Digital Asset Fund - Update March ‘20

23 March 2020

While we were finishing this update markets were ready to open up again on Sunday night for another volatile week in which assets are looking for a bottom after weeks of extreme fear, indiscriminate selling and search for liquidity. As more and more stimulus packages hit the wires from central banks, governments and the IMF, we tried to take all the latest actions into account. Continuous newsflow and stimulus packages flurried in with the latest announcement just now from the FED, pledging for asset purchases without a limit. They call it ‘infinite quantitative easing’. The past couple of weeks have been a rollercoaster on many fronts. The outbreak of COVID-19 in Europe and in the US has increased the global impact of the virus dramatically and completely changed how we live, move and do business.

In light of recent rapid developments in the financial markets, we felt it was appropriate to shed some light on how crypto has fared and under which circumstances. This is important because the credit crunch and flight to safety that took place in financial markets has not left the digital asset industry untouched. In this piece we will share our view on the sequence of events that took place in the past week(s). We’ll start with a brief summary of the measures taken by central banks and what this means for digital assets. After that we will give a short update on the last two weeks in the digital asset market and present our expectations for the coming months. We will conclude with a brief overview of the portfolio performance.

Central Bank response

Central banks and governments have not been idle during the turmoil in the world and the economy described above. Caused by the global economy coming to a halt and a global financial market meltdown, central banks had to create liquidity to try and keep the economy going. This is a goal put forth in their mandate. The ECB kicked it off this time by announcing a 120 billion EUR asset purchasing program. Consequently the FED announced they would reduce interest rates to the lowest rate bracket possible, 0-25 basis points. In addition, the FED restarted their asset purchasing program of up to 700 billion USD and added 1 trillion USD a day in repo loans to provide additional short-term liquidity to the market. As the crisis kept unfolding the ECB revealed an additional 750 billion EUR asset buyback program to calm rates and investors.

During the time of this writing we are seeing the first forming of a $2 trillion US stimulus package, which is around 10% of GDP and should be in place in the coming three months. These major moves by central banks are generally seen as vital and justified to maintain some form of growth and the health of the economy. But it is without a doubt that we are living in uncharted territories in which governments and central banks are effectively taking over private markets. Also, it is questionable how much more bloated the central banks balance sheets can become, as the balance sheet of the ECB was already at an all time high prior to the COVID-19 outbreak. All the serious money printing to support monetary policy and fiscal packages announced, will without a doubt, have major implications on inflation expectations going forward, which will be ever more unpredictable.

We are of the opinion that the events described above will lead to two major consequences for the digital asset industry. First, the Central Bank Digital Currency (CBDC) experiments will slow down. Times of global crisis are not a time to experiment with novel digital currency issuing methods. Since we wrote this yesterday legislators in the US have proposed using CBDC as a fiscal stimulus. However we believe the actual implementation to be more difficult than expected. For example rolling out a digital wallet to all citizens in a short period of time is not an insignificant task. Second, and more importantly, we believe the devaluation of currencies and the further reduction of interest rates will fundamentally make commodities or hard assets such as Bitcoin more attractive.

This is Bitcoin’s sweet spot, it being a ‘hard’ asset with a pre-programmed supply of a maximum of 21 million Bitcoin. Further consequences of low interest rates are reducing the opportunity cost of holding a commodity which yields no interest. This effect becomes even more apparent as interest rates become negative and holding a non-interest yielding asset actually has a negative opportunity cost (e.g. a revenue) compared to an interest yielding asset, which is obviously driven by safe haven demand. This results in alternative investments becoming more attractive for investors seeking a return when interest rates are low, non-existent or even negative. We are of the opinion that Bitcoin is slowly but surely earning its place among traditional assets.

Crypto and Bitcoin – An unravelling of events

Almost every liquid, tradable financial instrument in the world has seen a sell-off in the past weeks, as worldwide economic traffic slowed down significantly on the back of multiple (semi) lockdowns. Even gold, which is seen as the safe haven asset during financial volatility and uncertainty, has seen a price decline. This is similar to the behaviour of the gold price during the global recession of 2008. In that period between the bailout of Bear Stearns and the bankruptcy of Lehman Brothers  6 months later, the gold price declined by roughly 30%. This behaviour was unexpected for a so-called safe haven asset. The explanation for this, is that massive margin calls on equities and the demand for cash caused an enormous selling pressure in all assets.

Investors sought this cash in the most liquid asset that had performed the best up until that point: selling their gold stack. The same has happened in the past 2 weeks. Sell-offs in equity markets worldwide have led to an escape to cash to cover margin calls on leveraged equity positions. This has caused the price of gold and Bitcoin to decline. We see Bitcoin as a (digital) store of value in the making, but do also understand that due to its volatility and high price swings most still perceive it to be a risky asset. In whatever bucket one decides to put it, Bitcoin was prone to the same amount of selling as gold was in these extreme market conditions.

On March 12th Bitcoin recorded an extraordinary -40% day. We will outline the main factors leading to an unprecedented sell off and liquidity event. First of all, Bitcoin has different characteristics which can lead to more extreme outcomes. In the Bitcoin ecosystem, miners facilitate all the transactions in the network, and receive Bitcoins as a reward. To finance their energy consumption and hardware costs for mining Bitcoin, miners have to sell their mining rewards (Bitcoin) for cash. This is important as miners play a major role in the ecosystem and are generally perceived to be ‘informed investors’. Instead of selling their spot exposure at low(er) prices, miners can also lend out Bitcoin as collateral to specialized lending facilities in return for USD loans to finance their operations. We have observed this miner behaviour since the end of November. Whenever the Bitcoin price sees extreme declines, these loans get margin calls, and the lending facilities sell off the Bitcoin for fiat currencies on the open market. This puts a downward pressure on the market price and can even lead to very aggressive selling at all cost as the lending facility is incurring forex risk at the time.

Another reason for the exacerbated sell-off was caused by derivatives exchanges. On these exchanges investors can use leverage, much like the Turbo model known in The Netherlands. These platforms resolve these margin calls by taking over the custody of the long position, and selling it in their own orderbook. This mechanism puts extra pressure on the price in times of large price fluctuations and thus forced selling. In the image below, we see that the amount of liquidated long positions amounted to almost $2.5 billion, all being sold off in the orderbook of various big derivatives exchanges. This led to a price crash from $6300 to $3700 on the 12th of March. Followed by a rapid recovery to $5500 on the same day. At the time of writing Bitcoin is trading at $6650 and down -7,5% YTD ($).

Market fundamentals, asset correlation & portfolio update

The advantage of the public Bitcoin blockchain is that we have insight into every transaction that was ever made. In fact, with the proper tools we can analyse the exact moment in time that every existing Bitcoin was last transacted. Without going into more technical details, this means that we can conclude who sold off their Bitcoin in the past week during the large price drop. In the image below we can see a graphical presentation of different segments of Bitcoin holders. Each colour represents a different time interval. The blue band represents wallets holding Bitcoin that have not moved for the past 5 years. The green band presents wallets holding Bitcoin that have not moved for the past 1-2 years. The yellow, orange, and red bands present wallets holding Bitcoin that have not moved for the past 1 year or shorter time horizons (for a clearer animation, the chart can be found in the link in the footer).

If we analyze the different colour bands, and how they changed during the Bitcoin sell off on March 12th, we can see that the majority of the price volatility came from addresses holding Bitcoin for 6 months or less. From this information we can conclude that long-term holders have not panicked in the weeks, and are holding on to their Bitcoin. This can be seen as a very positive sign for the future.

Now how do we go from here and how has Bitcoin fared compared to other assets? 

The Bitcoin price moved together with gold and equities in the past weeks, being closely correlated in a risk-off environment. However, the past days Bitcoin (and gold to a lower extent) have decoupled from the movements from equities, showing that Bitcoin is trying hard to live up to its uncorrelated assets status. This does not mean Bitcoin will behave uncorrelated from here, as this should be measured over longer periods of time instead of days. The below figures show Bitcoin’s performance during the last two major global equity drawdowns.

Although it is probably too early to say, the decoupling in price correlation that is currently happening between gold and Bitcoin on the one side, and equities on the other side, resembles the situation of 2008. In the end of 2008, people fled to safety: cash. People got this cash from liquidating their gold stack. Gold went down from $1000 to $730. However, when this phase was over in 2008, gold saw an enormous price increase in the following months. The bull-run in gold started in the second half of 2009, when the price recovered and started a run to $1900 as a global safe haven (chart below). Today another candidate that fulfills the requirements of ‘hard asset with low (programmed) inflation’: Bitcoin. In fact, the programmed yearly inflation rate of Bitcoin is scheduled to decrease by 50% in May of 2020. This will reduce the yearly Bitcoin emission by half, which means less selling pressure on the price by miners. This reduction in selling pressure has historically led to massive bull runs for Bitcoin up to 12 months after halving.