The escape valve we didn’t need (yet)

Photo by Syed Hussaini on Unsplash

The litany of mockery that has rained upon the crypto markets and its acolytes in the past few weeks has been relentless: it’s a scam, it’s all a ponzi, it’s at best a failed experiment and (perhaps with some irony) “have fun staying poor” count among the most unpleasant lines uttered to the crypto crowd.

There’s little denying the extent of the damage done, and as headlines continue to stream out from the cryptosphere about the fallout from the unwind, it is hard to see the light at the end of the tunnel. Even the grandfather of it all, Bitcoin, seems to have “failed” – after all, wasn’t it meant to be the safest of the lot? In fact, wasn’t it meant to be an inflation hedge whose time to shine was right now, as we face all across the world inflation prints we haven’t seen in decades? What more of the challengers of its throne if even the most basic function – that of a store of real value – can’t be fulfilled?

Amidst the chaos of the bull market, what has perhaps become lost in all of the noise (including that of the “inflation hedge” crowd) is the underlying founding principles of not just Bitcoin, but all of the crypto space. In our view, this was never about being an inflation hedge (even if some coherent arguments in its favour can be made), but about something much more profound.

Rather, crypto was always about being an escape valve from the incumbent financial system, through the creation of self-sovereign money in an alternative system: Bitcoin set the standard for permissionless peer-to-peer money transmission, everything else followed in those footsteps.

This week at a group dinner, the participants were each asked to bring along an interesting chart to talk about. This was the Three Body Capital submission:

Data sources: Refinitiv Eikon, Coingecko

The aim was to map the performance some of tech’s greatest champions against the few crypto businesses and tokens which have been around for long enough to warrant comparison over the past 2.5 years or so. In this case, we picked Bitcoin, Ether and Binance Coin, and juxtaposed them against Amazon, ARKK, MercadoLibre, Facebook/Meta, Netflix, Sea, Shopify, Snap and Nvidia, for the period spanning Jan 2020 till this month.

The results are interesting to say the least: one often forgets that despite everything that has gone awry in crypto, Bitcoin is still holding on at around $20k (the all-time high from its previous run), and if it be true that the proof is in the performance, then the likes of BNB, for example, from peak to trough (and even over the period from Jan 2020 – Jul 2022) actually outperform some of tech’s most revered champions.

Failed experiment? Doesn’t look like that big a failure once put in context with everything else. Though not a roaring success (yet), crypto’s down but not out. Part of its travails is a result of bad actors in the space; the other part however could well be just a function of misguided expectations.

Perhaps this is a case of a meme taken too far and subsequently gone awry.

The inflation hedge blackhole

Veterans from the previous crypto cycle would remember the fight for survival back in 2017-18, after crypto’s first spectacular crash into the depths of crypto winter. The challenge then was existential: prove the need for crypto, show that it was more than just computer game money, demonstrate how it can be useful.

Back in those days before the emergence of USD stablecoins (MakerDAO code for minting DAI – or SAI, as it was initially, was only deployed on Ethereum in Dec 2017, believe it or not!), everything stood on the shoulders of Bitcoin. Perhaps more true to crypto’s original vision than is the case now, almost all tokens had their value based against BTC rather than against USD – remember when there were even tokens priced in “sats” (“1 satoshi”, for those unfamiliar with the unit, is equal to a hundred millionth of a bitcoin or 0.00000001 BTC)?

Of course, even back then the limitations of Bitcoin were already known: expensive to mine, limited in transaction capacity, perceptibly slow to settle (albeit quicker than tradfi’s T+2 settlement), to name a few. The entire host of “Bitcoin killers” (including forks like Bitcoin SV and Bitcoin Cash) staked their claims to value on being better than Bitcoin, but the technical reality which remains the case today is that Bitcoin is well and truly immutable not only because of its age (already 10 years old at the time of the last crypto winter), but because of the apparent disappearance (or death?) of its pseudonymous founder(s?) Satoshi Nakamoto.

This arguably led to a problem: on one hand, the shortfalls of Bitcoin as a P2P payment system were clear for all to see. While it was a great proof of concept, modifying it to make it fit for purpose was difficult, especially with a plethora of varied vested interests in play – miners, holders, whales etc. On the other hand, Bitcoin was the cornerstone of all of crypto – it HAD to be infallible, and to its merit, it embodied all of the ideals of the decentralised financial future the crypto community dreamt of: permissionless, immutable and censorship resistant. The only problem was it sucked at what it was meant to do (make payments).

So, while one branch of the Bitcoin community sought out ways to make it better, building rollups like Lightning to allow Bitcoin to compete with the likes of Ethereum without compromising the rather basic code primitives intrinsic to it, another branch pursued a different goal: meme Bitcoin into a new use case.

Thus the meme of “Bitcoin as an inflation hedge” was born: take the meme of “21m Bitcoins of maximum supply” and spin a narrative around scarcity and value retention around it, and suddenly it takes on a new identity, that of “digital gold”.

From Meme to Reality (but why numba still go down?)

As we’ve seen many times in the past, memes can easily translate into reality, and the longer a meme hangs around, the more likely it is to enjoy longevity. After all, why does gold function as a store of value? It’s not like one could eat it in a nuclear apocalypse to stay alive, and there certainly would be any need for its industrial or cosmetic functions if the world went into Armageddon.

Beyond the obvious criticism levelled against Bitcoin by the gold bugs being “but none of that’s going to work if there’s no electricity and internet HAH”, the “Bitcoin as digital gold” crowd is largely right about how Bitcoin possesses most of the characteristics required of a scarce store of value.

The problem is that Gold hasn’t done particularly well either this year. Sure, it’s only -15% from its peak of around $2,060/oz to around $1,740/oz currently, but you would’ve been better off holding USD cash if a zero-beta savings pot was what you were after.

“But, what about inflation?”

And here we get the point that we’re trying to make: the source of Bitcoin’s (and all of crypto’s) worries isn’t inflation or the lack of it, nor their ability (or lack thereof) to function as a hedge. Inflation is high, yes, but inflation isn’t the point.

In fact, in an inflationary world, if interest rates were equally high accompanying that inflation, then holding gold would be an equally terrible prospect. Why would you trade away a nominally positive savings rate for a zero-return stack of golden metal? Or a stack of digital analogues (sorry, couldn’t resist the pun) to said golden metal?

Gold bugs and “Bitcoin as an inflation hedge” bugs – here’s the bad news: you’ve been memed.

Bitcoin and Gold are alike, but not as inflation hedges. Rather, they’re escape routes from the incumbent financial system when faced with a severe debasement of fiat currency value.

That’s where they come into their element.

If you believe that the USD, EUR, GBP and every other fiat currency you hold your savings in is going to get inflated away to the moon, THEN gold and bitcoin get their chance to shine. No surprise then that while the prevailing narratives were about “fiat debasement” in its various forms including the “money printer go brrr” meme, Bitcoin and Gold were having their days in the sun. The moment that market narrative moved to QT and rising rates, the lustre of both Gold and its digital counterpart started to look a little less appealing.

Ultimately, inflation is insufficient – insofar as there remains broad faith and confidence in the fiat currency system, inflation or otherwise, the escape valve isn’t necessary. But if that confidence breaks, then the escape valve will be in great demand.

Wen bull market again?

In that context, we go back to the chart with which we started this note and a couple of observations can be made.

Firstly, while not entirely visible on the chart itself given the extent of the moves up in the likes of ETH and BNB, we can see from the drawdown numbers peak-trough that on a percentage level, cryptos have basically traded like tech stocks – rather similar to the behaviour of the more speculative cohort of tech names. That reinforces our long-held view that at least for the moment, crypto trades like growth tech, but ever further out on the risk spectrum.

That view might gradually evolve, and that takes us to the second observation: that despite the spectacularly large extents of their drawdowns, some of the more “proper” crypto projects (in this case we’ve picked Bitcoin, Ether and BNB, but there is a small handful of others that fall into this category) have nonetheless managed to still net a sizeable positive return over the 2.5 year period in question.

This is important because it is in the shakeout, amidst all the indiscriminate selling, that we find the best opportunities to own the most promising assets in the market. Of course, things will continue to evolve rapidly over the coming years in terms of technology and their applications and, very much like in the aftermath of the dot com bubble which heralded the explosion of the internet into the mainstream, the winners of the present still risk decline into oblivion (think Yahoo!) and the winners of the future may still remain obscure at this point (think Google, Facebook/Meta etc.).

That said, the number of winning incumbents that survived the dot com carnage and emerged as dominant names is also not immaterial: Apple, Microsoft, Amazon, Oracle, just to name a few. Nothing comes as a certainty, other than the fact that without taking any risks, there can be no reward. Our job is to manage these risks as we go along and if we have reason to believe we are wrong, we will re-evaluate our investment cases and act accordingly.

The big question on the minds of every crypto market participant must surely be “wen bull market again?”. Unfortunately, we don’t have an answer, but one could perhaps hazard a guess based on what we’ve discussed here.

If crypto truly is an escape valve from the incumbent systems of centralisation (financial, economic or otherwise), and if the trigger for breaking the glass to open the emergency exit is broad fiat currency debasement, then working out when that trigger gets pulled should offer some clues as to when crypto finds its renaissance.

In the meantime, if crypto is to have a chance of fulfilling this arguably noble purpose, then this bear market should be taken as an opportunity to build. Just like the internet and its dot com boom/bust in the early 2000s, the minimum viable product has been delivered. Product-market fit might not yet be completely clear, but if the building continues, it is almost inevitable that the right products will come along to fit market demand.

Then, crypto (and maybe even gold) can have its renaissance.

After all, it’s the same meme.