Research Round-Up: Commentary on Recent Digital Asset Price Volatility

Market Commentary

The price of bitcoin has fallen roughly 23% year-to-date and is approximately 46% off its November all-time highs at the time of this writing. Due to this notable price action, we are devoting this month's longer-form "Insights and Education" section to our analysis and commentary on the recent volatility.

News and Editorial

A curated list of the most relevant news and developments along with our two Sats.

Bitcoin Mining and Environmental Developments

This past month CEO Jack Dorsey announced that Block (formerly known as Square) is officially building an open-source bitcoin mining system, something that was previously only being considered.ⁱ Meanwhile, chipmaker giant Intel is expected to announce its own bitcoin mining chip (known as an ASIC or application-specific integrated circuit).ⁱⁱ The chip will reportedly be energy efficient and low voltage.

Finally, the first U.S. Congressional hearing on bitcoin mining was held on January 20.ⁱⁱⁱ Titled, "Cleaning Up Cryptocurrency: The Energy Impacts of Blockchains," the hearing sought to "examine the rapidly growing energy and environmental impacts that accompany the "mining" of certain cryptocurrencies."

Our Two Sats:

Although still light on details, we think the potential for Intel to jump into the mining space would be a positive for the industry as there are currently only two major ASIC manufacturers. This along with the potential for open-source solutions from Block or others could increase the decentralization aspect of Bitcoin's network as it would not be reliant on only a few producers of mining chips.

We note the U.S. Congressional hearing contained a fair amount of discussion around the energy usage amount and mix of energy sources that bitcoin miners use (whether they are renewable or how much carbon emissions they are responsible for). However, we would have liked to see more focus on education and understanding of the benefits of proof-of-work consensus mechanisms in order to be able to weigh this against the costs. For example, proof-of-work consensus could instead be viewed as the defining feature of bitcoin, not a bug or unfortunate byproduct, as it gives bitcoin the most security and decentralization compared to other digital assets, something that clearly has benefits for those viewing it as an aspirational store of value or alternative money.

Government Adoption of Digital Assets Heats Up - El Salvador and Rio De Janeiro

It appears El Salvador's "bitcoin bond" may be gaining momentum as 20 bills are being prepared to send to Congress in order to provide legal framework for the bonds.^iv However, credit rating agency Moody's Investors Services noted El Salvador's bitcoin purchases may be increasing its credit risk and the IMF recently urged El Salvador to remove bitcoin's legal tender status while also expressing concerns over the bitcoin-backed bonds.^v,vi

Meanwhile, Rio De Janeiro's mayor has announced it intends to invest 1% of the Brazilian city’s treasury reserves in "cryptocurrency" and is also looking into offering additional discounts on tax payments if paid with bitcoin.^vii

Our Two Sats:

We noted in our last month's newsletter the high stakes game theory at play as it pertains to governments, central banks, and even cities and states decision to adopt or purchase some amount of bitcoin. We think the above news is another data point that confirms this trend and would not be surprised to see more countries and cities around the world evaluate bitcoin.

Turkish Citizens Flee to Bitcoin and Other Digital Assets

Trade volumes on crypto exchanges that use the Turkish Lira have exploded, as reported by the WSJ, indicating many Turks are buying bitcoin and other digital assets, such as stablecoins, to escape the volatile and quickly depreciating official currency.^viii The Lira has lost approximately 40% of its value against the U.S. Dollar since this past September, as inflation surges, forcing many Turks to turn to subsidized bread and cut back on their consumption of meat and other luxuries.^ix

Our Two Sats:

Turkey's official annual inflation rate hit 36% this past December, but some outside economists estimate the real inflation rate is closer to 91% for the year 2021.^x The culprit for the inflation is largely due to Turkey's central bank continuing to ease monetary policy with multiple interest rate cuts. We are not surprised many citizens are turning to digital assets, particularly bitcoin, given its hard supply cap, scarcity, and predictable issuance schedule, combined with the ability to buy, send, and store bitcoin in a permissionless and censorship-resistant way (note that Turkey previously banned bitcoin transactions in April 2021).

News Quick Hits

• SEC delays decision on another spot bitcoin ETF on January 4, adding an additional 60 days.^xi
• Nearly a quarter of small businesses across nine countries plan to accept digital currencies as a form of payment in 2022, according to a recent survey by payment processing giant Visa.^xii
• Digital asset exchange BitMEX group announced plans to acquire a 268-year old German bank.^xiii

Insights and Education

A monthly long-form section where we provide a Fidelity Digital Asset's perspective or educational piece.

As mentioned at the start of this newsletter, the price of bitcoin has fallen roughly 23% year-to-date and is approximately 46% off its November all-time highs at the time of writing. Many major markets have shown a risk-off appetite to begin the year as the S&P 500 is down 10%, and assets seen as longer duration such as growth-oriented names have been amongst those hit the hardest. As a result, we have chosen to discuss the current views we hold on today's investment environment as it pertains to the recent volatility seen in bitcoin and digital assets, in addition to the pickup in correlation to broader risk assets in this month's edition of our "Insights and Education" section.

In our view, many of the price drivers inherent to bitcoin and digital assets can be boiled down to two simple categories, intrinsic and extrinsic. The first is the underlying fundamentals associated with these protocols – are networks growing, building, and expanding upon their reach? The second is broader in definition and pertains to the overall macro environment – are interest rates, inflation, and risk-appetites rising or falling? The latter factor appears to have taken the driver's seat for the time being.

The Intrinsic – Network Fundamentals

Today, bitcoin fundamentals continue to look strong irrespective of external market conditions or the price associated with the asset. We'll show a few here to help display the network continuing to entrench itself.

Security – Mining Hashrate Growth: Bitcoin miners, vital to the proof of work consensus algorithm, have not shied away from adding additional security in the form of hashrate to the network. In fact, hashrate has reached a new all-time high in the month of January. This group continues to signal that they are bullish on the long-term growth of this network as they expend millions on mining equipment with the sole purpose of receiving bitcoin and often maintaining ownership of the coins they are able to mine. Note that older generation equipment or high electricity cost operations may get crowded out during periods of sustained price declines, but the impacts to overall network security are likely to be minor in comparison to the backlog of new mining equipment purchase orders waiting to be filled by many of the largest and most efficient mining operators.

Decentralization – Node Count Growth: Another key metric that is less often quoted is the total number of node operators that are maintaining the history of the bitcoin ledger. The more node operators, the better represented those utilizing the network are. An increase in the total number of nodes and network hashrate are both critical metrics that on average signal an increase in network decentralization. Similar to hashrate, the number of bitcoin nodes is at a new all-time high as of January this year. This is a positive trend given that bitcoin’s core value proposition is derived from decentralization and security.

Scalability – Lightning Network Growth: The most promising scaling solution for bitcoin is the development of the Lightning Network, a layer two scaling solution where transactions can be sent nearly instantly and for almost no cost while utilizing the slow and secure base layer for full final settlement when needed. Lightning has continued to see its key performance metrics hit new all-time highs, including channel capacity, which represents a simple metric indicative of the adoption and use of this network. Today, there are over 3,000 bitcoin locked into Lightning channels, that's over 200% in year-over-year growth. Countries like El Salvador are battle testing this scaling solution and the creativity seen amongst venture backed firms in this space gives us further reason to believe that the Lightning Network will continue to be an important part of bitcoin's fundamentals on a go-forward basis.

From our perspective, we think it's quite clear that current intrinsic factors to the bitcoin network are a tailwind to the long-term picture of the protocol. As a result, we feel this creates a strong underpinning for investment in this emerging asset class and see recent market volatility being nearly entirely a result of investor sentiment regarding broader macro market conditions.

The Extrinsic – Macro Conditions

The winds associated with macroeconomic conditions have appeared to shift, mainly seen through the transition into a tightening cycle that the U.S. Federal Reserve has indicated in recent months. Markets have responded to this new potential reality with selloffs to begin the year in many major risk assets including broad equity markets and bitcoin as well as a sharp upwards move in real interest rates. We view central policy makers both fiscal and monetary, particularly those in the United States, as the most important cog in the wheel of today's global macro economy given that they have become critical to both the sentiment and functioning of financial markets. Here's how we view this current-day picture:

Fiscal Policy: Things appear to have tightened on the fiscal front in the United States following historic spending in recent years amidst the COVID-19 pandemic. Headline CPI inflation reached as high as 7% in recent months and has left lingering fear amongst many of those in congress surrounding continued spending as the economy potentially looks to be reopening. In the event that the U.S. midterm elections create a shuffle of sorts in Congress, there is a possibility that future large-scale spending bills under the current administration could face material roadblocks.

Monetary Policy: On the central bank front, the Fed has indicated it will begin a tightening cycle with rate hikes expected to begin in March, followed in tandem with some eventual form of balance sheet runoff likely in the months following. Jerome Powell, who spoke on Wednesday, January 26, didn't fail to mince words with respect to the intentions of the Fed beginning to tighten.

The result of fiscal and monetary policy both appearing to begin changing course has trickled its way into financial markets to begin the year. Real interest rates, shown below, have reflected these expectations and provide a visual for a system that is experiencing tightening. Forward 10-year inflation expectations have dropped to their lowest levels since September of last year, while 10-year nominal interest rates have risen to their highest levels since April of last year. Although real interest rates are still negative, they are currently near their highest level since the start of the pandemic in March of 2020. This sharp increase in real interest rates helps tell the story of financial markets that are beginning to bake in expectations of hawkish forward policy and is likely the main driver of the recent volatility in long-duration assets.

In our view, the problem with sustained higher real interest rates above levels that we are seeing today lies mainly in the structure of the global financial system and sovereign balance sheets. For instance, the United States current public debt to GDP sits at 122% as of Q3 2021.^xiv The 2021 net interest expense for that debt was $352.3 billion. Additionally, off-balance sheet liabilities in the form of pay-as-you-go programs like Social Security and Medicare amounted to a $696 billion differential between tax revenue received specifically for these programs and benefits paid (total gross costs of $1.79 trillion). These combined obligations amount to over 50% of total tax receipts today, with tax revenues at all-time highs.^xv

Upwards movements in inflation drives Social Security, a CPI-W adjusting program, and Medicare, a healthcare inflation adjusting program, obligations upwards in terms of ongoing off-balance sheet liabilities, while driving down the total real debt burden held on balance sheet. Meanwhile any increases in nominal interest rates raise the cost associated with additional treasury issuance and refinancing, something that is particularly interesting today given that over 70% of treasury debt exhibits maturities of less than 10 years.^xvi What's left is a system that would likely be forced to forgo either a large portion of entitlement obligations or other social programs were there a sustained rise in real interest rates from where they sit today, a less than palatable political situation. Instead, we see it far more likely that a rise in real interest rates for a prolonged period of time is unlikely this decade. Financial repression, whereby inflation is kept above nominal interest rates, appears far more likely and bodes well for non-sovereign store of value assets (bitcoin) and presumably equities as well.

Tying this back to bitcoin, we have witnessed a pickup in correlation between digital assets and broader risk markets. This could be the result of a multitude of factors, including the institutionalization of bitcoin and the correlation amongst all assets trading together during periods of risk-on and risk-off market environments as central policy makers have grown in importance. Though it is worth noting that the correlation between bitcoin and the S&P 500 is still only 0.5 even at today's historically high levels of correlation.

We wouldn't be surprised to continue to see this correlation given that it is still very early in the adoption curve of bitcoin and it has historically tended to trade in line with risk assets, particularly during periods of broad market instability. However, longer-term we do expect the resiliency of the bitcoin network to drive a decrease in correlation to risky assets and a reduction in levels of volatility as liquidity deepens and fundamentals intrinsic to the network matter more to long-term holders. The tradeoff with waiting for this eventual destination is that the price is also likely to reflect this newfound reality of a potentially lower volatility asset than is seen today (risk-reward tradeoffs).

The Takeaway

We view the long-term picture of bitcoin and digital asset markets as unchanged despite the recent 50% correction in price. Network fundamentals are arguably stronger than they have ever been. In the short-term, it's likely that all assets seen as risk-on, which includes these markets, will continue to trade with a high degree of correlation in response to ongoing developments regarding central policy decision making. We view it as unlikely for prolonged tightening within financial markets, seen most easily via the TIPS market, as a result of the current structure and in particular sovereign balance sheets. This doesn't necessarily imply that there won't be fits and starts along the way where financial markets begin pricing in tightening as we have seen in recent weeks. Ultimately, the long-term value accrual of this network won't be decided by policy makers, rather it will be decided by the efficacy of consensus code.