Long Take: What the market misses about Bitcoin and Ethereum in 2021

Hi Fintech futurists --

This week, we cover these ideas:

  • Crypto prices show increasing correlation in market swings, which hides the large substantive differences between projects

  • The core narrative of Bitcoin, and its fundamental indicators

  • The core narrative of Ethereum and Web3, and its fundamental indicators

  • A sanity check on potential market caps relative to gold, equities, and other assets

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Long Take

Now and again, we have to invoke these specters from the deep market dimensions where they reside. Come with us, apparition, let us read our fortune in the tea leaves.

Here is one of the worst charts. Drink it up.

This chart shows the normalized performance of Bitcoin and Ethereum over a one year period. BTC is up 250%. Ethereum is up 760%. Of course both are down, a lot, over the last month or so. There is no point in pointing out that waves roll in and recede, nor that time flows only forward as technological progress accrues.

It is not due to the volatility that we think this is one of the worst charts. Rather, it is that the chart tells us very little information.

Price is meant to be a summary of a thing, derived as a signal out of collective wisdom applied to a broad, complex information set. The market ingests reality and outputs an integer. We, the organs of the market, recursively generate concepts and ideas until the functions congeal into the magic answer. The price.

The efficient market hypothesis would have us believe that information advantages, like knowing what a blockchain is, or thinking that a network with no transactions is worth less than a network with transactions, get absorbed into markets through arbitrage opportunities. If you have an information edge, no matter how fundamental or obvious or small, you act on that edge, and get rewarded through profits over some time period. Therefore, incentives force rational actors to rationalize irrational markets.

But let’s not forget that social media and memetics exist, in part, to make machines out of our lizard brains and network them into the limbic system of the Internet of attention.

The price, then, is not just a cold calculation of truth revealed. Rather, the price is a signal to be politicized, warred over, and worshipped. If you can more easily move the sacred number with your heart than your mind, which would you choose? No need to do math homework. Just join the bannered tribe of the Bitcoin maximalists, Link marines, XRP army, Doge army, or some other multi-agent Twitter centaur, and tear into anything and everything that stands counter to your narrative!

The fact that people dote on price, and do nothing but talk about it — as a flag — is not new. But perhaps the amount of purchasing that is done based on that flag-waving alone is novel. Financial rallying cries are now the norm to teach enemies their lesson in financial ruin. The entertainment and spite of it is worth the cost of entry.

Another data point that says prices aren’t telling us much is correlations. Coinmetrics has a fantastic tool for plotting crypto asset correlations here. We can see correlations across projects starting to converge to the 0.6 to 0.8 range. Assets with very different stories, such as Bitcoin, Ethereum, Uniswap, Aave, Binance, and Yearn are collapsing any difference in performance towards higher and higher correlation.

Perhaps this signals a lack of discrimination by institutional actors when they take an asset allocation approach. This would imply putting money into a “sector”, rather than into a project. Thus you would put 10% of your hedge fund into crypto, rather than into particular assets. Then, when there is a need to deleverage or rotate into a different position, you would reduce a portion of your overall allocation, and thereby impact all the sub-component parts.

But it’s a bit hard to believe. The crypto funds playing in the space are immensely sensitive to risk and market structure, being pioneers among their peers. We are not talking about large, blind passive vehicles turning over forgotten positions.

Maybe instead the interconnected nature of leverage, and Bitcoin’s status as the store of value, has retail actors selling off well-performing but non-core assets to park whatever remains into Bitcoin. As the market overall has become bearish, selling off winners to pay off collateral calls or to turn off risk starts making sense. This seems more likely, and also sucks.

Lastly, it doesn’t make much sense to compare percentage changes either. Bitcoin is larger than Visa and its network market capitalization, now worth more than $600 billion. Ethereum is more valuable than Goldman Sachs, at over $200 billion. The longer tail of crypto networks floats somewhere in the hundreds of millions, to the tens of billions. Simply put, it is harder to grow fast from a larger base than from a smaller base. Or at least, it should be (looking at you Amazon!). This is another reason for correlations to converge, as network size move from the growth phase into defense mode.

Most crypto projects are growing into their valuations. That means they should be experiencing uncorrelated, fundamental, performance-based growth. Does it feel like this is the case reflected in the markets?

And further, different projects will grow into very different organisms — some with small narrow uses and limited revenue pools, and some into enormous oaks worth trillions of dollars.

The size of the opportunity is often counterbalanced by the likelihood of the opportunity bearing fruit. In all cases, it is important to track what the thing is likely to become if all goes right.

Sanity Check

We made the below slides in 2017 as the ICO boom was heating up, and Twitter personalities made predictions of $1 million Bitcoin. At the time, the market sat at $300 billion and we wanted to sanity check how much more exponential growth there was to load.

The first step was to disambiguate stocks (or levels of value) from flows (or changes in value), and thus to separate discussion of revenue or transaction volume in a network from its valuation. Such argument is largely behind us.

However, this analysis continues to ring true as the total crypto market cap fluctuates between $1 and $2 trillion in value. If the market value of all gold is about $10 trillion, give or take a few, then a 5x or 10x run in Bitcoin requires only its self-fulfilling prophecy to come to fruition.

All public equity, representing shares of 53,000 listed companies, are worth about $90 trillion today. So we can give crypto-assets about 50-100x growth when looking at an economy powered by human organization. DAOs, eat your heart out. Further, total wealth sits at somewhere between $250 and $500 trillion. That ekes it out to a 100-200x from today’s market capitalizations.

Does the world have to melt down and be reborn of grey blockchain-goo to make this work?

No. It just needs time to co-evolve. For example, ecommerce is still co-existing with physical commerce, despite the fact that one is melting and the other is accelerating.

But it becomes a matter of time, rather than something to debate.

Bitcoin’s fundamentals

In our discussion of the short-term wrongness of price, we seem like crazy people yelling at the wind! It’s all wrong! It’s not like the fundamentals! So if one is interested in being rigorous in thinking about crypto networks — and in particular Bitcoin and Ethereum — what are the metrics to actually track?

Bitcoin and Ethereum come with very different stories, and thus the thing to track them is quite different. If you would like the maximalist BTC take, check out this thread:

The short of it is that Bitcoin is digitally scarce, and therefore can be viewed as “hard and sound” money. The hardness refers to how difficult it is to create additional units of the currency. It is backed by its mathematical truth — with supply limited as pre-ordained by code. While the Chinese authorities may attempt to stomp out Bitcoin mining like a weed, this does little to change the network’s ability to secure transactions and generate a store of wealth for people who want to do so away from their governments.

In this way, Bitcoin is a political tool aimed at sovereigns, meant to strip away their monopoly on wealth. To the extent that a country cannot collect taxes, control its economy through monetary policy, and otherwise rule its people economically, that country is not sovereign in the medieval sense. When a decentralized Internet nation comes with its own decentralized Internet currency, and its robot promises of freedom and happiness, citizens of a country have an easily-accessible alternate to their hegemon. We may soon find a better social contract with a DAO than with a corporation or a nation. Thus the sovereign will use force to enforce the social contract it finds existential.

However, Bitcoiners believe market forces to be inexorable, assuming infinite demand. And so far, their view of the world has some good evidence. For example, the Bitcoin stock to flow model takes the schedule of BTC emissions with its halving events and overlaps it nicely on a logarithmic scale with the BTC price. The logic is that the harder it is to generate the next Bitcoin, the higher the price of Bitcoin will be.

But you know, maybe this is also just two exponential charts overlayed on top of each other? Like, you take one number and divide it by 2 and then you take another number and you multiply it by 2, and then you mess around with the vertical axis until your time period matches.

Another bit of the puzzle, when you know what supply looks like, is to try and project demand. There are various analytics about which types of accounts are selling (e.g., large of small), institutional inflows and outflows, and other leading indicators to transaction count. In some sense, this is an attempt to quantify how people feel about the future, and all sorts of alchemy exists in looking at social sentiment.

Still some of the best charts in our opinion for understanding the current valuation of Bitcoin have been developed by Willy Woo and are available here. The NVT cap, which is based on historic money flows relative to network value, suggests Bitcoin should be worth over $1 trillion. The value of all coins at the price of their last transaction is $370 billion. The market is floating somewhere in the middle.

Note, however, that the main variables in all these models are how Bitcoin relates to its own value. It is valuable to the extent people paid for it — the store of value — and at what rate they are performing such activity. And frankly, we can’t tell apart correlation and causation, because by design much of finance is recursive, reflexive, and self-similar.

Computation and Web3

It is a breath of fresh air to switch from talking about existential geopolitics and who gets to be the money god — a monarch, a president, or a computer program — to talking about creative computation.

Once you layer in programmability into blockchains, you are no longer constrained into talking about money. Yes, money is lovely. But it is also a mere derivative of actual things that actual people do. Money does not exist without some work that has gone into the tangible world, and then became abstracted into something else.

To us, it is that work that is important. While upgrading the transformation function that saves abstractions to be more modern and free is a gigantic opportunity, can’t we have a digitally native economy first instead of worshipping the golden calf?

Paying for your sandwich in BTC or Apple stock is not a digitally native economy. Building software that runs on Ethereum, or another bridged computational blockchain, definitely is.

Having open-source, mutualized financial engines that provide the best financial functionality in the world is a worthwhile goal. Fixing the original sin of the Internet by rewiring human creativity out of attention-eating advertising monsters and into economic exchange seems like a pretty good goal too. Designing, congealing, and governing an emerging Metaverse to make the cyber expanse feel grounded and worth inhabiting may be the largest goal of all.

To that end, we find it much easier to root in Ethereum’s fundamentals (note that we use Ethereum here as a shortcut for all Web3). It is also clear why Ethereum welcomes non-canon extensions, whether they are scalability networks like Polygon, Optimism, or Arbitrum, or whether they are the myriad decentralized applications extending the financial uses of ETH through trading, lending, investing, insurance, structuring, and asset management. The more others build, and the easier it is for them to build, and therefore generate economic exchange and transactions, the better off everyone becomes.

This is like watching the number of applications grow in Apple’s iOS or the number of merchants connected to Alibaba.

You don’t have to believe in stories about sovereigns, digital or flesh. Rather, you have to believe in stories about the benefits of non-coercive peer-to-peer economic exchange. To that end, instead of swapping out old governments for the Internet, the thesis is that you are swapping out the old economy for the Internet.

This then is our favorite chart, showing how Ethereum’s 1+ million in daily transactions is now combined with another 7 million daily transactions from Polygon.

Or maybe this one, showing 135 million contract calls in May — the song of software running code.

We are probably too romantic about robots, but you knew that already.

Key Takeaway

As the crypto markets continue to display both (1) pronounced volatility, and (2) increased correlation between different asset types, we thought it important to articulate the main difference between the motivating purpose of Bitcoin and Ethereum. We do not think crypto prices are telling a useful or clear story — and so it is worth re-constituting the fundamentals of what one is betting on to become true.

We also haven’t really evaluated the money printing and inflation numbers in the United States.

That symptom is a countervailing one to the crack-down in China, which we think is mostly motivated by the desire to digitally manage a large country with a proprietary digital currency.

Bitcoin and Web3 are aiming for quite different goals and will take very different paths to get there. Perhaps during some beautiful singularity, they will converge. The Twitter universe will yell at you until you comply to their price narrative, so instead be vigilant and pay attention to core principles. A lot is at stake.


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