December 2022 Bitwise Investor Letter

By: Matt Hougan, Anais Rachel, Alyssa Choo and Ryan Rasmussen

Market Overview

Dear Investors,

Bear markets can be isolating. As prices fall and headlines swirl, it’s natural to worry that you are missing out on something. What are other investors thinking?

One of the great parts about my job is that I get to speak with hundreds of investors at conferences, on webinars, and in one-on-one meetings. For this month’s Investor Letter, I want to share the most common questions I’m hearing from investors about crypto today, as well as my answers. 

I hope you find it helpful.

Question 1: What happened at FTX?

A classic fraud.

FTX was an offshore, largely unregulated crypto derivatives exchange that primarily served international customers. Customers deposited money at FTX and used the platform to trade. Instead of safeguarding client assets, as it was supposed to, FTX “lent” them to a hedge fund founded by FTX’s CEO, Sam Bankman-Fried. That hedge fund made highly speculative trades using significant leverage and, according to reports, lost all the money.

FTX is now bankrupt, and customers are left with essentially nothing.

Question 2: Why should I trust in crypto after FTX?

It’s important to think about what worked and what failed in the recent crisis.

One thing clearly didn’t work: trusting unregulated offshore entities with your money. In retrospect, turning your money over to a crypto derivatives exchange that set up shop in the Bahamas specifically to avoid U.S. regulation was a bad idea. Hindsight, of course, is 20-20.

But two things worked exceptionally well over the past year.

First, regulated institutions performed soundly. To date, no regulated U.S. custodian has lost customer assets, and U.S.-domiciled crypto-trading venues like Coinbase and Kraken have operated as designed.

Second—and more importantly—actual crypto applications like DeFi apps have proven their mettle. While FTX was freezing customer funds, DeFi exchange Uniswap saw increased trading volume. In fact, at the peak of the crisis, it briefly eclipsed Coinbase, processing $3.5 billion in trades in a single day. Meanwhile, lending platforms like Aave managed loans with no losses and no withdrawal halts for customers—a remarkable result considering the crisis, and one that compares favorably to any traditional bank and prime brokerage in the world.

Before November, it was fair to ask how DeFi would manage a high-volatility stress test. It turns out the answer is “perfectly.”

Question 3: Are you saying there is no fallout from FTX?

Not at all. There is significant fallout, both short- and long-term.

In the short term, FTX’s collapse is unquestionably bad for crypto. It led to the forced selling of many crypto assets by investors facing margin calls. It drove firms like BlockFi into bankruptcy and disrupted operations at crypto lenders and prime brokerages like Genesis. Bitcoin’s price fell from roughly $20,000 to $15,700. More importantly, it raised fear, uncertainty, and doubt in the minds of many investors. This, naturally, will cause them to sit on the sidelines. I suspect it will take 6-12 months for the air to fully clear.

In the long term, however, FTX’s impact looks different. The most obvious long-term impact is the speed with which new regulations will be introduced into the crypto market. Regulators and legislators will not sit idly by given the high-profile nature of the collapse.

But while some are worried about this—regulation made in haste is not always well crafted—we strongly believe that greater regulatory clarity will be significantly positive for crypto.

Ironically, FTX’s collapse may accelerate the development of the next bull market in crypto.

Question 4: Wait a second. FTX’s fall could be a good thing?

In a narrow but very important way, yes.

For the past decade, crypto has been on a journey from a largely unregulated past to a robustly regulated future. We are currently in the middle of that journey.

The recent crisis reinforced the benefits of sound regulation. Regulated U.S. custodians like Fidelity and Coinbase Institutional kept client assets safe, while unregulated offshore entities like FTX collapsed.

One challenge the industry faces, however, is that current regulations only stretch so far. Reach beyond the most basic services and you enter a regulatory gray zone, which stifles innovation and/or pushes investors into riskier options.

For this industry to reach its full potential, we need stronger regulations. Specifically, we need stronger regulations around stablecoins, so investors can have full confidence in their solidity. We need greater regulation of spot crypto-trading venues so investors know assets on those platforms are safe. We need greater rules around disclosures so investors can make better decisions with a full understanding of risk. And we need better regulation around investment products so investors can access crypto in familiar formats like ETFs, rather than being forced into more complex and often more expensive vehicles.

A lack of regulatory clarity in these spaces keeps institutional investors on the sidelines, as they can’t fully underwrite crypto’s risks. It stifles innovation, since talented engineers don’t know the parameters of what they can or cannot build. And critically, it confines the potential benefits of crypto’s disruptive technology to a niche market. We can’t, for instance, expect to see the creation of decentralized stock exchanges that can settle stock transactions instantly without the strong regulatory framework that would allow them to exist.

At Bitwise, we believe the next crypto bull market will be the biggest yet—and that it will be sparked by the moment crypto goes mainstream and starts impacting the day-to-day lives of millions. But that can only happen when clear regulatory guidelines are in place. By accelerating the progress of that regulation, FTX’s collapse may end up strengthening crypto’s foundations. 

Question 5: Did Bitwise trade or custody assets on FTX?

No. Here’s why. 

Bitwise uses institutional trading desks to keep assets safe during trading and to minimize exposure to exchanges. Using crypto exchanges to trade introduces risk, as doing so creates exposure to the exchange’s inherent risks.

Bitwise instead uses well-established over-the-counter trading desks where assets do not need to leave custody until settlement occurs, allowing trades to settle directly with third-party custodians. We have used these procedures for multiple years without incident and are proud of our approach to keeping client assets safe.

When trading on exchanges is necessary, Bitwise only works with U.S.-domiciled entities (like Coinbase) and limits the total exposure.

Question 6: What important news has flown under the radar during the FTX mess?

A lot, actually.

At Bitwise, we are particularly interested in areas where the price action in crypto doesn’t match the fundamentals. One area where that appears to be true is Ethereum. There are two significant developments that deserve our attention.

First is supply. A little over two months ago, the Ethereum blockchain went through its “Merge.” The upgrade shifted the blockchain from proof-of-work to proof-of-stake. Among other impacts, it dramatically reduced the inflation rate of the Ethereum network. In fact, at the time of this writing, the total amount of ETH in the world is roughly the same as it was at the time of the Merge, 77 days earlier. Under the old proof-of-work system, there would have been an additional 900,000+ ETH created, worth well north of $1 billion. This dramatic reduction is supportive for prices, and the value will compound over time.

The second development is the growth of Layer 2 networks like Polygon. Layers 2s allow Ethereum users to process transactions more quickly and at a lower cost than using the main blockchain. Nearly everyone in the Ethereum ecosystem believes they will be critical to Ethereum’s long-term growth.

Layer 2s have seen significant adoption by many users in the past few months. As one example, JPMorgan recently used Polygon to settle a currency trade on the blockchain. The table below shows the growth in the Layer 2 ecosystem.

Daily Transaction Counts for Ethereum and Layer 2 Protocols (Seven-Day Moving Average)

Source: Bitwise Asset Management with data from The Block and Blockscan from January 8, 2021 to December 1, 2022

Note: Layer 2 Protocols include Polygon, Optimism, and Arbitrum

This growth is really exciting, as it is required if crypto is to reach mainstream-level adoption in the future.

Question 7: What are you most excited about in crypto right now?  

One of the things that I’ve been thinking about a lot recently is how small the entirety of crypto is. According to CoinMarketCap.com, all crypto assets have a combined market valuation of just under $900 billion. That’s about half the size of Microsoft, or a little more than twice that of LVMH, the luxury goods brand that makes fancy purses and champagne.

Yet crypto arguably occupies a much larger mindshare than either. Why? Because people recognize how disruptive and significant it could be.

It’s a top item on the regulatory agenda in Washington because it has the potential to rewrite how finance works. It’s on the front page of The New York Times because it could change everything from social networks to collectibles to the foundations of the internet. It’s a lead item on the research agenda for institutional investors, financial advisors, and venture capital investors because they know that, if it is successful, it could be a life-changing investment.

With that framing, what I’m most excited about right now is the potential to learn, in the very near future, just how much crypto can deliver. 

Thanks to improvements in blockchain technology, like Layer 2 networks, crypto can now (or will soon be able to) support the level of activity required to sustain mainstream applications. Thanks to the influx of venture capital money over the past two years, crypto now has a large enough cohort of developers to build not just one or two, but many breakthrough applications. And thanks to the increased regulatory clarity that we are likely to get in the coming months, crypto could soon sit atop a policy platform solid enough to allow it to truly scale.

…

I hope these questions and answers are helpful as you navigate this challenging, but promising, period in crypto’s journey.

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Originally Posted December 6, 2022 – December 2022 Bitwise Investor Letter