In the desire for yield, investors may be ignoring important risks, again.
Fiat currencies, the tragedy of the commons, and why bitcoin might benefit.
Comparing bitcoin’s risk-adjusted returns to other asset classes.
Hunger for Yield is Apparent, But Caution is Warranted
This week saw the highly anticipated second stage of the Babylon bitcoin staking mainnet launch. While this round didn’t slam Bitcoin’s blockchain as the first one did, the demand for yield with bitcoin investors is apparent. According to the project’s website, after the close of the Cap-2 round, there are now 23,889.6 bitcoins ($1.4B) staked through Babylon.
What is Babylon and why is it so popular? It’s a platform led by a Stanford University professor and funded by some of the biggest VCs in crypto that allows bitcoin holders to generate yield on their bitcoin holdings by participating in the consensus of proof of stake networks, such as Cosmos, and earn “yield” on their bitcoins. Bitcoin is a non-income generating asset and given the popularity of Babylon, it’s clear there is a desire from investors to make their asset more productive while continuing to hold it. The activity requires investors to undertake technical, legal/regulatory, and crypto price risks, all for the hopes to generate PoS yields in the future (stakers are currently paid “points”, not staking rewards).
Investors have had a few options to generate yield on their bitcoins – they could lend, engage in options strategies, or wrap it and engage in defi activities (lending and liquidity providing on dexes). Catastrophic lending practices were at the heart of the 2022 meltdown (Genesis, FTX, BlockFi, Celsius, Voyager, UST/LUNA, etc.) and while those companies and protocols are no longer with us, alarming practices, such as uncollateralized lending, are once again becoming the norm. Options strategies aren’t subject to the same industry dynamics as lending but still have market risks. And while crypto native investors may be comfortable with the risks of a platform like Babylon, most investors, especially those from the traditional world, would not be. Numerous spelling and grammatical errors in the project’s “litepaper” do not exactly instill confidence. Protip: it’s a covenant, not convent or “convenant.” We shudder to think of what a bitcoin convent might be.
This serves as a word of warning for investors. We can understand the desire to generate yield on bitcoin, especially for large holders, but investors should not let that desire blind them to the risks they might be undertaking. Lending practices were at the heart of the last crash and it would be a shame to see the industry rise from the ashes of 2022 only to go through the same thing again.
Tragedy of the Commons: Fiat Currencies and Governmental Finances
The “tragedy of the commons”, a well-known economic concept, states that when individuals with unconstrained access to a shared and finite resource, they will tend to overuse it, harming its value or destroying it entirely. The issues is that self-interested actors will make their individually optimal decisions, which is at odds with the general good, absent regulations or coordination. While this concept is most often used to describe public goods such as natural resources, the environment, oceans, and fisheries, one can also think about it in the context of governmental finances and fiat currencies.
Election season here in the US has shown a spotlight on some of the divide within our nation, whether it be political, social, or economic. It is often in politicians’ self-interest to make financial promises to curry favor with voters, whether it be tax breaks or program spending, without having to bear the direct costs. Debt is issued, money is printed, consumption is pulled forward, and the can of the underlying problem is kicked down the road for the future generation of politicians and citizens to deal with. We see this time and time again, regardless of political affiliation or country.
What does this collective action look like graphically? The following chart is a good example. It presents the world’s money supply to world GDP. Theoretically, if politicians were not appeasing today’s voters with tomorrow’s spending, this ratio would be flat. But it’s not. Governments around the world are collectively engaged in devaluing fiat currencies, eroding their purchasing power. This is inflation.
This outcome is nearly assured given the self-interested actions engaged by politicians. Fiat currencies end up subject to a tragedy of the commons like-outcome. How are the problems with the tragedy of the commons solved? Communication, coordination, and regulation. Fishing quotas are put in place, hunting licenses are required, greenspaces in public parks are given days of rest to recover and regrow, and governmental regulations are placed on pollution. Unfortunately, these are not done for the money supply. Public debts have no lobbying organizations and no voting constituents. It is only when the byproduct of too much money printing is felt, inflation, do voters care. A regulation was put in place to curb this activity, the debt ceiling limit, which requires the Treasury to get Congressional approval to authorize more of the nation’s debt, but the regulation seems to just be a political bargaining chip for one party or another.
Given this dynamic is nearly assured, that nations collectively will continue to print money and devalue their fiat currencies, it should come as no surprise that individuals and corporations are increasingly turning to bitcoin, a globally available fixed supply asset. Furthermore, we like investments where the investors’ advantage is simply the passage of time – governments will continue to devalue their fiat currencies while bitcoin increasingly becomes scarcer.
Bitcoin’s Superior Sharpe Ratios
Earlier this week, CoinDesk shared a snippet from a Goldman Sachs research report comparing asset class returns to their volatility. From what we can see of the report, the piece concluded that even though bitcoin was up over 40% year to date, its performance was not sufficient to compensate for its volatility and that only two non-fixed income growth sensitive indexes had worse return to volatility ratios. That didn’t sound right to us, so to quote Michael Jordan, “and I took it personally.”
The following table is a more complete comparative analysis of Sharpe ratios (the ratio of excess returns over the risk-free rate to return volatility) of various asset class benchmarks over different holding periods. The usage of a return to volatility ratio seems like a strange shortcut as does measuring performance on a trailing 9-month basis. We use monthly total returns to create rolling Sharpe ratios and present the most recent reading (trailing 12 months is the minimum time frame) as well as the average, median, min, and max.
As the table shows, bitcoin ranks favorably compared to nearly every asset class on every metric over every time frame. True, gold technically has a higher Sharpe ratio in the past 12 months, but 1.94 vs 1.92 is splitting hairs. There is nothing to support Goldman Sach’s claim that bitcoin’s returns aren’t sufficient to compensate for volatility. This analysis shows the contrary, that the risks (price volatility) that bitcoin investors endure are more than made up for in terms of returns.
Finally, while we understand that the statistically accepted measure of “risk” by the investment professional community is “price volatility”, the standard deviation of historical returns, that fails to incorporate a host of risks endured by individuals and organizations. Underperformance, loss of purchasing power, censorship, seizure of asset are some additional risks, just to name a few, none of which are measured by “price volatility.” Additionally, while the Sharpe ratio may offer some measure of the efficiency of an asset or portfolio, and thus perhaps the adeptness of a money manager, the thing that allows investment objectives to be reached is returns. One cannot pay for college, mortgages, retirement, pension obligations, or employee salaries with Sharpe ratios. Those can only be met with returns and here, bitcoin stands apart from the crowd.
Market Update
Bitcoin fell 2.2% on the week as its rangebound trading continues. We had hoped that the FOMC interest rate cut coupled with China’s new stimulus might take it out of the range, but that was not to be the case. Little fundamental information came forth this week. The judge in the FTX bankruptcy case approved the bankruptcy plan, which would see $14.7B - $16.5B in cash end up in the hands of creditors, much of it within 60 days of the effective date of the plan (still not decided). Because this involves the movement of cash, not coins, this could potentially be an opportunity for creditors to buy back into the market, not sell, as was the fear with many other bankruptcies, such as Mt Gox.
Fears about potential overhangs from the US government’s holdings being unleashed circulated the market, but we think both are premature. The Supreme Court declined to hear an appeal in the Silk Road case (69.4K BTCs) plus the government made moves to reach those affected by the Bitfinex hack (119.8K BTCs). While we don’t detect any movement out of government wallets, nor does anything appear to be imminent, coins recovered from these two cases make up the bulk of the US government’s holdings.
All eyes seem to be focused on the election, with Donald Trump taking the lead this week on betting platforms. While we agree that a Trump presidency would on its face be better for bitcoin and other cryptocurrencies, both candidates offer an improvement over the Biden administration. Often overlooked by crypto pundits, however, is the legislature, with both the House and Senate up for grabs. While the President is certainly important, just as important is the legislature with two bills, one on market structure and the other on stablecoins, waiting in the wings.
Finally, a word of advice to market prognosticators. For those relying on “Coinbase premium indexes,” which measure the price of bitcoin trading on Coinbase (BTC-USD) with bitcoin on Binance (BTC-USDT), Cryptoquant and Coinglass are two examples, this is simply the price of Tether. For this to be a useful metric, one that measures the price discrepancies between two exchanges, and for it to be correctly named, one must translate the Coinbase price into Tether or Binance price into USD. We’ve seen this referred to a lot recently trying to explain market movements, but once that correction is made, there is very little price discrepancy between the two exchanges lately. It would be more informative and less misleading for investors to simply look at the price of Tether (USDT-USD).
You are receiving this email because you signed up to receive our weekly research at www.nydig.com
This communication has been prepared solely for informational purposes and does not represent investment advice or provide an opinion regarding the fairness of any transaction to any and all parties nor does it constitute an offer, solicitation or a recommendation to buy or sell any particular security or instrument or to adopt any investment strategy. Charts and graphs provided herein are for illustrative purposes only. This communication does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of New York Digital Investment Group or its affiliates (collectively NYDIG).
It should not be assumed that NYDIG will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein. NYDIG may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this communication.
The information provided herein is valid only for the purpose stated herein and as of the date hereof (or such other date as may be indicated herein) and no undertaking has been made to update the information, which may be superseded by subsequent market events or for other reasons. The information in this communication may contain forward-looking statements regarding future events, targets or expectations. NYDIG neither assumes any duty to nor undertakes to update any forward-looking statements. There is no assurance that any forward-looking events or targets will be achieved, and actual outcomes may be significantly different from those shown herein. The information in this communication, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.
Information furnished by others, upon which all or portions of this communication are based, are from sources believed to be reliable. However, NYDIG makes no representation as to the accuracy, adequacy or completeness of such information and has accepted the information without further verification. No warranty is given as to the accuracy, adequacy or completeness of such information. No responsibility is taken for changes in market conditions or laws or regulations and no obligation is assumed to revise this communication to reflect changes, events or conditions that occur subsequent to the date hereof.
Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Legal advice can only be provided by legal counsel. NYDIG shall have no liability to any third party in respect of this communication or any actions taken or decisions made as a consequence of the information set forth herein. By accepting this communication, the recipient acknowledges its understanding and acceptance of the foregoing terms.
