, particularly judicial ones.
The extradition treaty that the Hong Kong authorities are trying to pass is in direct contradiction to these values. The treaty allows for Chinese authorities to seize and extract any Hong Kong citizen to China if they accuse them of a crime that is also a recognised crime in Hong Kong. In short, this legislation undermines the entire judicial independence of Hong Kong and centuries of Western judicial practice.
Crossing the Rubicon
For now, the protests seen these past few weeks has put the legislation on hold, however, the authorities intend on repackaging and passing it by other means. There is a very high chance that if successful, the US may revoke the privileges afforded to the region. The resulting effects could prove disastrous for the Chinese, as it would block off their route of raising dollars which they are running out of fast, along with other reserve assets. This blockage would make its current account, fiscal account and reserve holdings position calamitous. We could be a mere matter of months away from a major banking and financial crisis in both China and Hong Kong.
At the same time, it has been noted that much of the recent demand for crypto assets has been driven by East Asian investors. It is no coincidence that as the frailty of the Chinese economy is exposed and investors become wary of a crisis, that crypto assets become the benefactor. The portability, censorship resistance, and borderless nature of them make them an ideal mechanism to move capital out of China and hedge risk.
It is possible that positive news comes out of discussions between Trump and Xi Jinping at the G20 next week, however, it is highly unlikely that anything near-resembling a full resolution is reached. I strongly believe that a widespread financial crisis will be hitting East Asia before the end of the year. Given this, I expect the growing inflows to the crypto markets from the region to only accelerate and perhaps go exponential for a period in Q3 and Q4 of this year.
Today Bitcoin sits at $9,100 and is range bound between $8900-9400. Breaching $10,000 would be a major marker for Bitcoin and the rest of the markets given its psychological significance. Furthermore, despite the euphoric movements towards the end of 2017, Bitcoin has actually spent very little time above this level. Sustaining a break above this level could well result in a similar melt up. However, in the shorter term, I think we are likely to see a retrace.
First of all, market sentiment is essentially euphoric right now, even if that is not matched by institutions and the wider retail investment public. At least within the crypto market right now, participants are overwhelmingly bullish. The Fear & Greed Index is right now at 82, signalling ‘extreme greed’ as the chart below shows.
This index essentially measures and tracks the emotions and animal spirits of market participants. When sentiment gets into extreme territories at either end, as it is just now, it is usually a very strong signal that the market is overbought and a retracement is needed.
On the fundamental side, my indicators are also flashing a warning. One of my favourite fundamental indicators is something called the NVT ratio. This stands for the Network Value to Transactions ratio and tracks the on-chain usage of a crypto asset relative to its market cap or network value. Since crypto assets are monetary vehicles, they are intended to be used as stores of value and as mediums of exchange. The NVT ratio tracks the relationship of the medium of exchange function relative to price. Ideally, we want, the usage of a blockchain to track its market value, as it is representative of usage rather than just speculation.
Critics of the ratio argue that it is irrelevant as these assets are driven almost exclusively by speculation and institutions are buying them merely to sit on, rather than use in transactions. While this is somewhat true, the ratio has been a strong indicator of reversals throughout Bitcoin’s history. More specifically, an adapted signal called the Kalichkin NVT indicator has been a more accurate and predictive signal of such reversals.
As you can see below this signal has given preemptive warnings of every other significant pullback in Bitcoin’s history.
Right now, this indicator is well above the healthy range and may well be telling us that we are in for at least a short term fall.
Beginnings of Historic Bull Market
All this being said, I believe these warning signs are consigned more to the short-term. We are now in a very strong bull market with a global-macro picture conducive to major inflows of capital from legacy markets. At the same time, it looks like this summer could well mark the start of genuine investment from institutional firms. The Bakkt exchange, owned and operated by ICE, who also owns the New York Stock exchange along with several other major global exchanges, is set to launch its futures products towards the end of July. Once we break the $10,000 mark for Bitcoin, we are set to witness the largest crypto market cycle yet.
What is striking about this cycle so far is the dominance of Bitcoin relative to the rest of the altcoins. This dominance has grown in recent weeks. I expect that this trend is about to reverse and indeed some early signs have emerged in recent days with Ethereum, XRP and Litecoin beginning to show positive divergence from Bitcoin.
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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