Bitcoin remains tremendously important, even if it's difficult to defend at times.
It's not as flashy as other crypto applications. It's got a big carbon footprint, and the "maximalist" religious zealots that promote BTC are a hostile bunch. Bitcoin can be used by people we don't like and that can, at times, be inconvenient and undermine policy objectives. But as a single purpose, commodity money, and secure settlement system, it has held up miraculously. It has proven durability and will continue to serve as a powerful check on absolute sovereign authority.
It's also on the right side of the U.S. Constitution. Monetary code is speech, and self-custodied bits of computer code won't be subject to unreasonable search and seizure (we'll fight it to the bitter end at least). That extends to privacy coins and "zero-knowledge" tech that powers some of crypto's cutting edge payments systems, which I submit are technologies embedded not just with cypherpunk values, but with the values of the U.S. nation's Founders.
We will debate Bitcoin's role in society for as long as it exists. As Bitcoin grows (and it will resurge, I'm sure), I don't expect the powers that be to stand idly by without a fight. As it's been for a decade, Bitcoin's best defense will continue to be its inability to be held hostage by one charismatic leader, and its volatility and boringness will deflect attention in different ways.
That said, bitcoin's role as a usable currency will continue to be questionable. You can't (or shouldn't) build debt systems around 100 vol assets. You can't (or won't) integrate bitcoin into state governable central banks as a primary reserve any time soon.
That's what makes it so important to build stablecoin infrastructure (the right way) in parallel. Stablecoins are bridge currencies to a future where nations play a smaller role in centrally managing their economies.
Under a central bank digital currency (CBDC)-led future, finance looks dystopian and authoritarian. It looks exciting with cryptocurrencies.
Bitcoin is "Outside Money"
I mean, we canceled a country this year. What more is there to say?
Credit Suisse analyst, Zoltan Poszar, is one of my favorite macro analysts to read and follow. His investment bets aren't always on the mark, but his mental models and frameworks for how to think about the world's dominant reserve currencies are required reading for any serious investor. Zoltan popularized a term called "outside money," which is a more elegant descriptor for non-sovereign currencies than what those of us who have been into bitcoin from the early days have been able to come up with ourselves.
When the U.S. decided to sanction Russia for its invasion of Ukraine, and more importantly, to seize its U.S. Treasury reserves, it was a "cross the Rubicon" moment for crypto. Zoltan called it Bretton WoodsIII:
"When this crisis (and war) is over, the U.S. dollar should be much weaker and, on the flipside, the renminbi much stronger, backed by a basket of commodities. From the Bretton Woods era backed by gold bullion, to Bretton Woods II backed by inside money (Treasuries with un-hedgeable confiscation risks), to Bretton Woods III backed by outside money (gold bullion and other commodities). After this war is over, "money" will never be the same again…and Bitcoin (if it still exists then) will probably benefit from all this."
According to Zoltan, the trend towards deglobalization and on-shore manufacturing, domestic supply chains, and commodity reserves would have a persistent inflationary effect. Nations outside of the U.S.-EU alliance will "inevitably, but not imminently" look to outside money like gold and other commodities instead of G7 "inside money" and FX reserves that slowly lose purchasing power.
Bitcoiners often get ridiculed for "moving the goal posts" on bitcoin as an inflation hedge, but most of us have always used inflation as shorthand for "long-term monetary debasement" (QE is permanent), not point in time hedges on changes to Fed rate policy (target interest rates are temporary and subject to rapid adjustments).
Bitcoin is big now, and its continued ascendance will be slow, but powerful.
We're in a foot race to see whether more emerging market central bankers begin to bid on BTC or the big reserve currency nations move to kill the invention. Pro-crypto reservists are starting to pop up in unlikely places like the Harvard economics department, so we're getting closer to the end game than ever before, despite this year's market stress.
Bitcoin maximalists are often rightly derided for their tone and toxicity, but it's telling that Vitalik's tongue-in-cheek April Fools post on maximalism does steelman the thesis for Bitcoin.
It's unlikely global authorities will like technologies that make their jobs harder. I'm not talking about bitcoin's pseudonymous nature (crypto is notoriously easy to track with forensic tools like Chainalysis). But I am talking about how challenging it is to freeze or seize bitcoin at scale.
It's not popular with the Chinese Communist Party or the Canadian Government alike for the same reason: It's incompatible with dragnet financial surveillance and the one-click financial deplatforming that authorities covet.
That's why you will typically hear bitcoin maligned as a tool for terrorists, money launderers, and rogue states, even though it's a rounding error according to the data we do have. It may be politically expedient to draw attention to the outliers and negative anecdotes, especially when financial experts within the government refute those narratives based on hard data. They certainly never praise the tech when its same attributes allow refugees in wartorn countries to raise money in times of distress. Or people to survive financially during a total currency collapse, such as the current awful situation in Lebanon.
For instance, the Treasury Department itself knew that there wasn't a realistic risk that Russia could use cryptocurrency to evade sanctions at a meaningful scale. For bitcoin to do that, we'd be talking about multiple orders of magnitude larger flows of money than would be possible to conceal on a public ledger like bitcoin's. When it comes to evading U.S. sanctions, Russia is almost certainly going to turn to digital assets, but it seems more likely to be the digital yuan, given recent trends.
That didn't stop opportunists from using a red herring, slamming bitcoin as a potential tool for theRussians at the time and later as fodder for an unnecessary, overreaching bill to stamp out crypto in the name of "security." And I'm trying to think of something recent and more dystopian than the Canadian government putting American CEOs on a watch list for promoting self-hosted crypto wallets: a thuggish response to protected online speech of foreign citizens.
We've largely forgotten about it only because so much has happened since.
In light of ongoing regulatory uncertainty worldwide about the very legality of owning crypto privately, I rather like the concept of tracking "institutionally seizable dollars" (ISD%) or the amount of crypto that could be confiscated by a central service or authority at a given time.
If you're new to crypto or high profile (physical safety is at a premium) and you live in a "safe" jurisdiction, you should likely have a high ISD%.
If you're a bitcoin OG, anonymous, or live in an unsafe jurisdiction (like communist China or Canada) you should aim for a low ISD%.
Money is not the root of all evil, it is simply a tool for trading tangible resources (food and shelter) and human time (labor). Crypto is a monetary innovation, and those who call it a tool for evil are often projecting their own geopolitical worldview onto a neutral, amoral, and permanent technology.
Bitcoin will outlive the Euro. So it's best for the folks in Brussels to learn how to deal with it.
Bitcoin Mining
There's been some terrific research done on the economics of mining, and I won't cover that here, other than to say that it hasn't been a very good year for miners. One year ago, bitcoin miners operating in Texas could produce bitcoin for between ~$5-10k, and bitcoin traded at $60k. It now costs closer to $15-20k to produce the same bitcoin, and more miners are in distress.
(Here's an excellent article from Compass Miningthat breaks down the top 10 miners by performance, balance sheet, and overall financial condition if you are interested in specifics. Zack Voell also recaps the monthly carnage. The Septemberupdate was "what happened this month." The October update was "not a great month." The Novemberupdate was "a remarkably sh*t month.")
But we don't need to talk about the idiosyncrasies of hardware operations or harp on the fact that a capital and energy intensive sector has struggled amidst the 75% bitcoin price decline.
Instead, let's talk about mining, and the regulatory crosshairs in which it now sits. To do that, let's talk about the "good facts" and "bad facts" about proof-of-work mining and whether bitcoin can actually help improve the environment.
Bad facts:
Bitcoin mining produces a lot of e-waste each year, about the same amount as a country the size of the Netherlands. Only about 17% of this sort of waste is recycled today.
In environments with acute energy shortages and high costs, bitcoin mining can be seen as driving up marginal energy costs for the average consumer.
At the beginning of the year, only 39% of bitcoin mining was renewable. CoinShares estimated that nearly 60% of bitcoin mining power comes from coal and gas. (I'm awaiting CoinShare's January refresh to see how things have evolved in 2022. This is a fairly manual and tricky data set to compile, and they have the best we've reviewed.)
Good (or mitigating) facts:
Bitcoin mining costs are fixed and capped by market forces. Bitcoin does not become marginally more energy intensive if more people use bitcoin. Instead it is a function of bitcoin's market cap and energy costs. As mining issuance rates decline over the next 5-10 years, energy consumption and e-waste will be capped by the marginal cost it takes to mine a single bitcoin, and that cost will only face upward pressure if bitcoin's entire market cap resurges. (You wouldn't buy more energy than BTC is worth to mine.)
Today, mining creates a carbon footprint that's about the same size as tumble dryers and about a third the size of gold mining. It's also significantly less energy intensive than the global banking system or the militaries that secure it. Not exactly a global killer.
And finally, bitcoin miners are "the dung beetles" of the energy world. They'll eat energy that no one else wants or can use. The trend towards leveraging wasted and stranded energy sources continues. Bitcoin miners have been increasingly co-locating to capture flared methane, stranded geothermal energy, coal refuse, and even recycled waste tires.
Flaring is a particularly valuable segment to highlight, as even the White House Office of Science and Technology wrote about it favorably in their crypto climate report.*
Natural gas is a common by-product of crude production. Because oil drilling sites typically reside in remote locations where pipeline and powerline infrastructure is non-existent, excess natural gas is often flared (combusted) away. Methane leaks directly into the atmosphere, causing more than 30 times the greenhouse effect of CO2 over a 100-year period.
Bitcoin miners have found ways to leverage wasted energy and reduce the carbon footprint of the oil industry. CoinShares estimates that 69 TWh of wasted power in the U.S. is lost annually to flaring, which results in a carbon footprint of 78 million tons of CO2e emissions. In other words, the wasted energy from flaring in the U.S. alone is equal to 78% of the energy used by the global Bitcoin network in 2021 (89 TWh). Repurposing flared energy towards bitcoin mining would drastically reduce the amount of greenhouse gasses entering the atmosphere. Enough to potentially offset all the network's CO2e emissions or even make it carbon negative.
Bitcoin as an ESG asset. I am very sorry to disappoint you, but it's going to happen!
And we should make Bitcoin cleaner and more sustainable if we can!
Look, I think ridiculous double standards on energy policy should be fought hard. (Can we create a better carbon credit market using crypto? Of course!)
But I also know that a) bitcoin miners will be prime targets for load shedding because they are centralized and easy to spot, b) are not a particularly lovable bunch given their energy usage is tied to a bearish bet on the competence and responsibility of global governments, c) in my opinion, they're wasting valuable policy resources fighting the reopening of coal plants for bitcoin mining, and d) renewables are the future anyway.
The narrative deck is already stacked against us. Why make it any easier to target Bitcoin?
(*Note: The White House also notes that mining can help strengthen renewable energy grids, as renewable energy is unpredictable and results in excess energy during off-peak times that results in energy producers curtailing (or dumping) that energy. Miners can be a constant energy buyer of last resort, increasing profitability for renewable energy operations.)
There's no such thing as a free lunch. One of the knocks on bitcoin over the past few years has been that it doesn't generate yield or "do anything." That is a feature, not a bug of a store of value that is difficult to confiscate (or borrow).
One of the really great things about the financialization of bitcoin is that you can make 5, 7, 10% interest, risk free! All you have to do is let one of the industry's top crypto lending businesses like BlockFi, Celsius, Genesis, or Voyager borrow your funds and watch the cash roll in. Nothing bad could possibly happen...
Bitcoin can't be staked, and recent history has shown why you don't really want to lend it out to centralized counterparties. But what if there was a way to generate yield on bitcoin natively without incurring counterparty risk? That's something Sami wrote up for us earlier this year, and I'm fascinated by the concept, particularly for countries and companies that are otherwise sitting on large stashes of BTC. It all boils down to a bet on the Lightning Network, which I have grown tired of betting on as it has only ever disappointed me. Current lightning capacity is about $90 million. Wrapped Bitcoin on Ethereum (WBTC), which is itself just 10% of the TVL in DeFi applications, is 40x larger.
In a rising rate environment, I'm not sure that many corporate treasurers are willing to load up on balance sheet bitcoin. If anything, we're more likely to see supply-side shocks from miners covering costs and debt service payments, tax loss harvesting, and (in very bearish scenarios) potential default driven sales from Microstrategy. Short of a significant Fed pivot on interest rate policy, the next demand-side shock for bitcoin will likely happen at the global government level, not big corporations.
Out of the top 25 crypto assets by market cap, the top three performers in Q4 have been Dogecoin, Litecoin, and Ripple's XRP.
If you had told me this when I started writing ~200 hours ago, I would have done a tweet thread instead and called it a day.
Privacy Coins & Private Transactions
Defaults are powerful when it comes to crypto networks. Blockchains like Ethereum are transparent by default and allow for private or "shielded" transactions to be processed in specific pools. But it's not clear whether that will prove to be a feature or a bug at scale.
On the plus side, I'm not sure we would have been able to scale public blockchains under real-world regulatory constraints if they had started off fully private from day one. From an auditability and transaction-monitoring standpoint, we've benefited greatly from default public and pseudonymous chains. The people who track criminal financing for a living have a slightly easier job, so less of a panic at the disco.
On the other hand, the default public nature of most blockchains has now put "privacy preserving tech" into the naughty category for crypto applications. We'll need a major uptick in viewing key support and acceptance in order to keep authorities at bay in the coming years. Otherwise, applications like Tornado Cash will continue to run the risk of being targeted for "aiding and abetting money laundering." (I don't agree with it, but it's a clear and present risk.)
That may create opportunities for the largest private-by-default networks, Monero and Zcash, as well as privacy-focused Layer-2 scaling solutions such as Aztec (already flagged by at least one exchange as a high risk protocol) and Polygon's Nightfall (a jointly launched solution with accounting firm EY that preserves on-chain transaction privacy for enterprises without hindering their bookkeeping requirements).
Ethereum won't solve base layer, end-to-end privacy for many years (if ever). That opens the door for a pure play private L1 like Zcash, or as Balaji suggests, a ZEC-ETH hybrid.
If we think about the dollar-banking and markets system as our leading "tech company," one of the easy wins we should notch is on the stablecoin front.
The U.S. dollar continues to dominate as the world's reserve currency, and there is an almost insurmountable distribution advantage if we merely lean into stablecoins as a national priority.
Our entrepreneurs have been leading the crypto infrastructure and DeFi buildout. Over 50 million Americans own crypto today, and it's likely that Americans own a plurality of all crypto in circulation. Crypto is also a sector in which China simply cannot compete with us, since open financial architecture is fundamentally incompatible with Beijing's authoritarian model.*
There is a burning need for USD-pegged stablecoins in countries with sky-high inflation such as Argentina, where a dozen conflicting exchange rates overlap and the government is creating new rules around who can access dollars:
"Most commonly Argentines use the "dolar blue," a free-floating, all-cash rate of 280 per dollar that's technically illegal. Other rates include one for investors buying stocks and bonds, another for credit card purchases, one for the "Qatar dollar" that effectively doubles the official rate for foreign travel (associated with the World Cup's timing, one for "Coldplay" which involves a 30% "tax" on top of the cost of tickets for concerts by artists who charge in foreign currency."
If we want to prolong our status as the world's reserve currency holder, we should get better at exporting digital dollars without the shackles of a CBDC - something that no country will want for national security and privacy reasons. As we covered up top in the "outside money" section, there are plenty of geopolitical reasons that other countries may want to move away from the dollar reserve. We shouldn't make it easier for them to switch off by falling behind on the tech and regulatory frameworks.
We don't need to do much to win. We just need to not butt fumble a huge lead. We already have $900 billion of dollar-denominated stablecoin transactions per month, about what the Fedwire servicedoes per year. That terrible month we just had? Another record for USDC.
Stablecoins come with tradeoffs. You can optimize for their censorship resistance, their price stability, or their reserve auditability, but not all three. Well-regulated stablecoins like USDC from Circle are stable and audited, but they're also censorable. The Cowboy stablecoin, Tether's USDT, is stable and tough to censor, but you're making leaps of faith on the accessibility of its underlying reserves at any given time. Purely algorithmic stablecoins like Terra's UST work well…until they depeg, and really don't work so well.
We need all three experiments as stablecoins to be the backbone of DeFi and global crypto payment networks. Here's where the puck is heading next year.
(*I've had this paragraph in my notes for a while. I think I wrote it, but I'm not actually sure. If it came from someone else, I'll fix the attribution.)
The Stablecoin Trinity
I have spent a lot of time the past few years writing about the various types of collateralized stablecoins. I don't want to be redundant to prior reports, so let's do a speed round.
1.The Majors: There are two well-regulated USD-reserved stablecoin issuers in the U.S.: Circle and Paxos. Circle has $45 billion in USDC and counts Blackrock and BNY Mellon as its custodians. Paxos issues the Binance USD stablecoin (*on Ethereum) and Paxos dollar, which combined have about $20 billion in circulation, 95% of which is BUSD. Paxos is regulated by the New York State Department of Financial Services as a trust company, while Circle is a licensed money transmitter.
Those legal details matter in terms of how these issuers may jockey for regulatory positioning going forward. Paxos has a trust company charter and conditional OCC charter, so it likes keeping things cozy in New York State, while Circle is pushing harder for federal stablecoin legislation. Paxos is "more regulated" and has the biggest global exchange (and Mastercard and PayPal) as its white label customers, and USDC is the most dominant Ethereum-based stablecoin, and DeFi reserve, but faces FUD at times.
2.The Cowboy: Tether's market dominance has declined each year over the past several years, and it continued to narrow this year, as BUSD and USDC ate into its ETH-based market share in particular. USDT is still 50% larger thanks to the dominance of Tether on the Tron blockchain, but it has otherwise lost its lead. USDT on Tron is mostly an international phenomenon: the leading "not quite U.S.-blessed" digital eurodollar.
I explained last year why it was not quite right to call Tether a fraud. USDT seems to live by a code vs. any one law. Maintain full reserves (they publish semi-annual audits, but no one will ever be happy), but keep out of reach of any jurisdictions whose authorities seem trigger happy to seize assets. At times, they have been under-reserved, such as the 2016 Bitfinex hack (and customer bail-in) and the 2018 theft where they were a victim of an $850 million fraud themselves. (Good Tether overview on Odd Lots.)
You can think about the fully-reserved stablecoins on crypto exchanges and blockchains almost like Balkanized digital nations. On Ethereum, the ranking goes USDC, USDT, BUSD. On BNB Smart Chain, the order is reversed. On Solana, Avalanche, Polygon and most other major L1's and L2's, USDC and USDT are usually #1-2 in circulation. On Binance, and most international crypto-crypto exchanges, USDT is the top quote currency. All three are useful, and USDT on Tron is particularly underestimated, but powerful in its own right.
Then there's the crypto-collateralized stablecoins:
1.Dai: MakerDAO is one of the cockroaches of crypto, and I mean that in a good way. Though its circulation has roughly halved to $5 billion from its March 2022 peak, it has shown resilience once again in a brutal bear market. Despite the repeated shocks in the centralized crypto lending markets, MakerDAO and Dai haven't experienced any material issues or destabilization of the Dai peg.
2.Others: most of the other crypto collateralized stablecoins are rounding errors compared to Dai though they have similar structures, such as Liquity's LUSD (and soon competitive stablecoins from Aave and Curve). There's only one other meaningful crypto collateralized stablecoin, the last algorithmic stablecoin team left standing, Frax.
Algo-Stables: Crypto's WMDs
This year's failure of Terra and its LUNA token and TerraUSD stablecoin was swift and savage. The pain inflicted on investors was severe, and many people lost their life savings directly or indirectly betting on Terra's UST. It's a fair question as to whether we should continue running these high stakes algorithmic stablecoin experiments or whether they are all doomed to die the same painful death eventually.
I'll save you the look-back: I was optimistic on Terra in the 2022 Theses and will double down on why below. I only started to sour on the project in January 2022 as Do Kwon's swagger began to depeg from reality and into God complex territory. The aggressiveness I liked in 2020 and 2021 started to look like VC-fueled narcissism as the numbers got bigger. I sold most of my stake at the "arm tattoo" moment in January (and said as much on Twitter).
I did warn about the very thing that undid LUNA in the end:
"[Terra's] biggest headwinds are known unknowns, and it's unclear whether they would prove manageable or catastrophic to the entire Terra ecosystem…the reflexivity of UST and its usage of LUNA as a primary source of collateral [is something] to worry about. In a full "risk-off" environment, it's unclear how resilient Terra and UST might be. During the spring [2021] dump of LUNA, UST nearly became insolvent as the value of LUNA fell below the total value of UST in circulation. It took a $70mm capital infusion from Terraform Labs to shore up the stability reserve at Anchor, a systemically important Terra lending protocol. That lender of last resort model works until it doesn't."
These seigniorage share models are supposed to bifurcate risk into a speculative asset that absorbs volatility and backstops the system and a stable asset that is the object of stabilization. But they have reflexivity in down-trending markets that create "bank runs" and assumptions around "lenders of last resort" to shore up the share token during periods of distress.
I still think this model is possible. You have to grow conservatively and leverage an "insurance" contract funded from trading and lending fees (like BitMEX), though. For illustration, had Terra been able to leverage fees from their payment partner Chai or net interest margin from sister lending protocol Anchor and contribute that to an insurance fund, they might have had a shot at averting a bank run.
But when conservative, fee-driven growth went out the window, so did the unit economics and risk guardrails. This is banking 101 stuff, and their capital ratios sucked.
To be clear, I'm just not sure the experimentation in seigniorage share models is worth the risk anymore. Sure, you can invent a nuke, or do gain-of-function research in the coronavirus lab, but should you? Is it really healthy to give these programmatic black swans oxygen?
Fractional reserve models are still interesting to me, though. That's because we know most people are already comfortable keeping some funds in fractional accounts in legacy finance. One way to do this would be to meter withdrawals by wallet size (quadratic withdrawals?) which would serve as a sort of programmatic FDIC insurance. (OHM is a little bit like this, but it hasn't really 3,3'd its way to greatness this year…circulation is down 90%.)
Fractional reserve stablecoins (pioneered by Frax Protocol) build upon the idea that there is a sweet spot between overcollateralized and pure algorithmic stablecoins that allow for a scalable, capital efficient, decentralized stable value asset. The fractional reserves dampen reflexivity during periods of contraction, offering stablecoin holders 1:1 convertibility between stablecoins and the underlying collateral, and generally provide greater confidence in the peg compared to purely algorithmic models. Frax still has $1 billion in circulation and has maintained a tight peg throughout the year, despite the background noise.
Frax and Tron-based USDD now account for 70% of the algorithmic stablecoin market. It's probably good that this whole market is an order of magnitude smaller than it was in May.
I was disappointed to see Fei unwind (disclosure - I was a seed investor) after multiple hiccups. They had a rocky launch, ill-fated merger with a team that suffered a brutal hack, and sat between a rock and a hard place after the Terra collapse this spring. But they did push the envelope on a number of fronts: introducing the concept of "protocol controlled value" (PCV) in which protocols (not their liquidity providers) own the assets users deposit to the system, and they were aggressive in terms of the business development and "corporate actions" they pursued out of the DAO. It was a good team but messy unwind.
In terms of other experiments, I'm excited about Rai and Reserve, but neither have been able to make the jump into relevance.*
I ask again, is the juice worth the squeeze in this sector? I'm not sure. Last year I wrote:
"There are ponzi-like game theory attributes of these protocols that drive interest and participation, but it's unclear how those will hold up amidst a broader crypto selloff."
I don't love the chaos, but still see the need for new algorithmic stablecoin implementations. As reserve currencies continue to inflate away purchasing power, we need new currencies that maintain their purchasing power.
(*Isn't that ironic? Sheeeiiiit. The ones for their designs and conservative approaches are too small to cover still as they aren't serving as meaningful reserves.)
CBDCs & Dystopia
What's worse for society than a $60 billion algorithmic stablecoin collapse and bankruptcy? A central bank digital currency.
Circle's Head of Policy, Dante Disparte noted that the CBDC craze really started with Libra. It's not that they were angry with Facebook's boldness. It's that they were jealous of its potential and wanted it for themselves. "In keeping big tech at bay, 105 central banks began flirting with an even more perilous societal prospect, namely that central banks would become retail banks."
Here's Dante's comparison table, in case you want to make the full-throated argument against CBDC enthusiasts in your bureaucratic circles.
The two best lines for those incapable of squinting:
The case for CBDCs is often framed as a panacea for ills in the banking system that could be solved with policy and rules-based competition, rather than taxpayer-borne science experiments with money.
A CBDC would be tantamount to the Federal Aviation Administration flying planes and building jet engines, rather than defining competitive, rules-based safe passage in the skies.
There are many ways governments could wrap the economic arsenic of a CBDC in a colorful candy shell, such as airdrops for certain behaviors (or political allegiances). And honestly, I can't think of anything more sinister or dystopian.
