DEC 2020 - NEWSLETTER
Start of a Parabolic Advance
By Kas Vardhanabhuti
December 9, 2020
We believe that Bitcoin is at the beginning of a parabolic advance. It is probable that prices will make new all-time highs in 2021. To be clear, our quant algorithms do not take big directional bets based on qualitative views; we control the net exposure and the value-at-risk and trade based on high probability quant strategies to optimise Sharpe ratio. However, the Bitcoin scenario below is interesting enough to share because the Bitcoin market mechanics is unlike anything we have seen. The conclusion from this analysis is that Bitcoin prices could see a supernova squeeze higher, driven by a Soros-style reflexive loop of magnitudes that we have never seen before.
One of George Soros’s key investment insights is the theory of reflexivity, which refers to the self-reinforcing effect of market sentiment. Rising prices attract buyers whose actions drive prices higher still. We believe Bitcoin is in a positive reflexive cycle currently. The more Bitcoin prices go up, the more people buy, which in turn drive prices even higher.
The mechanism of transmission for this reflexivity is Grayscale Bitcoin Trust (GBTC). GBTC is the largest passive Bitcoin fund in the world with AUM of $10.2bn. Think of GBTC as a Bitcoin ETF but with unique characteristics. Investors who purchase GBTC directly get exposure to Bitcoin; the Trust company will issue new shares and use the proceeds to buy Bitcoin in the market. Much like ETFs, GBTC will buy Bitcoin at any price when the Trust receives inflows. But unlike ETFs, GBTC shareholders cannot redeem. They can only sell in the secondary market. Currently, there is no mechanism in place for GBTC to sell its Bitcoin holdings, except to pay for trust fees and expenses. This is a critical point to understand because GBTC is like a blackhole that pulls in Bitcoin. Bitcoins can only go in but cannot come out. GBTC is a major Bitcoin supply sink.
The implications of GBTC on the Bitcoin market are far-reaching and not yet well understood, in our view. We highlight a few important points:
The growth of GBTC is creating a huge supply demand imbalance. Incremental Bitcoin demand per month from GBTC is greater than the whole market’s incremental supply per month from miners. 4Q2020 will be the first quarter where GBTC monthly Bitcoin demand account for more than 100% of Bitcoin’s monthly supply from miners. In November 2020, GBTC alone bought 60k Bitcoins (~$1bn) vs. 30k Bitcoins in terms of mining supply. GBTC is not the only player buying and it competes with hedge funds, institutional investors, corporates, and retail investors to buy Bitcoins. These participants must bid at prices high enough to entice existing holders to sell. We think spot buying by passive funds such as GBTC is the main reason for the explosive price moves seen in the past 2 months.
GBTC is Now Buying more Bitcoins than Ever Before
Grayscale Bitcoin Purchases Bitcoin Supply from Miners
• Market participants will continue to buy GBTC (and indirectly, buy more Bitcoins) because of 1) momentum and 2) arbitrage opportunities. As prices go higher, the ecosystem draws in more investors, as described in the reflexive loop above. In addition, there are complex mechanics in play (I will not go into too much detail here) where sophisticated investors use GBTC as an arbitrage play. US accredited investors can lock in a 30-40% annualised profit, almost risk-free by buying new shares of GBTC at NAV and shorting GBTC in the OTC markets (which today trades at a 30% premium to NAV). The GBTC premium in the OTC market is so large that hedge funds are buying GBTC at NAV, and driving up Bitcoin demand from GBTC.
GBTC will eventually be the largest holder of Bitcoin free float. At the current rate of growth, we estimate GBTC will hold 1.0-1.5mn Bitcoins (c.5-7% of the total available Bitcoin supply) by December 2021. If we strip out lost coins, unmined coins, and long-term holders who are unlikely to sell, we estimate the free float of Bitcoin to be closer to 8mn. This means that by the end of next year, GBTC could hold nearly 20% of the Bitcoin free float. When the Hunt Brothers cornered the silver market in 1979-1980, they held about 1/3 of the available free float, and this led to a 700% increase in silver price. When Porsche cornered Volkswagen shares in 2008, this resulted in a 500% increase in Volkswagen share price. We think there is a possibility that the Bitcoin market is cornered inadvertently by GBTC.
These dynamics will drive Bitcoin price much higher, and this Bitcoin reflexive loop could lead to the biggest bull market the world has ever seen. Why? Because 1) Bitcoin has a finite supply of 21mn coins (with a much smaller free float), 2) GBTC is a unique in that it can only pull in supply and 3) Bitcoin is a global asset. With other reflexive loops, the participants are local. With the Bitcoin reflexive loop, the participants are global. When everyone realises that there is only 6-7mn Bitcoins free float left, the whole world (investors from all countries and continents big and small) will be scrambling to buy Bitcoin at the same time. That is when Bitcoin price rises into the stratosphere.
The sequent to this scenario is that Bitcoin prices will eventually collapse. Reflexive loops continue until they become unsustainable, resulting in a classic boom and bust cycle. GBTC will be the vehicle that is left holding all the Bitcoins in a collapse. We will cover this in future letters but for now, the most likely scenario we believe is that Bitcoin is going much higher.