A YEAR OF PROGRESS[1]

What a difference a year makes.  This is how we started the January 2023 letter:

Dear Investors,

Let’s pretend it’s January 1, 2022.  Imagine that I told you that by January 17, 2023 Tesla would be down 63%, Meta down 60%, Amazon -42%, PayPal -57%, Square -54%.  It was the worst-ever year on record for U.S. bond investors.  According to an analysis by Edward McQuarrie, a professor emeritus at Santa Clara University who studies historical investment returns:

“Even if you go back 250 years, you can’t find a worse year than 2022.”

Now, I ask you to guess how much Bitcoin would be down.  I’d imagine that the majority would say more than 54%…

Blockchain’s resilience in the face of a terrible macro market for risk assets and historic idiosyncratic disasters is impressive…

Blockchain is going to change the world.  It will certainly survive these issues. 

It did – impressively. 

The price of bitcoin was down in line with those tech companies last year.  This year it has massively out-performed most.

That’s the 14-year story of bitcoin – higher lows and higher highs each cycle.

(More on that at the end of the letter.)

The naysayers and retrograde politicians are so good at being negative that it’s important to step back and appreciate the huge amount of progress the blockchain industry made in 2023.

The dominos fell relentlessly in 2022 – one toppling into the next, causing a relentless cascade of failures.  We saw hopefully the last few bad dominos topple this year.  Binance, the largest of those remaining pieces, will be addressed later in the letter.

The interlocking dominos seem to have fully played out.  The reason to be very bullish is that the vast majority of significant events in 2023 were good news and the blockchain industry made meaningful, necessary progress.

Some of the key takeaways:

– Institutional adoption has accelerated. The headline news has been the imminent approval of spot Bitcoin ETFs sponsored by large names in traditional finance – like BlackRock and Fidelity – and the leader in blockchain ETFs, Bitwise.  Similar to the first international gold ETF in 2003 and U.S. gold ETF in 2004, this opens a new channel for traditional capital to flow into “digital gold” that might not have participated previously.

– Our ability to rely on the U.S. court system to be fair and impartial has been reassuring. Ripple’s native token XRP ruled as not a security, Grayscale’s win in their lawsuit against the SEC regarding their Bitcoin ETF application – a few indications that a favorable regulatory landscape for blockchain in the U.S. can be achieved, enabling further innovation to occur onshore.

– Blockchain’s “dial-up” to “broadband” moment is happening. We can see this with the growth of Ethereum layer 2s and hyperscale blockchains – Arbitrum has accounted for nearly 100% of the increase in transaction growth this year in the Ethereum ecosystem.

– The market has rebounded since the start of the year. Bitcoin’s yearly low was $16,680 on January 2nd.  The overall market capitalization of cryptocurrencies has doubled, from $0.8tn to $1.6tn. 

We’ll dive deeper into some of these in this letter.  First, here’s a visual recap of some of the major events of 2023:

CRYPTO MARKET UPDATE

By Jeff Lewis, Product Manager, Hedge Funds

Exactly a year ago, the European Central Bank put out this not-so-prescient tweet calling for Bitcoin’s final moments before fading into “irrelevance”.

The ultimate tell was the ornamentation and exaggeration of language. 

Hindsight is 20/20, but really?

“artificially induced last gasp”

“embarks on a road to irrelevance”

At that time, I took it upon myself to respond to this drivel, laying out a four-point explanation for why we may see better days ahead for crypto.

You can read the full thing here, but I wanted to revisit the first point I made:

“1. The percentage of BTC held by wallets that have not sold in over a year is now 2/3, the highest reading ever, according to Glassnode [for this letter, we’ll refer to this metric as the “1-Year HODL Wave” or “indicator”]. In the past, new highs in this indicator have correlated with market lows. The accuracy of this indicator makes a lot of sense as the market has effectively restricted tradeable supply when it makes a high. Last fall, when BTC peaked, that indicator was at a two-year low of roughly 53%. Roughly $100B would buy every BTC in existence that is not in a long-term wallet. That is not a big number.”

The day of the ECB tweet, bitcoin opened at $16,445 – just nine days after the market bottomed on November 21st at $15,599 post-FTX fallout.

I don’t need to explain what happened next.

1-Year HODL Wave :: Where In The Cycle Are We?

Now that Bitcoin has rallied 160% since the ECB tweet, a question people are asking themselves is, “where are we within this cycle today?”

The 1-Year HODL Wave could help us answer that question.  It tracks the percentage of all bitcoins that have not been moved from one wallet to another for at least one year.  Side note: “HODL” is an acronym for “Holding On for Dear Life” but originated from a community member who misspelled “hold” in a post to a Bitcoin forum in 2013.

How is that metric useful? 

As bitcoin’s price approaches a new cycle peak, there’s a noticeable reduction in the percentage of coins held for over a year.  This trend is partly attributed to holders of these coins opting to realize profits by selling, leading to these coins no longer being categorized as 1yr+ in this analysis.  As a result, the 1-Year HODL Wave, represented by the orange line, declines while the price, shown by the black line, rises.

Historically, the price of bitcoin has increased slowly and steadily into the indicator’s peaks.

After peaking and rolling over, the price has ramped up quickly and steeply, with those rallies lasting 1.3 years on average from the indicator peak to the peak in price.

Here are the returns heading into 1-Year HODL Wave peaks and what occurred after.

For this cycle, we haven’t seen any clear indication that the indicator has topped out.

The punchline is: if historical price action around peaks in the 1-Year HODL Wave is any indication of future performance, the majority of gains this cycle have yet to come.

A natural follow-up question would then be, “when does the indicator peak this cycle and we see a sharp run-up in price?”

What’s interesting is that the peaks in the indicator have occurred no more than two quarters from Bitcoin Halvings – 0.2, 0.5, and 0.3 years before or after halvings.  The next halving is expected to occur at the end of April 2024.

JAMIE DIMON, THE LONGSHOREMEN’S UNION OF MONEY MOVEMENT

“If I was the government, I’d close it down.”

— Jamie Dimon, JPMorgan, CEO, Congressional Hearing, December 6, 2023

He reminds me of the longshoreman’s union in On the Waterfront.  (A 1954 film about an ex-prize fighter turned longshoreman who struggles to stand up to his corrupt union bosses.)  He’s always trying to shut down the competition.

The Marlon Brando character says:

Terry:  “Hey, you wanna hear my philosophy of life?  Do it to him before he does it to you.”

Jamie Dimon has been trying to kill bitcoin since 2014.

“I’ve always been deeply opposed to crypto, bitcoin, etc.  You pointed out the true use case for it is criminals, drug traffickers, anti-money laundering, tax avoidance….”

— Jamie Dimon, JPMorgan, CEO, Congressional Hearing, December 6, 2023

So, let me get this straight:  the CEO believes it’s only for criminals, drug traffickers, anti-money laundering, tax avoidance…but he sells the product to the bank’s clients? 

Isn’t that an ethics issue?  I guess not to him.  According to the Good Jobs First violation tracker, JPMorgan has incurred $35bn in penalties for financial and consumer-protection-related crimes, frauds, and other offenses.

Satoshi Nakamoto created bitcoin, has $50bn of bitcoin, and has never used a penny.  Satoshi gifted this technology to the world for free, without patent – to release billions of people from predatory banking and remittance fees.

“He that is without sin among you, let him first cast a stone.”

— John 8:7

Nobody’s voting for Jamie Dimon to cast the first stone.  But what strange bedfellows anti-bitcoin rhetoric makes. 

“I am not usually holding hands with the CEOs of multibillion-dollar banks.  But this is a matter of national security,”

— Senator Elizabeth Warren, replying to Jamie Dimon’s comments, Congressional Hearing, December 6, 2023

It boggles the mind that a Progressive can’t see the sublime beauty of bitcoin.  That Elizabeth Warren supports anti-competitive oligopolists like Jamie Dimon over the interest of the world’s population is hard to fathom.

While pondering this I happened to look up at my wall.  There it is!  The opening line of the Bitcoin paper: 

“A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.”

— Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System, 2008

Wouldn’t a populist want the people to be able to move money themselves – without going through a financial institution?  How odd that she’s holding hands with somebody who has extracted a half a trillion of value from the people.

Senator Warren may not be as tight with her Native American ancestors as she once was, but one Congressman actually lives in the Bronx – Ritchie Torres D-NY.  Congressman Torres actually knows how hard it is for his constituents.

Rep. Torres’s bio on X (f.k.a. Twitter) is as succinct as it gets: 

Born & bred in the Bronx.  Grew up in poverty.  Product of public housing.

He knows how the system works:

“The lowest-income families in the Bronx are often forced to pay predatory fees to transfer their own money to their loved ones abroad.”

— Congressman Ritchie Torres, U.S. representative for New York’s 15th congressional district at Pantera Blockchain Summit 2022

He knows that many of his constituents work for an entire month to pay their money-transfer fees.  Their families back home only get 11 months’ of their wages.  (The average remittance fee is 8.00% — one-twelfth of the income.) 

Rep. Torres shared his enthusiasm for bitcoin and blockchain at Pantera Blockchain Summit last year:

“I approach it as a representative of the South Bronx, which is often said to be the poorest congressional district in America. And crypto for me can be a powerful tool for addressing many of the symptoms of racially concentrated poverty….

“I feel like there are some use cases that have the potential to fundamentally reshape the lives of the most vulnerable communities. We have a traditional financial system that has fundamentally failed the lowest income Americans who are often left behind.  20% of the residents in the South Bronx are unbanked, 30% are under-unbanked….

“There is concern that DeFi could present a challenge to the traditional financial system, to which I would reply, “so what?”  I mean that’s the nature of technology, creative disruption, right? We have no obligation to protect legacy institutions or incumbent institutions. If those institutions are failing to serve communities like mine, that’s their problem.  We should welcome dynamism and creative disruption….”

— Congressman Ritchie Torres, U.S. representative for New York’s 15th congressional district

Look at the man Senator Warren supports:

Jamie Dimon’s bank won’t accept 99% of the world’s population as a customer and is extracting value equal to $458 billion market capitalization from those it is willing to do business with.

vs.

Bitcoin is permissionless.  Anybody on earth with a smartphone is welcome to use it.  Satoshi extracted not a penny.  Isn’t that a populist’s dream?

Senator Warren is right that blockchain is a matter of vital national security interest – she just has it backward.  The former chairman of the U.S. Securities and Exchange Commission Jay Clayton wrote an op-ed to stress this:

“Regulation is essential to our financial markets, and there is no doubt that tokenized financial assets should be regulated to ensure financial stability, promote capital formation, prevent illicit activity, and protect consumers.  But there is more the U.S. government must do.  Innovators must have assurances that if they follow time-tested regulatory principles, they will be free to pursue the market opportunities provided by better functionality.  The government should actively facilitate the adoption of technology in core U.S. dollar funding and payments markets. This is a matter of national security and financial stability.”

— Former SEC Chairman Jay Clayton, “America’s Future Depends on the Blockchain”, Wall Street Journal

The United States is losing this key strategic area to China.  The longer the retrograde regulators and politicians repress development in the United States the further back the U.S. falls.

On the Waterfront includes the iconic line, ranked #3 in the American Film Institute’s list of the top 100 movie quotations in American cinema:

Terry Malloy:  “You don’t understand, I could have had class. I could have been a contender. I could have been somebody.”

Bitcoin is a title-belt contender.  It will help billions of people get access to the financial services which are denied to them by the legacy oligopolists.

Jamie Dimon’s 10-year struggle against the future reminds me of Br’er Rabbit.

— Joel Chandler Harris, The Tales of Uncle Remus: As Told by Julius Lester, 1987

This guy better be careful.  The more he hits Br’er Bitcoin the more his legacy is going to be totally stuck to it…

NO MORE SHOES TO DROP

By Jeff Lewis, Product Manager, Hedge Funds, and Erik Lowe, Head of Content

After the fallout of FTX, many market participants were wondering, “who’s next?” or “what’s the next shoe to drop?”

On November 21, in what came as a surprise headline to many, the U.S. Department of Justice announced they had settled a criminal case with Binance and now former CEO Chengpang Zhao (known as “CZ”).

“Binance admits it engaged in anti-money laundering, unlicensed money transmitting, and sanctions violations in largest corporate resolution to include criminal charges for an executive.”

— Office of Public Affairs, U.S. Department of Justice, November 21, 2023

CZ was forced to step down and will possibly face jail time.  Binance must pay $4.3bn in penalties to the CFTC, FinCEN, and OFAC – nothing to the SEC.  Luckily for Binance, they can turn the page, refine their compliance practices, and still operate – there’s a long list of obligations that imply that the U.S. government is effectively in charge of their compliance department for the coming years.

Despite what may have felt like an anticlimactic resolution in comparison to the SBF/FTX saga, the Binance settlement marks a major milestone in the industry’s transition.

The market dipped 5% on the news but recovered immediately.

We believe the industry can now move on and away from the negative associations that have encumbered it to date.

The path from here is forward.

2023 REGULATORY RECAP

By Katrina Paglia, Chief Legal Officer

This year was full of developments in the blockchain regulatory landscape.  Positive rulings on high-profile cases have generated renewed interest from investors.  In addition, there are many areas to monitor from rulemaking to pending litigation that will have meaningful implications over the coming year.

In both this letter and future communications, such as our regulatory newsletter, we will highlight many of these developments, providing digestible information and practical insights to help our investors and entrepreneurs stay informed in this rapidly changing regulatory landscape. If you are interested in receiving our regulatory newsletter please sign up here where you can read a more detailed analysis on all of the below as well as follow for our future publications.

Settled Enforcement Actions

NFTs

The SEC recently announced their first two enforcement actions against non-fungible token (“NFT”) issuers under federal securities laws: Impact Theory, a California-based media and entertainment company and Stoner Cats 2, the producer of an adult animated television series. This marked a notable expansion in the commission’s regulatory focus.  The SEC alleged in both cases that the NFTs being sold were unregistered securities. Subsequent to the charges being announced, both companies agreed to settle with the SEC for ~$6.1 m (Impact Theory) and $1m (Stoner Cats).

The SEC’s case in both instances was centered around the way that the issuers primed investor expectations by promoting and marketing its NFTs, leading investors to believe that they would profit based on the efforts of others, a key aspect of the Howey Test that is used in evaluating digital assets as potential securities. The increased scrutiny on NFTs is intriguing since the spotlight had previously been on digital assets rather than NFTs.

Both enforcement actions strongly suggest that there could be additional SEC scrutiny of NFTs and that issuers selling these assets should look closely at, among other things, the way they design, market and promote their product. In light of these developments, we are paying particular attention internally and with our portfolio companies as to how a digital asset or project is promoted and sold.

Exchanges

Another material SEC settlement action this year was with Kraken, a leading digital asset exchange, which settled with the SEC for $30 million on the basis that their staking service was an unregistered security and met the definition of an investment contract.

Similar to the SEC’s findings in the NFT enforcement actions against Impact Theory and Stoner Cats, the SEC highlighted, among other things, the way in which Kraken promoted its staking service, which advertised an annual return of as much as 21%.  Kraken also could change the yield on the staking service at its own discretion and co-mingled its assets with its customers.

The SEC focused on “efforts of others and expectation of profit” in that settlement, and Kraken immediately ceased all their staking services in the US in connection with that settlement. 

Case Law

SEC vs. Coinbase

A central regulatory theme throughout the past year was the SEC’s aggressive enforcement stance towards some of the ecosystem’s largest exchanges. Coinbase was amongst the biggest exchanges that was charged by SEC. 

To summarize, the SEC’s complaint against Coinbase alleges that the exchange has been operating an unregistered securities exchange, an unregistered broker dealer, and an unregistered clearing agency.  And, like their case with Kraken, the SEC alleged that Coinbase’s staking service was an unregistered security. Coinbase then responded to the complaint by filing a motion to dismiss, with a ruling expected in January.  To the extent the court does not rule in favor of Coinbase with respect to its motion to dismiss, which is an extremely high standard to satisfy, we expect this battle to be drawn out and last for quite some time.  It’s interesting to note that a couple of months before the SEC filed its charges, Coinbase sued the SEC under the Administrative Procedure Act, or the APA, to compel the SEC to respond to its previously filed Petition for Rulemaking for digital assets. Essentially, Coinbase, through its lawsuit, is trying to force the SEC to write regulations explaining how securities laws apply to cryptocurrency and to engage in a formal notice-and-comment process to allow the public to weigh in.  

Under its complaint against Coinbase, the SEC will need to successfully prove, among other things, that digital assets or, in the case of the staking allegation, arrangements involving digital assets, constitute investment contracts and are securities. In addition, with respect to the unregistered exchange, broker-dealer and clearing agency allegations, the SEC, also named several digital assets claiming that they are unregistered securities, including widely traded assets such as Solana, Polygon, NEAR, and MATIC.

In this case, as with many other SEC complaints, the commission is not only going after the intermediary. While the Commission has not actually sued or charged Solana, NEAR, MATIC, or Polygon, by naming them in the Coinbase complaint, they are effectively putting them on notice by claiming that each of these digital assets are, in their view, operating illegally as unregistered securities. In light of this and to the extent the SEC decides to continue to be aggressive vis a vis its enforcement stance, we should expect an action packed 2024. 

SEC vs. Ripple

Another big headline driven by the SEC this past year revolved around its ongoing battle with Ripple Labs, where the SEC asserted that Ripple’s token, XRP, is a security. In July of this year, Judge Torres, the presiding judge over the case, which was heard in the District Court for the Southern District of New York, ruled both in favor of Ripple and the SEC on various motions. In making her decision, Judge Torres essentially reviewed and ruled on four distinct sales or distributions by Ripple of its native XRP token:

1. XRP sales by Ripple, through wholly owned subsidiaries, to a number of institutional buyers were investment contracts due to an expectation of profit based on the efforts of others.

2. XRP sales by Ripple on crypto exchanges “programmatically,” or through the use of trading algorithms are NOT investment contracts. Because the sales were “blind bid/ask transactions”, the buyers could not have known if their payments of money went to Ripple, or any other seller of XRP.”  Therefore, the buyers in the Programmatic Sales had no expectation of profit based on Ripple’s efforts so Judge Torres concluded that the XRP sold in the Programmatic Sales were not investment contracts under the Howey Test.

3. XRP distributions by Ripple to various employees, as compensation, or to fund third parties that would develop new applications for XRP and the XRP blockchain ledger were not investment contracts.

4. XRP sales by Ripple’s CEO and Chief Legal Officer, in their individual capacities, on crypto exchanges were not investment contracts for the same reason that the programmatic sales were not investment contracts – given that the CEO and CLO did not know the identity of the sellers whom they sold XRP to. Therefore, these purchases were not made with an expectation of profit based on Ripple’s efforts, and so could not be investment contracts.

While the ruling on these transactions is quite complicated, the key implication for our industry is that Judge Torres’ ruling made clear that XRP in and of itself is not a security. Based on Judge Torres’ ruling, we would have to look at how the assets are sold to determine if it is a security.

Taking Judge Torres’ ruling in totality, it was received as decisively positive for the industry given the only instance where she ruled in favor of the SEC was in direct sales of digital assets from the issuer to institutions.  However, while the ruling was undoubtedly a blow to the SEC’s enforcement campaign, the case is still on appeal and subject to being overturned.  On that note, another decision from a judge in the same district was issued shortly after Judge Torres’ Ripple ruling. 

Judge Rakoff, in the Southern District of New York (SDNY), denied a motion to dismiss an SEC complaint alleging that Terraform Labs and its CEO, Do Kwon, violated securities laws through the offering and sale of multiple crypto assets.  In his ruling, Judge Rakoff explicitly disagreed with his colleague, Judge Torres’ distinction between purchasers of crypto assets in primary offerings and the “blind” transactions of on-exchange crypto asset purchasers.  Specifically, Judge Rakoff did not draw the same distinction between direct primary sales and secondary sales, but focused, again, on the purchaser’s expectation of profit, similar to what the SEC continues to emphasize in its lawsuits, as previously discussed.

Following these two conflicting decisions and subsequent motions and appeals, it appears that for the time being, the SDNY is split as to whether and when on-exchange transactions in crypto assets amount to offers and sales of investment contracts. A clear answer to this question is likely to be of vital importance to crypto market participants.

Bitcoin ETF Applications

Another topic we have seen dominating headlines and discussions, particularly recently, is the pending applications by several large institutions for an SEC-approved Bitcoin Spot Exchange Traded Fund (“ETF”).

Grayscale has been in a battle with the SEC for years over its application to have the Grayscale Bitcoin Trust (“GBTC”) listed on a securities exchange as an SEC-approved exchange traded product. In June 2022, the SEC denied Grayscale’s application to launch a spot Bitcoin ETF and Grayscale counter-sued the SEC, claiming the SEC “arbitrarily and capriciously” denied the GBTC application while simultaneously approving applications for Bitcoin futures products. Grayscale came away with a partial win in the D.C. Circuit when the judge recently found that the SEC did not have sufficient basis for denying the GBTC application, which means, essentially, the SEC must now reconsider the application.

We are expecting an answer soon on this latest SEC review of the application because there are certain timelines under which the SEC must make a decision.  Specifically, any time between now and early January 2024, we expect to have a decision on GBTC, and then the SEC’s decision on the other applicants either simultaneous or in short order thereafter.

DeFi Regulation

There have been a few lawsuits and regulatory actions in the DeFi space as well this year.

Ooki DAO

Ooki was a case brought by the Commodities Futures Trading Commission (“CFTC”) whereby the CFTC alleged that the Ooki DAO (“decentralized autonomous organization”) and any person or entity that held a token and voted for certain governance proposals on that DAO were operating as an unregistered futures commission merchant (“FCM”) by soliciting and accepting orders from customers, accepting money or property as margin, and extending credit, in violation of the Commodities Exchange Act (CEA).  One material hurdle in this case was whether and how a decentralized protocol was able to be properly served.  The CFTC alleged, and the court ultimately agreed, that Ooki Dao is an entity capable of being sued as an “unincorporated association under state law”, rather than just being a technology.

The judge issued a default judgement in favor of the CFTC finding that Ooki DAO was an illegal trading platform, was acting as an unlawful unregistered FCM and failed to adopt an appropriate Know Your Customer program, ordering the DAO to pay fines of approximately $640,000 and to cease its operations.  While the monetary penalty may not be as large as other settlements, the key impact of this case was the fact that the court determined a DAO could in fact be considered a legal entity, giving concern to token holders who participate in various governance votes, as to whether the individual token holders could also be found liable in future actions.

Compound

A private class-action litigation to be aware of involves Compound Labs. To note, this was not brought by a regulator. Compound Labs is a DeFi protocol that issued compensation tokens, COMP. In December 2022, a class action lawsuit was filed alleging that the COMP token is an unregistered security and claimed that Compound Labs and the associated venture capital investors violated securities laws by soliciting the purchase of the COMP token by the plaintiffs. 

The court, in September 2023, denied the defendants’ motion to dismiss finding that the plaintiffs had “plausibly alleged” that each defendant did solicit the purchase of the COMP tokens.  While still in early stages of the litigation, this will be an important case to monitor and we will continue to do so throughout 2024.

Future Regulatory Updates

This year, we’ve embarked on a few initiatives to help educate our portfolio companies and those interested in keeping a pulse on the regulatory landscape.

We partnered with prominent law firms to produce our regulatory newsletter. The newsletter is distributed on a regular basis with the primary goal of taking regulatory headlines (like the information above) and synthesizing them into bite-size snippets for our portfolio companies to use.  We want them to understand what’s important, what matters, and provide information in a way that makes sense as they continue to build going forward. 

In 2024, we plan to have even more thought leadership and content distributed. We’re going to start in January with a panel that I’ll be moderating with senior thought leaders in the blockchain policy space. Stay tuned for our January Blockchain Letter, which will recap this discussion.

In addition, we will continue producing more content in 2024 which provides updates on the blockchain regulatory and policy space.

It has been an exciting 2023 for our industry and we look forward to even more in 2024.

DEVIATION FROM TREND

I can imagine an investor thinking: “Bitcoin is up 162% this year. Well, I missed it.” and giving up.

No.  That’s the wrong mindset.  It’s up almost that much EVERY year (on average).  The 13-year trend growth rate is 117%. 

Bitcoin, as a proxy for our industry, is still very cheap relative to its 13-year exponential trend. 

Zooming into the graph of the log trend of bitcoin you can see that the rally in 2023 is just normal – the gold line has barely outpaced the 13-year trend.

So, even the rally we’re experiencing isn’t doing much to change the relative undervaluation of bitcoin.  Here’s a graph of the deviation of bitcoin from its 13-year trend growth rate.  Even after the rally it’s still 74% cheap to the trend.

It’s only spent 13% of the last 13 years at that level or cheaper.