We look back at the third quarter and the events that shaped it, as well as look forward to important events in the future.
QUICK TAKEAWAYS:
The price of bitcoin increased by +25.2% during the quarter as it recovered some, but not all, of its Q2 losses.
Bitcoin is still up over +49.1% year-to-date, making it the best-performing asset class of 2021.
El Salvador adopted bitcoin as legal tender, making it the first country to do so, but the rollout has not been without technical glitches and opposition.
Network hash rate continued to recover as new hash rate came online in areas with strong property rights and green grids, like the U.S.
Digital asset regulation in the U.S. continues to be highly topical, including broker reporting requirements, numerous public comments from regulatory agency chiefs, and a focus on the prevention of ransomware attacks.
China continues to crack down on digital asset activities with a new prohibition on domestic trading activities and access to offshore exchanges.
Potential catalysts in the next quarter include the Taproot upgrade, a bitcoin-based ETF approval, and the growing use as a medium of exchange.
Bitcoin Bucks Typical 3Q Seasonal Trends
Bitcoin gained +25.2% in the third quarter, following a decline of -40.7% in the second quarter. Both of these quarterly moves counter historical trends, as second quarters have historically seen stronger performance than the third quarter. That said, this has been the fourth time in eleven years that bitcoin has had better performance in the third quarter than the second, so this price action is not extremely unusual.
Bitcoin is the Best Performing Asset Class of 2021
After the strong Q3 performance bitcoin is now up +49.1% year-to-date, making it the best performing asset class of 2021.
Bitcoin Shrugs off Potentially Negative News
Bitcoin’s bullish run started early in the quarter following a positive conversation between Elon Musk, Jack Dorsey, and Cathie Wood at "The B Word” conference. This bullish run continued throughout the quarter and shrugged off potentially negative headlines related to regulations and tax code changes. Ironically, bitcoin fell ‑10% on the day that bitcoin became legal tender in El Salvador, ending the run. Bitcoin drifted downwards over the rest of the quarter, facing other negative headlines such as China’s announcement of increased restrictions and numerous critical speeches from U.S. regulators. Bitcoin was also caught in the wake of a broad risk-off market movement following concerns about the solvency of the massive Chinese real estate development firm, Evergrande. This late-quarter reversal, however, was unable to completely erase the earlier gains.
El Salvador Legalizes Bitcoin Amidst a Rocky Rollout
On September 7th, the Republic of El Salvador achieved a major milestone by becoming the first nation to call bitcoin legal tender. This accomplishment was celebrated across the Bitcoin community, with supporters flooding in from all over the world to take videos of themselves making purchases at global franchises such as Starbucks, McDonald’s, and Pizza Hut. Transactions were enabled by the Lightning Network, a second-layer payment network that rides on top of Bitcoin and is designed to make fast payments at a low cost.
While many in the community celebrated this accomplishment, the roll-out has not been without some controversy. For one, the law is not particularly popular with Salvadorans, with various polls indicating a majority disapproved of the law. Perhaps unfairly, this skepticism was exacerbated by bitcoin’s price decline following the September 7th launch. There are also concerns with the technical implementation of the government-sponsored Chivo wallet, although it’s worth noting that third-party wallets are allowed in the country and appear to work seamlessly. Chivo wallets can hold both bitcoin and U.S. dollar balances, but the nature of these holdings for its users is unclear, concerning observers that the government may centrally control and monitor holdings. Furthermore, the international community’s disapproval is noted, with Salvadoran bond yields nearly doubling since the intention to adopt bitcoin as legal tender was first unveiled at the beginning of June. Regardless, we think the El Salvador case is important to follow and may serve as a template for other counties wishing to incorporate bitcoin as legal tender.
Hash Rate Rebounds as China Ban Makes for a Greener Bitcoin
Bitcoin hash rate fell significantly in Q2 as China cracked down on mining in a swift and pervasive manner. Before the ban, China was by far the largest mining country in the world, with an estimated 65% of the world’s hash rate, and this was reflected in subsequent data. Hash rate dropped as much as 55% from its spring peak. It has now recovered to 75% of its original value driven primarily by new miner deployments in regions such as the United States.
While the mining ban was partially responsible for bitcoin’s losses in Q2, there are significant long-term benefits to mining power leaving China. One is a greener footprint for mining. China has a relatively dirty electrical grid with 65% of the nation’s electricity generated by coal as opposed to 20% in the United States.
Another upside is improved long-term stability to the network and potentially to prices. China has released numerous edicts over the years (discussed below) with vague and repetitive language that seems to further restrict cryptocurrency activity. When a new statement is released, it can take days to weeks before the community understands its full impact, as ultimately the impact is defined less by the words on the transcript than the actions the government ultimately takes. The network is better served with activity taking place in countries with a more robust rule of law.
Spotlight: China Cracks Down on Crypto. Again.
Last Friday, September 24th, China ratcheted up the pressure on the digital asset industry once again. China, which as mentioned above was once home to 65% of the network hash rate, has had a contentious relationship with the mining industry since 2013. Over the past 8 years, various regulatory agencies and banking institutions within China, such as the People’s Bank of China (PBOC), have attempted to push out the industry in various ways. Our view is that China has taken an incremental approach to this effort because of its desire to maintain social stability. Officials in China know that its citizens own cryptocurrencies. Making a complete break or disorderly exit from the industry could jeopardize this desire for social stability. For this reason, digital asset investors should be prepared for China to continue to intervene in digital asset markets.
History of China’s Intervention with Crypto Markets
The following is a synopsis of China’s intervention with crypto markets. We have done our best to translate various policy announcements but some of the enforcement actions have been undertaken without a formal declaration.
December 2013 – PBOC Prohibits Bitcoin Risks
China’s first intervention with crypto markets came on December 5, 2013, and effectively ended the 2013 bull market. At the time, China-based investors were a big driver of the rally, with bitcoin quoted in RMB trading in China at 40% premiums to U.S. dollar–based quotes outside of China. The 2013 notice came from five ministries including the PBOC with the stated aim to “prevent Bitcoin risks.” It classified bitcoin as a virtual commodity and denied its legal status as a currency. It also forbade citizens from using it as payment and financial institutions from buying, selling, or providing bitcoin-based services, including insurance products or financial services to bitcoin-related service providers. Importantly, it did not prevent people from buying or selling bitcoin at their own risk and required exchanges to file activity with their telecommunications management agency.
September 2017 – China Prohibits ICOs and Cash Trading
The second intervention in China came from an official announcement from the PBOC and a private letter to exchanges that was reported by the media. The first announcement from the PBOC on September 4, 2017, made Initial Coin Offerings (ICOs), a popular way to raise capital by collecting bitcoin and ether for a new project’s token, illegal. The second activity, a prohibition against cash trading of cryptocurrencies, appears to have been enacted by a letter sent directly to exchanges. It required certain exchanges to stop new user registrations and wind-down activities by September 15th. Notably BTCC, and ViaBTC closed their doors during this time, while Huobi and OkCoin remained open.
January 2018 – Some Miners are Ordered to Close
While no specific regulatory pronouncement is accompanied with this event, on January 13, 2018, after much analysis from various regulators and economic and energy agencies, numerous mining entities were ordered to close. Most notably, ViaBTC, the world’s fourth-largest mining pool operator at the time, said that many miners in its pool were facing closure. While some miners closed their doors, the upward trajectory in network hash rate was unaltered — unlike in the May 2021 crackdown — indicating that most miners were unaffected.
May 2021 – Mining Ban
On May 21st, a pervasive shutdown of mining throughout China was undertaken following the 51st meeting of the State Council Financial Stability and Development Committee presided over by Vice Premier Liu He. The statement following the meeting also focused on the need to clamp down on trading activities, but subsequent actions seem to have been focused on derivatives and over-the-counter (OTC) trading. Although not regulatory bodies, industry associations in technology, banking, and payments affirmed service provider commitments to the guidelines that were similar to those set forth by the PBOC in 2013. The notification from industry associations initially appeared on May 18th, just ahead of the pronouncement from the State Council Financial Stability and Development Committee.
June 2021 – Reaffirmation on Banking Prohibitions
On June 21, a joint statement led by the PBOC that included notable banks and Alipay reaffirmed their commitment to preventing certain virtual currency–related business activity. While many of these activities were already covered by the 2013 pronouncement from the PBOC, the reaffirmation appears to have been in support of the financial stability meeting headed by VP Liu He.
September 2021 –Trading Criminalized
In its most forceful statement yet, the PBOC criminalized the trading of bitcoin, ether, and tether in all forms. It also made it illegal for offshore trading platforms to serve China’s citizens and blocked access to crypto news and information sites like Coin Market Cap and CoinGecko via the so-called “Great Firewall.” China further redoubled its effort to stamp out mining entirely, as some hash rate likely crept back online following the May ban. Huobi vowed to stop new customer signups for mainland clients and close accounts associated with mainland users by year end.
What’s Next for China?
It is important to note that while China continues to turn up the heat on digital assets, ownership of bitcoin is still not illegal. Neither are peer-to-peer transactions. While these activities may ultimately be deemed illegal at some point, ownership of bitcoin amongst China’s citizens is likely not as large as the media headlines and price moves would leave one to believe. According to data from Glassnode, the balance of bitcoins held by exchanges which have previously operated in China, Huobi and OkCoin, is only about 181K bitcoins, less than 1% of the 18.8M bitcoins in existence and about 7% of the 2.5M bitcoins held on exchanges. In addition, nearly all bitcoin mining within China was eliminated after the May crackdown, and currently only about 1% of nodes globally are being run in China (though this number may be obfuscated by the use of anonymizing software such as Tor).
Rhetoric is High Amongst US Regulators
The discussion around crypto regulations in the U.S. was front and center during the third quarter. From the infrastructure bill to public appearances by SEC Chairman Gary Gensler, the topic of crypto regulations was pervasive this past quarter. The following is a summary of important discussions.
Infrastructure Bill Further Legitimizes Industry
Crypto regulations and taxation were highly topical and contentious topics in the final stages of the Senate’s negotiations on the new bipartisan infrastructure bill. The bill sought to raise $28B from better tax reporting and compliance from digital asset “brokers.” The point of contention was the definition of the term “broker” and who that applied to in the digital asset industry. While the definition of a “broker” that was ultimately retained was broad, the fact that the industry played a significant role in attempting to shape the bill and that lawmakers acknowledged the industry in the bill and will rely on it as a source of revenue is a legitimizing one, a far more important takeaway to us than the fight over semantics.
Gensler Talks About the Need for Greater Investor Protections
SEC Chairman Gary Gensler made several public appearances during the quarter with comments directed at numerous activities within the digital asset industry. Gensler, who has demonstrated deep knowledge about the industry, has focused comments on the need for investor protections and safeguards. Activities within the industry that may be under the purview of the SEC include secondary market trading of digital assets that it deems to be securities, borrowing and lending activity, certain types of stablecoins, decentralized finance, and staking. While this may be concerning to many players in the crypto market, owners of bitcoin can feel comforted by the fact that the asset fits no legal definitions of a security and therefore has the best-defined regulatory position amongst cryptocurrency peers in the United States (actions like lending aside).
White House Steps Ups Actions inRansomware Attacks
Following recent ransomware attacks on critical infrastructures, such as the Colonial Pipeline, the White House vowed to step up activity on illicit actors to disrupt future ransomware operations. The Office of Foreign Assets Control (OFAC) placed Bitcoin addresses linked to such attacks on its Specially Designated Nationals (SDN) list. It’s worth noting that Bitcoin has only been the medium of exchange for ransom payments and that the real issue lays with insecure networks, poor security training, and freely available hacking software and services. And while Bitcoin is frequently cited in the media as an anonymizing tool, we think successful law enforcement actions highlight the open-source nature of Bitcoin’s blockchain and the fact that it makes for a poor tool with which to commit a crime. Bitcoin’s transaction history is available to all participants and is thus easy to trace.
Looking Ahead to 4Q
Taproot Implementation
On block number 709,632, which will most likely be mined in mid-November, Bitcoin is set to implement its most significant update since Segwit in 2017. Taproot contains several enhancements to Bitcoin’s functionality built around the introduction of Schnorr signatures. Bitcoin’s current signature system uses Elliptic Curve Digital Signature Algorithms (ECDSA). At the time that Satoshi Nakamoto wrote the code for Bitcoin, Schnorr signatures were a known alternative, but the technology had been protected by a patent since its creation. Though the patent had just expired when Nakamoto wrote the Bitcoin code, it was less used and therefore less trusted. In the time that has passed between Bitcoin’s creation and today, Schnorr signatures are now better understood, and its enhancements can be utilized. The new algorithm allows for several benefits including better privacy for multisignature transactions, space savings, and potentially better security.
The Race to Launch a Bitcoin ETF
Numerous asset managers have filed applications this year to create ETFs that invest in spot bitcoin. The SEC has to approve or deny the first application in the queue, the VanEck Bitcoin Trust, by November 14th. It is difficult to handicap the probability of a spot bitcoin-based ETF approval, but lately, SEC Chairman Gary Gensler has signaled support for ETFs based on bitcoin futures traded on the CME as opposed to spot-based ETFs. Unlike spot-based ETFs, futures-based ETFs may be registered under the Investment Company Act of 1940 (“1940 Act”), which generally provide greater protections to investors. Based on this guidance, a spate of filings emerged in recent months for 1940 Act bitcoin futures ETFs.
There are downsides to investors in only allowing exchange-traded products to invest in bitcoin futures. Bitcoin futures generally trade in contango, meaning that the cost of buying a bitcoin future is higher than the spot price. Other commodity futures frequently trade in contango, but their futures curves can contain supply and demand information about how spot may move in the future. For example, natural gas tends to be more expensive in the winter since that’s when consumers need to heat their homes. Bitcoin has a fixed supply curve and lacks a similar fundamental use, so contango simply reflects a premium for investing in futures instead of spot. Retail investors in bitcoin need to bear this cost. In addition, there are limitations to how big futures-based ETFs can get, based on the limitation in the number of futures contracts an entity can hold. The CME currently imposes a limit of 2,000 bitcoin futures contracts for the most liquid front-month futures which, if bitcoin were priced at $50K for example, may limit a single fund to $500M in notional exposure (each bitcoin contract is for 5 bitcoins).
Bitcoin's Growing Use in Medium of Exchange Applications
Bitcoin is best known by investors as a form of digital gold, a store of value that is nearly infinitely divisible, weightless by design, and highly transmissible around the world. But Bitcoin was created as a digital currency, an electronic currency for the internet age. And while Bitcoin has been less used as a payment network for medium of exchange applications, several test cases are reclaiming this initial use case. For example, El Salvador's adoption of bitcoin is an important test case for sovereign nations seeking the benefits that bitcoin can bring to their country. Indeed, politicians in other Central and South American countries have begun to explore the potential of introducing bitcoin to their countries in a formalized manner. The Lightning Network, the technology that enables fast and cheap payments using bitcoin, has been growing rapidly, both in channel capacity and the number of network nodes. And finally, numerous payment technology companies, including PayPal, Visa, and Mastercard, have all rolled out initiatives that will allow consumers to make or settle transactions with digital assets. We are watching these initiatives closely and expect to report next quarter with ever-increasing signs of using bitcoin as a medium of exchange.
Thanks for joining us again this quarter. Please reach out with any questions or comments.
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