“How did you go bankrupt?” Bill asked.
“Two ways”, Mike said. “Gradually, then suddenly.”
- Ernest Hemingway, The Sun Also Rises
In the land of Yap – a small group of islands in modern day Micronesia – the currency in use for hundreds of years were called Rai stones. Rai stones were circular stone discs carved from crystalline limestone, of various sizes ranging from small to enormous (12 feet in diameter and 20 inches think, weighing over 8,000 pounds).
While there is some disagreement over the origin story, Rai stones appear to have come from seafaring Yapese explorers who, at some point in the 1600s, discovered a limestone cave in Palau – an island ~250 miles away – and decided to carve the limestone into discs and returned home with them on small bamboo canoes and rafts. Over time, the boats got bigger and stronger, enabling the transport of larger discs.
As there was no gold or silver in Yap, the Yapese decided that these stones would serve as money or a store of value. The discs were considered very valuable and not used for small things like everyday transactions, but rather for large transactions like dowries, political alliances, or battle ransoms. The challenge was that much of this money weighed approximately as much as a car, making it impractical to physically move.
Because moving these stones was extremely difficult, the islanders developed an oral record of all transactions. If one person owned a particular stone, everyone in Yap knew it. If that person transferred the stone to someone else, everyone was made aware of it. As such, the stones rarely moved and were impossible to steal because their ownership was known by everyone.
In fact, so accepted was this oral record of ownership, there are reports of a particularly large stone being lost at sea on its way back to Yap from the quarry. Despite no one having physical possession, everyone agreed it must be there at the bottom of the ocean and so it was decided that stone would be recognized as having comparable value to other, similar stones. For hundreds of years, it was used as money and simply recognized as the stone in the ocean.
Due to the difficulty in quarrying these stones and safely transporting them back to Yap, the Rai stone monetary system was a hard money system with a high stock-to-flow ratio, as relatively few new stones arrived in any given year.
That changed, however, in 1871 when a shipwrecked Irish-American Captain named David O’Keefe sought to create a business by selling Yap’s coconuts to coconut oil producers, but couldn’t figure out how to motivate the Yapese to work for him as his money had no value to them.
He eventually sailed to Hong Kong, purchased explosives and modern quarrying tools and a large boat and sailed to Palau to mine several gigantic Rai stones. He then sailed with the stones to Yap to pay the locals and the Chief. The Chief, however, rejected his stones, claiming they were too easily obtained and should not be considered of value, as his stones were not obtained through the blood and sweat of the Yapese. Others on the island disagreed and accepted his Rai stones in exchange for the coconuts. Over time, quarrying and transporting new Rai stones became easier, and more and more new Rai stones were brought to the island each year, lowering the stock-to-flow ratio and devaluing the existing Rai stones. This, in turn, resulted in conflict and, ultimately, led to the demise of Yap’s Rai stone monetary system – a system that had worked well for hundreds of years until the hardness of the money became compromised by excessive quarrying.
For context, global reserve currencies throughout history have fallen in similar fashion. The Florentine Florin and Venetian Ducat were dominant from the 13th to 15th centuries. This was followed by a brief run (~50 years) of the Portuguese Real in the early 16th century, which was followed by a longer run (~200 years) by the Spanish Real. The twilight of the Spanish Real overlapped with the rise of the Dutch Guilder in the mid-1700s, which also overlapped with the French Livre around the same time. Both of these endured for ~100 years before passing the baton to the British Pound Sterling which had its own 100+ year run from the late 1700s to the early 1900s. Since then, of course, it’s been the US Dollar running strong for just over 100 years now.
Back to the Global Crypto Grind…
Naturally, the monetary history of Yap serves as a cautionary tale, and one that is apropos given the amount of money printing occurring not just domestically, but at central banks around the world. Here’s a question. Do you know by how much the global money supply (M2) has increased since 2003? It has risen by 295%, from $25 Trillion to $98 Trillion, a CAGR of 7.9%. $20 Trillion of that rise has occurred in just the last two years, a CAGR of 11.8%.
Is it a coincidence that global money supply is higher by 26% in the last two years and median home prices in the US are higher by 25% in the last two years, or that gold is higher by 27% in the last two years? Possibly, but probably not. Both real estate and gold are hard money assets. They both have high stock-to-flow ratios, like Rai stones did in their early days.
Each year there are approximately 2,750 tons of gold mined and that compares with the ~200k tons that have been mined throughout history – a stock-to-flow ratio of 72x (200/2.75). US Residential real estate has a similar stock-to-flow ratio (93x) on the basis of roughly 1.5M new units added per year on an existing base of 140M.
This is the segue to the focus of today’s note: digital assets. To keep this under 3,000 words, I will limit the focus to only the two largest digital assets: Bitcoin and Ethereum.
Bitcoin is a hard money asset like gold and real estate. This is a direct function of its program design. There will only ever be 21,000,000 Bitcoin. The last Bitcoin will be mined more than 100 years from now. Every 210,000 blocks (each new block on the blockchain is mined approximately every 10 minutes) sees the reward for mining Bitcoin cut in half – this happens roughly every four years. There have been three such “halvenings” since Bitcoin’s inception. The initial reward was 50 Bitcoin per block. That fell to 25 per block, then to 12.5, and is currently at 6.25 BTC per block.
The program has multiple ingenious features including its cryptographic, decentralized blockchain design which prevents double-spending through consensus authorization of each transaction, but perhaps the smartest feature is the difficulty adjustment. The program measures the total hashing power of the network (all Bitcoin mining) and adjusts the difficulty of solving for new blocks so that no matter how much computing power is added or subtracted from the Bitcoin network, it will always take approximately 10 minutes to mine a new block. Therefore the final block won’t be mined for over 100 years. For reference, when Satoshi Nakamoto mined the genesis block on his laptop the difficulty rating of that laptop was 1. Today, the difficulty rating of the network is approximately 25 trillion. In terms of computing power, the bitcoin network is the largest computing network on Earth.
Now let’s consider the stock-to-flow implications of this preprogrammed halvening schedule. The current stock-to-flow ratio for Bitcoin is ~57x. There are 900 new Bitcoins mined per day (~328k/year) on an existing base of 18.7M. (18.7/0.328). However, unlike gold and real estate, where the stock-to-flow ratio is relatively static, Bitcoin’s stock-to-flow ratio rises exponentially as its numerator (stock) grows while its denominator (flow) shrinks.
For perspective, in January, 2010 BTC S2F ratio was 1x, by January, 2013 it was ~10x, by January of 2017 it was 23x and today it’s at 57x. In January of 2024 it will surpass 100x (eclipsing both gold and real estate) and in January of 2036 it will exceed 1,000x, en route to >10,000x by 2051.
Interestingly, Bitcoin’s price has loosely followed its stock-to-flow ratio, at least thus far, despite its growth being an exponential function. In this respect, Bitcoin could be considered not just a hard money asset, but an ultra-hard money asset based on its not just high S2F ratio, but its exponentially growing S2F ratio.
Here are a few things to consider about Bitcoin.
- Demographics. 35–54-year-old demographics play a huge role in determining asset class performance, and different demographics favor different asset classes. The silent generation favored gold. Baby Boomers and Gen X have favored equities. Millennials are the first native digital generation and the odds that they will embrace digital assets is high. This is not just speculation. A survey by PYMNTS found crypto asset ownership to be 3.2% for Baby Boomers, 13.2% for Gen Xers, and 19.2% for Millennials. Bear in mind too that there are around 95 million Millennials versus around 65 million Gen Xers. The oldest Millennials are 37 and the youngest just 18. Median household incomes rise sharply from 34 to 44, meaning the Millennial generation will become an investing force over the next twenty years, and their preference for digital assets is likely to create a tsunami of demand against a shrinking new supply.
- Network effects. Metcalfe’s law characterizes the network effects of communication technologies and networks such as the Internet and social networking. It relates to the fact that the number of unique possible connections in a network of n nodes can be expressed mathematically as the triangular number n*(n-1)/2, which is asymptotically proportional to n-squared. The greater the number of users with the service, the more valuable the service becomes to the community. Two telephones have one connection, but five telephones have ten connections and twelve telephones have sixty-six connections. NYDIG ran an analysis and found that 93.8% of the variation in Bitcoin’s market cap from 2011 through 2020 can be explained by the square of its network addresses, and network addresses have been growing at 15-20% per year (18% in the most recent year). But even if network addresses kept growing at 25% per annum for the next five years, total network addresses would still equate to less than one percent of the world population. In other words, there is still a lot of room to grow.
Beyond this, it’s notable that the last few years have seen a growing number of blue-chip companies embrace digital assets, such as MassMutual, BNY Mellon, Visa, Mastercard, PayPal, Square.
Also notable is the fact that the first country, El Salvador, has decided to adopt Bitcoin as legal tender. Yes, El Salvador is a tiny country with a GDP roughly half the size of Rhode Island’s, but it is a monumental development that a country has decided to adopt Bitcoin as legal tender. It will be interesting to see whether El Salvador’s announcement triggers a domino effect across Latin America. Adoption, as Hemingway wrote, could happen gradually, then suddenly.
On the risk side, the longer-term existential risk of sorts is a heavy-handed governmental regulation. The short-to-intermediate term risk is Tether (USDT), a $60Bn AUM stable coin (the largest circulating stable coin) with just 13 employees that refuses to be audited. The NY Attorney General found the company to be overstating its reserves and required Tether to begin reporting quarterly its assets backing its reserves. The March disclosure revealed that just 3% of its assets were in cash with the rest split between positions in CP, secured loans and corporate bonds. Moreover, it carries exceedingly thin capital levels – less than 40 bps exist for any loss absorption in the event its holdings lose value. Finally, the other risk is the extent of rehypothecation in the crypto space, aka leverage.
Now, let us turn to Ethereum.
If Bitcoin aspires to be the global reserve asset, Ethereum aspires to be the crypto global financial system operating platform and, at a broader level, the Internet 3.0. Created in 2015, Ethereum is an open-source, blockchain-based, decentralized software platform which uses Ether as its cryptocurrency. Essentially, it is an Internet without any central authority.
What does Ethereum make possible? Here are a few examples.
One of the biggest sets of applications on the Ethereum network are DeFi apps, or decentralized finance. DeFi is aimed squarely at the heart of remodeling traditional financial services through an emerging ecosystem of decentralized financial applications that enable lending, borrowing, trading and derivatives.
At present, the DeFi space remains small with only around $50B in TVL (total valued locked) – a drop in the bucket compared with traditional financial services – but consider how quickly that has grown. The $50B today is up from $1.25B one year ago – that’s 4,000% growth Y/Y, and up from $500M two years ago and $160M three years ago (and just $4 four years ago – yes, four dollars). So, it tripled from June 2018 to June 2019, then doubled from June 2019 to June 2020 and then rose 40-fold from June 2020 to June 2021. Mighty oaks from little acorns grow. Because of DeFi’s decentralized nature, there is no middleman – no central financial institution, ie no institution there to charge economics. This means it should be able to provide lower-cost services and if those services are easy to use, safe and reliable, growth should remain robust.
An imperfect analogy would be that, over time, DeFi is poised to compete with traditional financial services in a way not unlike how passive investing has risen to compete with the active investment landscape.
But DeFi is just one avenue for Ethereum. Ethereum also enables NFTs - Non-fungible tokens – which are any unique digital asset. They can be pictures, video, songs, or anything digitized. Their non-fungibility is facilitated by the blockchain and large and growing NFT marketplaces like opensea.io already exist. In May 2021 opensea.io processed $138M in volume, up from $1.06M in May 2020 – an almost 130-fold Y/Y increase.
Overall, more than $1.5 Trillion in transactions were settled on the Ethereum network in just the first quarter of 2021, that is more than the prior seven quarters combined.
Beyond DeFi and NFTs, Ethereum will enable content creators to monetize their likes, retweets and views via micropayments from followers without any platform operator taking a cut. Individuals can get paid for opting in to view ads or consenting to share their personal information. Moreover, transferring valuables such as art or real estate could no longer require intermediaries and extensive paperwork.
Yet another way of thinking about Ethereum blockchain is as the next major computing platform evolution – the fourth such iteration in the sequence beginning with mainframe computing, evolving towards client-servers and then transitioning to cloud-based computing.
And yet another way of thinking about the network is that Ethereum currently commands the largest share of crypto developers of any platform in the world. Of the roughly 9,000 active monthly crypto developers, more than one in four (~2,400) is developing on Ethereum’s platform, and this number has grown over 200% in the last 3 years. Bitcoin – the second most actively developed – has grown its developer base by 70% in the last 3 years.
Ethereum also has an upcoming catalyst of sorts. Ethereum, like Bitcoin, is a PoW – proof of work – model. However, Ethereum is in the process of transitioning to a PoS – proof of stake – framework. This will a) reduce its environmental footprint, b) enable faster and cheaper (and more) transactions, and c) create an interesting and substantial reduction in the issuance rate of new coins. Unlike Bitcoin, which has a fixed supply, Ethereum’s supply is not capped and currently stands at around 115M coins, which is up ~4.5% Y/Y, which is around 3x the rate of increase in Bitcoin now. After the transition to Ethereum 2.0 (expected later this year), however, the inflation rate in Ether is expected to drop to 2 million per year or less – a reduction to a 1.7% Y/Y rate of growth – or an effective ~”thirdening”. Given what we have seen from Bitcoin’s price in response to its halvenings, Ethereum’s thirdening should be a significant catalyst.
Recently I presented a bull-bear deck on Coinbase – the largest US crypto exchange. For perspective, Coinbase went from $27M in EBITDA in 2019 to $527M in EBITDA in 2020 to $1.1B in EBITDA in Q1 of 2021. Moreover, Coinbase has risen from having ~4% of global crypto assets on its exchange in 2018 to 9% in 2019 and to 11% in Q1 of 2021. If you would like to see our work on Coinbase, contact sales@hedgeye.com
Additionally, in conjunction with our Macro Policy head, JT Taylor, we have begun hosting a crypto regulatory and politics series we call Crypto Capitol. Our first installment featured Ed Moy, who was the head of the US Mint at the time the Satoshi Nakamoto white paper was released – he had some fascinating takes on a huge range of issues surrounding the interplay of governments around the world and crypto. Let us know if you would like access to that replay.
Finally, several months ago our Macro team introduced its daily Crypto Quant product which provides risk ranges, levels, correlations, implied Volatility and other metrics for tracking Bitcoin, Ethereum and other crypto-related equity vehicles.
Moving forward, we see the crypto space as one of the most interesting opportunities for investors and we plan to continue broadening our research efforts therein.
If you would like to learn more about my research team's in-depth investing research please reach out to .
Immediate-term Risk Range™ Signal with @Hedgeye TREND signal in brackets:
UST 10yr Yield 1.43-1.61% (bullish)
SPX 4180-4291 (bullish)
RUT 2 (bullish)
NASDAQ 13,977-14,322 (bullish)
Tech (XLK) 140.91-145.22 (bullish)
Energy (XLE) 52.23-56.77 (bullish)
Financials (XLF) 34.90-38.03 (bullish)
Utilities (XLU) 62.87-65.08 (bearish)
Shanghai Comp 3 (neutral)
Nikkei 28,185-29,724 (bullish)
DAX 15,444-15,847 (bullish)
VIX 14.38-19.43 (bearish)
USD 89.67-92.64 (bearish)
Oil (WTI) 70.07-73.90 (bullish)
Nat Gas 3.13-3.40 (bullish)
Gold 1 (bearish)
To your continued success,
Josh Steiner
Managing Director
