Never Waste a Good Liquidity Crisis

Key Takeaways

Weekly Market Recap

For the first time in over a month, Bitcoin failed to establish a new local high, as its price fluctuated between $47,000 and $49,500 for the week ended Wednesday morning.

Ethereum continued to trade between $3,000 and $3,250 throughout the week until demand entered the market on Monday evening, launching ETH beyond $3,400 on Tuesday and to a local high of $3,560 on Wednesday morning, marking the first time ETH has traded above $3,500 in over three months.

The premiere of Layer 2 scaling solution Arbitrum One, which launched its Mainnet on Tuesday, seemingly catalyzed the surge in $ETH price Arbitrum, like other Layer 2 networks, enables developers to build decentralized applications with faster transaction finality while continuing to leverage the decentralization and security of Ethereum. This increased demand was met by favorable $ETH supply dynamics that we will touch upon in the sections below.

Despite the resistance faced at $50,000, $BTC remained above the 200-day SMA for the duration of the 7-day period. To reiterate one of Tom Lee’s top rules of Bitcoin investing: always buy above the 200-day SMA. We would also like to note that the gap between the 50-day SMA and 200-day continued to close, which constitutes a positive trading indicator for many.

A September to remember?

There is plenty to romanticize about September – cooler evenings, autumnal foliage, pumpkin spiced lattes from your local barista. Unfortunately, there is no love lost between Bitcoin investors and the ninth month of the year. Dating back to 2011, September is the only month in which $BTC has experienced a negative average return. Based on the chart below, we can also see that the patterns in monthly returns roughly match the seasonality we experienced the past 12 months, with price increases in late-fall to early-winter followed by an all-time high in April.  

Source: Glassnode

Below we break down Bitcoin’s performance in September by year. We are on a 4-year streak of drawdowns.

Source: Glassnode

To be clear – we do not view this as a reason to trim any positions. Bitcoin having traded bearishly in the past September months does not preclude it from reversing the trend this time around. We are merely putting these charts front and center to present interesting context about Bitcoin’s past and to prepare investors for further opportunities to “stack chips” into Q4. As we will discuss below, the current supply dynamics and macro picture continue to lean bullish. Thus, even if Bitcoin continues to mirror its historical seasonality, October through December could present an opportunity for outperformance.

Positive supply dynamics persist

For several weeks, we have emphasized the favorable supply dynamics on the Bitcoin network and their positive impact on $BTC price. As coins are removed from centralized exchanges and long-term holders build their positions, the liquidity of the circulating Bitcoin supply decreases. This subjects investors to potential supply “squeezes” in which the market lacks sufficient liquidity in the face of a sudden uptick in demand.

Last week, we noted some apparent midweek profit-taking signaled by coins moving out of self-custody wallets and back onto centralized exchanges. We noted that this was likely a short-term anomaly rather than a pattern reversal. Since that time, our prognostication was proven correct. As demonstrated by the chart below, coins are once again being removed from exchanges, as the aggregate $BTC exchange balance nears levels last seen in April 2021.

The red arrow on the chart below indicates the acute movement of coins onto exchanges that caused a stir in the market last week, while the green arrow highlights the subsequent removal of coins from exchanges and a continuation of this bullish pattern.

Same story, different chain 

We think it’s time to start paying attention to Ethereum supply as well. On August 4th, we discussed the latest upgrade to the Ethereum network, EIP-1559, and its potential implications for $ETH price. As a refresher, EIP-1559 removes the opaque bidding process for gas and replaces it with an algorithmically determined “base fee”. Pre-upgrade, users bid on how much gas they were willing to spend to have their transaction included in an upcoming block. Miners then decided which transactions they would facilitate based on bid amounts. The issue with this system is that the bids were mere estimates suggested to users by their wallets and may or may not have represented the correct gas needed. This caused users to overpay for gas – a problem that rapidly compounds in an active market and results in highly volatile fees and network congestion. In addition to improving user experience, we viewed EIP-1559 as a major update to Ethereum’s monetary policy. Pre-upgrade, transaction fees were paid to miners. Under EIP-1559, base fees are “burned” or permanently removed. Since the base fee must be paid in ETH the burn puts disinflationary pressure on ETH’s circulating supply. Theoretically, during times of high network activity, the amount of ETH burned could exceed new ETH issuance from block rewards (2 ETH every block) making the network net-deflationary.

Since that time, the Ethereum network has burned over 155,000 ETH, equating to nearly $500 million in total value at current market prices. Since August 4th, the price of $ETH has increased by over 30%, spurred on by the latest NFT craze. Network activity has led to a disinflationary, and at times deflationary, supply schedule for Ethereum. We anticipate this dynamic to continue.

Further adding to Ethereum’s favorable supply dynamics is the amount of $ETH that staked in the ETH 2.0 contract. As many crypto investors are well aware, the Ethereum network’s ultimate goal is to transition from a proof-of-work network to a proof-of-stake network. To facilitate the transition, $ETH holders can commit their $ETH to a staking contract, which earns the holder staking rewards but is subject to a lock-up period. Needless to say, this effectively reduces the amount of liquid circulating supply, potentially leading to similar supply “squeezes” we anticipate Bitcoin being subject to. As we can see in the chart below, the total value staked continues to climb, currently hovering above 7 million ETH.

Based on the trajectory of ETH staking, the burn rate of EIP-1559, and the continued entry of ETH into other “smart contracts” across the decentralized ecosystem, we see the potential for outsized supply-driven returns for Ethereum over the near-to-medium term. 

Put/call ratios reflect positive investor sentiment

On the derivatives front, we see a continued reluctance to short both $BTC and $ETH as the put/call ratio for each has nosedived over the past three months. As of Tuesday evening, Skew data displays a put/call ratio of 0.49 for Bitcoin and a 12-month low of 0.48 for ETH across all derivatives exchanges. 

The put/call ratios for Bitcoin and Ethereum last reached current levels in June 2020 and March 2020, respectively. We view this positively as investors are less concerned with hedging downside risk at current price levels. We expect that this is likely due to the “tame” march higher that we discussed in last week’s Crypto Weekly.

Alpha opportunity update

On August 18th, we highlighted an opportunity to outpace any potential returns on $BTC and $ETH by purchasing Bitcoin and Ethereum Grayscale products, especially if you were part of an institution or must gain exposure to crypto through traditional equity products.

At the time we observed discounts to NAV on both the Bitcoin ($GBTC) and Ethereum ($ETHE) Grayscale trusts of 15.31% and 12.87%, respectively. The caveat with this play is that the reasons for Grayscale’s NAV disconnect are opaque and hard to isolate, so purchasing Grayscale shares in hopes of a reversion to NAV may require some patience.

Fast forward to today, and we can see in the chart below that increased demand for $ETHE has narrowed the gap between share price and NAV as the discount currently stands at 2.81% – meaning that if you bought $ETHE on August 18th, you would have achieved a 26.2% return on your shares, a nearly 10% premium to the 16.9% return on $ETH. 

We wanted to highlight this fact as the discount on $GBTC is still above 15%, as demonstrated by the chart below. This may be something worth allocating to in anticipation of the next leg up.

The bottom line

At the risk of sounding like a broken record, we continue to maintain a bullish stance through the remainder of the year. Regardless of any near-term selling pressure, on-chain data coupled with a dovish stance from the Fed positions both Bitcoin and Ethereum for a bullish run into this fall. We think that any “choppiness” through September should be viewed as an opportunity to allocate to Bitcoin and Ethereum for the moment that traditional capital allocators move higher up the risk curve, and we start to see leverage enter the market. If new data that contradicts this thesis enters the picture we will advise on our change in stance, but until then, we think the setup for a prolonged bull run remains intact.

Crypto on Capitol Hill (Continued)

Last week, the US House of Representatives approved a $3.5 trillion budget bill despite reluctance from a steadfast group of moderate democrats that wished to debate the infrastructure bill before approval of the budget. In exchange for their votes, House Speaker Nancy Pelosi committed to passing the infrastructure bill by September 27th. 
For those just entering the fray, the infrastructure bill has garnered plenty of attention from the crypto community due to how the legislation defines a “broker.” We have spoken about this in past Crypto Weekly reports, but to recap: the bill had cited a $28.0 billion “pay-for” sourced from tax revenue paid by crypto brokers. The area of concern was related to the broad definition of “broker” used within the bill, which left many in crypto circles to believe that this leaves parties such as wallet developers, miners, and node operators subject to the same tax reporting requirements as centralized brokers. 

Competing amendments that offered different levels of specificity surrounding the definition of a broker were brought to the Senate floor, and after intense lobbying and public outcry, the rival groups of Senators were able to reach an agreement on an amendment that narrowed the crypto-related language in the infrastructure bill. The compromise was presented to the Senate by Toomey for unanimous consent, meaning that a single objection would kill the proposal. Senator Richard Selby from Alabama offered approval contingent on his defense spending package being added to the bill. The combined amendment was struck down by Bernie Sanders, thus torpedoing the revised crypto amendment as collateral damage and making it highly likely that the original language will be what ends up in the final bill.

As the bill still needed to go through the House, many in crypto circles still felt there would be an opportunity to amend the language during the House debate. However, according to our Policy Strategist Tom Block, the passage of the budget bill signaled the end of any House debate. 

Here is Tom providing us with a lesson on the nuances of House Parliamentary procedure:

The House has long had rules that govern how a bill is debated and amended on the House floor. With 435 Members without ground rules on the debate, bills might never get passed. Therefore, nearly every bill that comes to the House floor is given a “Rule” that is adopted by the House before the bill being debated. Each Rule sets the time for the bill to be debated, whether amendments will be allowed, and often limits the number of amendments to be offered.  An Open Rule means any amendment may be offered, a Closed Rule means that no amendments may be offered, and a modified closed rule specifies which amendments may be offered.  

As the Senate passed bipartisan infrastructure was a carefully negotiated package, most observers of Congress thought it would come to the House under a Closed Rule.  Indeed, under the compromise reached last week between the moderate Democrats and the Speaker, the bipartisan bill will be voted on in the House under a Closed Rule.

There will be other opportunities for Congress to consider a technical fix to the broker definition, and as the IRS writes rules to implement the disclosure procedure there will be opportunities to influence the definitions.  This is especially true since Senator Wyden was a big supporter of changing the sloppy disclosure language, and he chairs the Senate Finance Committee that has jurisdiction over the IRS.

Despite a lack of opportunity for the House to amend the definition of broker, our stance on this topic remains consistent with our prior convictions. On balance, this is a bullish moment for the industry. This piece of hastily crafted legislation will certainly usher in an era of legal and regulatory battles for crypto, but that is part of “growing up.” We witnessed a relatively small industry puff its chest and flex its decentralized muscle through community mobilization and lobbying efforts. Led by trade groups such as the Coin Center and The Blockchain Association, the crypto industry stalled an overwhelmingly bipartisan infrastructure package that was seemingly 5+ years in the making and made DC take notice. We expect investments in legal, compliance, and government relations to increase and for innovation in decentralized platforms to accelerate following this battle on Capitol Hill, as crypto further entrenches itself into the mainstream consciousness.