JUNE 2021 INVESTOR LETTER
“The future depends on what you do today.”
― Mahatma Gandhi
The second quarter was extremely challenging for cryptocurrency markets. There was nowhere to run and nowhere to hide, as the overall crypto market-cap dropped 49% from a peak of $2.52 trillion on May 11th to a low of $1.28 trillion on June 27th.
In the second quarter, Bitcoin returned -40.5%. Although we were able to outperform on the way up, and manage successfully through the drawdown, we continue to strive for better performance to maximize returns for our partners. We (and almost every other fund in crypto) did not expect to have a -55.6% (peak-to-trough) drawdown in Bitcoin this early in the post-halving bull run, especially since there was not an initial blow-off top at the beginning of the year like we experienced in 2013 (see chart below).
Many price prediction models were exactly on track for the beginning of the second quarter (as can be seen in this tweet from Dan Morehead, the CEO of Pantera Capital), but unfortunately did not take into account the dual black swans of China and Elon & the ESG Gang (discussed below). When fundamentals and prices deviate to an extreme, it often provides the best opportunities.
The price has also (most certainly) not followed the 2017 post-halving pattern. 2017, for the most part, was a straight-line up with six mid -30% corrections. In fact, every quarter in 2017 was positive.
The 2017 price action looks heavenly compared to the hellish downside volatility we have endured the past two months. As Travis Kling of Ikigai fund notes, we have “[n]ever had a cyclical top this flat. Never had a pullback this deep.” That leaves us in uncharted waters, with many crypto market participants calling a cyclical top and throwing in the towel on the bull run. We firmly believe these calls are premature and will prove to be costly for impatient investors.
The strongest empirical data we can point to, along with our past experience understanding the emotions accompanying new price patterns in an emerging asset class (and being able to recognize the fear and greed as normal – and not the end of a cycle), is the simple fact, noted in the Ikigai investor letter: Bitcoin does not have distributed or flat tops. Bitcoin has always given investors a tiny window to sell highs during blow-off tops. Considering past price behavior, the probability that Bitcoin will not have at least one blow-off top this cycle is extremely low and would be unprecedented. Human emotion at tops and bottoms is always amplified and leads to poor long-term investing decisions. We believe the pervasive fear and angst among crypto investors now is likely more indicative of a cyclical bottom during a bull run vs. an early onset bear market.
China Crypto Crackdown
Undoubtedly, the most impactful news contributing to the price drawdown in Bitcoin and cryptocurrency markets since the April highs is the Chinese Communist Party (CCP) implementing strict regulations surrounding Bitcoin and Bitcoin mining. In the past, reporting on these new policy changes by the CCP has been sparse, exaggerated, and often incorrect. For example, going back to the 2017 bull run, many tweets and news headlines frequently read “China Bans Bitcoin.” That is not at all what actually happened.
China started cracking down on cryptocurrencies in 2017 when it forced several local exchanges to shut down and banned initial coin offerings (ICO’s). The 2017 ICO ban and other smaller regulatory actions since then were incremental and calculated, not amounting to an all-out war or ban on cryptocurrencies. Crypto investors have always had their eye on the CCP and regulatory actions, but until now, it seemed China was going to closely regulate the industry and not attempt to replace it. However, in retrospect, the ban on mining and industry involvement does make sense, especially considering the CCP’s desire to control all aspects of its citizens’ lives. Bitcoin is an experiment in economic freedom outside the system that is a formidable alternative/competitor to the digital central bank backed currency the CCP has been developing.
Starting in March this year, China began to signal a change in its stance toward crypto, becoming noticeably more aggressive by banning Bitcoin mining in its Inner Mongolia region (which accounted for ~8% of all Bitcoin mining). The CCP has since followed suit in the rest of the country (most recently in the Sichuan province), even introducing a hotline that can be used to report suspicions relating to mining operations. In June, China took the additional step to prevent financial institutions, like Alibaba’s Alipay, from providing services for virtual currency transactions. Below is a detailed timeline from Ikigai with all of the actions taken by Chinese regulatory authorities in June. As you can see, it has become an all-out war against anything crypto-related.
The ban on Bitcoin mining in China is a surprise to us from an economic and game theory perspective. However, it does make sense from a clean energy policy perspective, and also because the CCP is getting ready to launch their own central bank backed digital currency. Prior to the recent regulatory actions, China accounted for between 65-75% of global Bitcoin mining. Earlier this year, crypto became a trillion dollar market for the first time. Depending on future growth assumptions and overall outlook for the crypto industry, Chinese regulatory actions could prove to be a costly mistake from an economic and strategic standpoint in the near future.
There are several major silver linings to the China “black swan” regulatory actions, especially in the medium-to-long-term. First, before the CCP crackdown and the start of the “great mining migration,” the United States only accounted for ~7% of global Bitcoin mining. As of now, almost all large Chinese miners have been forced to close shop and to look for a place to relocate operations. Many of the large mining operators are coming to Texas, Wyoming, and other regulatory-friendly areas of the United States and other countries. We see it as a big net-positive for the majority of Bitcoin mining operations to be in more stable and friendly political jurisdictions. Geographically diversifying the overall Bitcoin mining hashrate, by not having 65%-75% in one unpredictable country like China, will make Bitcoin even more attractive and robust going forward.
Second, the “great mining migration” resulted in a decrease of around ~50% in the overall hashrate of the Bitcoin network. It is debatable (depending on the time period) if price follows hashrate or vice versa. This time around, price definitely followed hashrate. However, despite the 50% reduction in hashrate that resulted from basically being attacked by a sovereign nation, the Bitcoin network functioned flawlessly, and the price only briefly dipped below $30,000 per Bitcoin. We believe this is a major positive for Bitcoin in the long-run because it amounts to the ultimate stress-test.
Elon & The ESG Gang
As Bitcoin has garnered more attention over the past several months, there has been a particular amount of focus centered around the energy usage and efficiency of Bitcoin mining. The most publicized case is the wavering support and critique from Tesla and Elon Musk.
In late 2020, Elon Musk expressed interest in adding Bitcoin to Tesla’s balance sheet and, with some advice from Michael Saylor, accumulated ~$1.5 Billion worth of Bitcoin over the next few months. This was made public in Tesla’s February 2021 SEC filing, and it jump started the first quarter rally in the price of Bitcoin as retail and institutional investors looked to follow suit. A few months later in April, Musk announced that Tesla will accept Bitcoin for car purchases. However, only a month later, Tesla reversed this decision, claiming the transactional cost of Bitcoin was too energy intensive and harmful to the environment. This apparent 180° was a major contributing factor to the drop in the price of Bitcoin over the past few months. Similar to the compounding support to the upside, as Tesla changed its tune, many others also hopped on the criticism bandwagon to voice energy related concerns. Musk did later clarify that Tesla still holds its core Bitcoin position and would again accept Bitcoin as payment, once more than 50% of the energy used to mine Bitcoin comes from renewable sources. Additionally, in response to these issues, Elon Musk and Michael Saylor teamed up again to form the Green Energy Bitcoin mining council.
The energy usage of Bitcoin has become a hot topic for Bitcoin critics. Because Bitcoin’s energy usage is easily quantifiable, news stories love to call out large numbers and compare them to arbitrary measurements like the overall energy usage of countries. However, it is much more important to compare Bitcoin’s energy usage to other industries that it is more directly related to, such as gold mining or the current financial banking system. These numbers are less talked about, only because they are harder to quantify. However, accounting for all input materials and energy costs, the amount of energy used to mine gold in 2020 was more than double that of Bitcoin. Additionally, the amount of energy used to run banking branches and ATMs alone was more than 5 times that of Bitcoin.
For another relevant comparison, one could look at the amount of energy used to mine Bitcoin compared to the amount of value that is generated, as demonstrated in the chart below.
As measured by multiple different metrics, a Watt of energy spent on Bitcoin goes further than if spent on many other categories. Additionally, Bitcoin mining operations are becoming more and more powered by renewable resources. In doing so, Bitcoin mining is also a significant driving force in the development and advancement of green energy technologies, such as solar and wind power. Therefore, a larger scale adoption of Bitcoin and cryptocurrencies over current financial and store of value systems will actually be a net positive force for environmental sustainability.
The growing pains of broader adoption, characterized by Tesla’s mixed support and criticism of Bitcoin, is emblematic of the traditional market’s hesitant but progressive involvement in crypto. However, even with the heavy criticism and wavering support, the longer-term picture is clear: Bitcoin’s ESG concerns are solvable problems that are already improving and ultimately will be a net positive for the environment.
Mining Energy & Bitcoin Network Hashrate
Even with the relatively efficient and increasingly green supply of energy for Bitcoin mining, it’s important to remember why all of this energy is necessary and what it means for the network. By the nature of the proof of work protocol that Bitcoin transaction blocks utilize, the longer the proof of work chain, and the more Bitcoin miners performing verifications, the harder it is for a single entity to alter or spoof any transactions. Therefore, the more energy or computational power being used to power the network correlates to the security of the network. The level of computational power used to verify Bitcoin transactions at a given time is called the hashrate.
A decrease in the Bitcoin hashrate could potentially cause a slow down in the time needed to verify Bitcoin transactions; however, there is another feature built into the Bitcoin network’s structure called network difficulty. This is a variable that adjusts the computational difficulty needed to verify a transaction and mine Bitcoin. The Difficulty coefficient can auto-adjust every 2,016 blocks (roughly every two weeks) and is determined based on the length of time that is needed to mine the previous 2,016 blocks. As the network hashrate decreases, the difficulty also adjusts, thus making Bitcoin mining more attractive, lucrative, and incentivising miners to come back onto the network in order to keep the hashrate at a stable level.
As previously mentioned, a number of Chinese mining centers have temporarily paused operations as they relocate due to regulatory changes. This has caused a dip in the current Bitcoin hashrate and has resulted in one of the largest difficulty adjustments in recent history. While the exodus of Bitcoin miners from China and decrease in hashrate has caused a significant decrease in price, the difficulty adjustment will have the inverse effect, as Bitcoin mining becomes increasingly attractive. Historical data confirms every major difficulty adjustment to the downside has resulted in a corresponding price move to the upside as shown in the chart below. This is a strong, positive catalyst for Bitcoin that will be coming in the near future.
We would also point out that the network hashrate has always recovered from dips to reach new all-time highs! As of the time of this writing, Bitcoin is close to being the most profitable to mine (due to network difficulty adjustments) than it has ever been in its history. Looking a bit into the future, as the Chinese miners relocate and miners come back online later this year, the hashrate will recover. We strongly believe price will follow, and want to be there when it does.
Leverage can quickly fuel market cycles both ways and can make moves extend past fundamental values. Many crypto exchanges allow traders to trade on margin accounts with leverage to help magnify profits. However, it can also leave traders in a much more vulnerable situation if the price goes in the wrong direction, especially when liquidations occur, forcing positions to automatically close at the best available rate.
What we saw in May, was a complete unwind of leverage across the entire cryptocurrency market. As market participants pullback their positions during volatile time frames, this further amplifies the selloff of leveraged positions creating a cascading effect of liquidations. Nothing changes fundamentally for the underlying technology during the price decline. These pullbacks are often seen as buying opportunities after the profit-taking has subsided.
Data around different global leverage metrics suggests that institutional longs held through the selloff, while retail/small account positions showed a steady decline as prices retraced. Open interest in derivatives positions also fell considerably since Bitcoin’s all-time high. This is indicative of retail and institutional investors reducing leverage. We are closely monitoring increases in open interest across the board as an indicator that the correction has run its course.
How DeFi Amplifies Leverage
DeFi allows people to lend or borrow funds from others, to trade derivatives to speculate on price, and to stake tokens to earn interest or yield by providing liquidity for decentralized exchanges. DeFi borrowing and lending has many facets. The key difference between traditional borrowing and DeFi borrowing is that DeFi borrowing is usually fully collateralized, instead of borrowing on credit. DeFi borrowing and lending platforms quickly became the earliest and biggest DeFi applications.
In DeFi, users can borrow and lend assets without any credit checks simply by supplying ample collateral. If the value of the collateral drops below the minimum to keep the loan current, third-party liquidators can trigger a function that sells the collateral off, levying a hefty liquidation fee on the borrower. Once the loan and fees are paid, the remainder returns to the borrower.
A lot of what we saw during the crash in May and June was partially caused by positions unwinding quickly to avoid expensive liquidations as the markets tumbled. On May 19th, $662 million in loans were liquidated in a 24hr period, the highest level of liquidations in DeFi so far. These leveraged positions that were liquidated drove prices down even more, triggering additional liquidations as borrowers rushed to close their positions when the market fell, causing a further cascade in prices.
El Salvador and Bitcoin for Countries
Recently, El Salvador became the first country to accept Bitcoin as legal tender. The proposed bill was announced by the president of El Salvador at the Bitcoin conference on June 6th and was passed by congress a few days later. This is a great development for the people of El Salvador and huge news for the Bitcoin ecosystem. El Salvador has had many issues with corruption and instability in its government and national bank resulting in an unstable currency and economy. Over 70% of the population of El Salvador does not have a bank account, making it extremely difficult for El Salvadorians to build their wealth and attempt to improve their social and economic standing.
Moving to accept Bitcoin as legal tender improves El Salvador’s situation in many ways. First, using a decentralized and predetermined currency and transactional network decreases the reliance on the government and central banks, thus making the economy more resistant to corruption and unrest. Second, the decentralized Bitcoin network is self-sustaining, which alleviates the government’s responsibility to maintain the country’s monetary or payment system. Additionally, Bitcoin lowers the barriers to entry for individual citizens to start saving and building their wealth. While many El Salvadorians do not have access to a bank account, a much larger number of people have access to a smartphone, which is all that is needed to create a Bitcoin wallet.
El Salvador’s announcement has led to a number of other countries with similar monetary issues to consider following suit. Political officials from several countries (i.e. Nigeria, Cuba, and Panama to name a few) have been questioned on the subject and have signaled they are looking into it. If the rush to buy Bitcoin in late 2020 and early 2021 was led by companies’ adoption of the digital currency, the next wave of adoptions may be led by countries.
The Path Forward
Although we have just experienced the worst second quarter for Bitcoin in eight years (see chart below) and third worst Month ever in May (down 35%), we remain steadfast in our thesis, and specifically our belief in the four-year halving cycle based on past bull-run experience. While the China, ESG, and leverage concerns may have delayed Bitcoin’s path this year, we maintain our price targets of $100,000 per Bitcoin ($5,000 for Ethereum) for the current cycle.
We have seen this movie before, specifically in 2013 and 2017. Neither bull run was a straight-shot to the yearly highs (although we would much prefer the path the price took in 2017, as evidenced in the table below). In fact, the only years where Bitcoin did not have a positive yearly return were 2014 and 2018, the two years immediately following bull run years (this year in the four-year cycle). Although past performance does not predict future returns, we firmly believe it has an outsized effect on future return probabilities. In other words, the odds are overwhelmingly pointing to a strong finish for crypto in 2021.
Part of our job is to provide perspective and reassure our partners during the difficult parts of the crypto cycle (i.e. the past 2 months) and to see the forest when everyone else is concentrating on the trees. We are also tasked with not allowing ourselves to get too euphoric during periods when we have hyperbolic price action to the upside. With that lens in mind, we strongly believe now is a time when wise investors will look to put additional capital to work. In the next month or so, we will likely see some of the best entry prices for crypto assets for the remainder of the year.
Although we can always trade better (we are constantly striving to improve performance), in the past few months, we have managed to keep a portion of the gains from the first quarter, while putting the fund in position to capitalize on the second half of the year. A buy and hold strategy would have given all yearly gains back (and, depending on the asset mix, would likely be significantly down as of the time of this writing). Due to a series of deft maneuvers the past couple months, Parkour remains in position to make the right moves now and going forward to capitalize on an impressive end to 2021.
Thank you for your trust!
The Parkour Team