This week's macroeconomic data releases were not particularly exciting for investors in risk assets, as they failed to generate much enthusiasm in the markets.
Wednesday brought the release of Euro Area HIPC inflation data. The headline rate came in close to consensus forecasts at 8.6%. While still well above the European Central Bank’s (ECB) 2% target, it represents a continuation of a deceleration trend. With Brent crude oil some 30% off the summertime highs and northwest Europe natural gas prices down more than 80%, this moderation of the headline rate is expected.
Alas, the core rate which excludes volatile food and energy commodities came in at 5.3% and indicates a more worrying acceleration trend that is likely to keep ECB President Christine Lagarde on track to raise rates this year.
The main event was the release on Friday of the January U.S. Core Personal Consumption Expenditure (PCE) Price Index, the preferred inflation gauge of the U.S. Federal Reserve. The month-on-month change came in higher than consensus forecasts at 0.6%, making the year-on-year change 4.7% - far above the Fed’s 2% inflation target. Rates markets reacted by pricing in greater credibility for Fed Chairman Jerome Powell to follow through on his schedule of rate hikes. Fed funds futures now indicate expectations of 0.75% in rate hikes this year, albeit with a Christmas rate cut of 0.25%.
The dollar strengthened and share prices trended lower. The benchmark S&P 500 index has now given up more than half of its 2023 gains.
Crypto prices followed the trend of other macro markets lower. Large-cap protocols gave up most of last week’s rally, while holding onto substantial year-to-date gains. With BNB +20%, ETH +30% and BTC +40% in 2023, crypto investors seem relatively undaunted by tightening financial conditions.
But then again, crypto is certainly not like other risk assets. TradFi luminaries often criticize crypto for having a single use case: speculation. Fair enough. But what are investors speculating on?
As mentioned previously, I believe there are mostly two buckets: Bitcoin, and everything else. Notwithstanding the hype surrounding Ordinals, Bitcoin is primarily trying to be a new monetary system. The rest are aiming to be a new financial system.
The narrative regarding Bitcoin’s use case has evolved from the peer-to-peer digital cash described in the Bitcoin whitepaper, to a store of value or inflation hedge, to a neutral digital reserve asset. Each new use case seems to follow both a failure of the previous narrative and a sharp rise in price.
Using the prominent recent narrative, Bitcoin is a bet on competing with the U.S. dollar as the dominant reserve asset. With the current M2 monetary aggregate of $21 trillion, a bet that Bitcoin attains half that market cap would result in a 23x return for investors. That would give Bitcoin roughly the market cap of above-ground gold, another favored comparison of advocates.
For general-purpose blockchains like Ethereum, the narratives are more varied and complex. TradFi analogs dominate. According to DeFiLlama, two thirds of Total Value Locked (TVL) on smart contract protocols, some $32 billion, are in decentralized exchange and borrow/lend protocols. This is down sharply from the 2022 highs of over $100 billion. But a compelling case can be made that the addressable market is the financial system itself.
Companiesmarketcap.com pegs the financial services sector at a market cap of $10.5 trillion, with the top 10 worth about $2.5 trillion. The market cap of all crypto excluding Bitcoin is roughly $660 billion. A coherent pitch can be made to institutional investors that general purpose blockchains, decentralized finance protocols, along with a host of other decentralized technologies threaten to disrupt the financial system and can add substantial alpha to their portfolios.
Take the example of Visa (market cap $461 billion) and Polygon ($11 billion). It is conceivable that an L2 scaling solution like Polygon can disrupt payments infrastructure providers. Polygon is a well-funded project with native support for USDC. Its network can settle payments to any internet connection, and it substantially undercuts Visa on fees. Most of the major decentralized finance protocols have been deployed to the network, implying a certain amount of due diligence. (This blog is never investment advice)
If a pension fund investment committee buys into a thesis that Polygon could disrupt Visa, it will not take much of an allocation to add significant alpha. To take an oversimplified example, Polygon challenging the market cap of Visa would yield a 40x return ($461b/$11b). So, for example, the $456 billion California Public Employees Retirement System (CALPERS) which is running a $1 billion position in Visa could hedge it (in a certain sense) with a $24 million position in MATIC (the token of the Polygon network). It can be thought of as insurance against a specific risk, a put that can go to zero but never expires.
Disruption would compound the returns. If Polygon truly disrupts Visa, one position would pay off while the other is torpedoed. Of course, the use cases for Polygon are much more varied than simple payments, so there are more ways for that hedge to be a winner.
Could Polygon go to zero? Yes. But if Polygon succeeds, not just Visa, but some of CALPERS other big investments could be taken down a couple of pegs as well.
Facebook is vulnerable to decentralized social networks like farcaster.xyz. JP Morgan’s letter-of-credit trade finance business, to pick just one example, could be savaged by smart contracts powered by oracle networks like Chainlink. The Solana dev team has built a decentralized mobile app store just like Apple’s, but without the 30% skim.
This is a facet of the well-worn description of an investment in crypto as an asymmetric bet. From this perspective, it is possible that even niche protocols like Chainlink and Optimism could have a place in the conservative portfolios of large pensions and endowments.
The decision to have an allocation to disruptive technology broadly, and to crypto in particular, should be straightforward. But in the case of crypto, due diligence of specific protocols and companies poses a problem because nuanced expertise in the crypto space is in short supply. It is not an easy process for those putting in the work.
But as Ted Lasso said: “Taking on a challenge is a lot like riding a horse, isn't it? If you're comfortable while you're doing it, you're probably doing it wrong.”
I believe this process has begun. Bitcoin and Ethereum are understandably the first past the due diligence gauntlet. The maturity of price action in crypto markets indicates that these types of institutional investors are participating in the 2023 rally so far. This is not the FOMO and FUD crowd. They are not traders. They allocate for the long term in tranches at regular intervals.
Nor is there a stampede. Uncertainty on the regulatory front and news surrounding enforcement actions has probably chilled institutional flows from certain players. But progress on regulation has been made in other important jurisdictions, such as the European Union’s Market in Crypto Assets (MiCA) legislation which is scheduled for final approval in April.
Surprisingly, crypto regulation has also moved forward in China.
On Monday, Hong Kong’s Securities and Futures Commission (SFC) opened a public comment period for its proposed regulation of “virtual asset trading platforms” (VATPs) operated by “virtual asset service providers” (VASPs). Under the current regime, VASPs can opt into licensing by the SFC. The new bill will require licensure of VASPs, with compliance mandated by the end of a 12-month grace period beginning when the legislation is implemented in June.
Among the provisions the SFC is seeking comment on is the availability of services for retail investors. If the actions of Gate.IO and Huobi are an indication, retail investors will indeed be served. Both exchanges, which operate large retail crypto platforms, have applied to the SFC for licenses. Their respective CEOs have tweeted their enthusiasm at the prospect of serving the market.
This follows a recent speech given by Huang Yiping, a former member of the Monetary Policy Committee of the People’s Bank of China (PBOC), suggesting a re-think of China’s crypto ban.
Among other things, Mr. Huang Is quoted as saying “Banning cryptocurrencies may be practical in the short term, but whether it is sustainable in the long run deserves an in-depth analysis,”
China’s lifting of the ban would probably destroy my thesis that institutions will be the decisive players in 2023. But continuing innovation, widening adoption, and regulatory initiatives in important jurisdictions could motivate American legislators to put their own house in order. That would remove a hurdle for institutional participation and might even create a little FOMO. For now, the Gary Gensler show is the only one in town.
But the trickle continues. German powerhouse industrial conglomerate Siemens AG recently issued a €60 million bond on the Polygon blockchain. According to Siemens’ media department, the hash of the transaction could not be shared because the issue was a fully subscribed private placement.
In the press release announcing the issue, Siemens Treasurer Peter Rathgeb is quoted as saying, “By moving away from paper and toward public blockchains for issuing securities, we can execute transactions significantly faster and more efficiently than when issuing bonds in the past. Thanks to our successful cooperation with our project partners, we have reached an important milestone in the development of digital securities in Germany. We are going to actively drive their ongoing development.”
We got rid of some paperwork for a bond issue. Hooray! How long until we can get the local land registry and department of motor vehicles on board?
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