Pantera Capital: Unlocking Bitcoin’s Potential

1. The Absence of Bad Things

At the Bloomberg Invest Conference last June, I had a discussion with Former Chairman of the SEC Jay Clayton covering the crises in banking, global macro markets, and blockchain. Closing out the panel, the moderator asked me what black swans we should expect. My response was:

“Everybody ignores black swans until one happens. Then all everybody wants to talk about is ‘the next shoe to drop’. I would say the biggest surprise is that we already had all these massive shoes drop last year – and it’ll be nothing crazy happening.

“But if you make me say something, I would say regulatory clarity is the one thing nobody’s expecting. There are a few ways that could happen.”

A very important theme now is the absence of bad things. For most of 2022 and 2023, all kinds of rare, crazy bad things were happening.

The swings in global macro markets generally were beyond history. 2022 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.”

2022 was the worst year for the classic 60/40 stock and bond portfolio since the Great Depression.

The impacts were even larger in private markets – which impact our venture space. IPO proceeds raised were down 95% and number of deals down 85% from the year prior.

Blockchain markets were hit with all that plus mega-crazy things a 5-million-person crime by Sam Bankman-Fried and ludicrous leverage at a half dozen lending institutions.

Total cryptocurrency market capitalization went down 70%.

In my opinion, these are all once-in-a-generation-type weird things. Nobody’s going to be lending to levered crypto hedge funds without collateral and no transparency again for 10 or 15 years. (Having seen 25 years of cycles, I do know that somebody’s going to do it again in the next generation!)

Below is a visual of the wave of what many believed to be catastrophic events in blockchain’s history.

Since none of those could kill blockchain, the absence of those super bad things is, on the margin, a massive positive.

The other big positive is the removal of some of the regulatory drag that was holding back our industry – and institutions that wanted to get invested in this new asset class.

Over the last year, there have been positive rulings on high-profile cases such as Ripple’s native token XRP ruled as not a security and Grayscale’s win in their lawsuit against the SEC regarding their Bitcoin ETF application. In our view, these may be indications that regulatory clarity for blockchain is being achieved, enabling further innovation to occur in the United States.

Institutional adoption appears to be accelerating after the spot bitcoin ETF launch in January.

With the halving expected to occur in late April 2024, we believe the convergence of these positive things will provide strong tailwinds for the next bull market.

In addition, blockchain’s “dial-up” to “broadband” moment may be happening. We can see this with the growth of Ethereum layer 2s and hyperscale blockchains.

We’ve been through three full crazy cycles – massive rallies, and then, unfortunately, 85% or so downdrafts. I think we’re in the beginning of the fourth big cycle now.

The stock market crashing in 2022 had a huge “denominator effect” on institutions – and they really pulled back from investing in private markets. With stocks back at record highs, they can invest in private markets again, and so I think the next 18 or 24 months are probably going to be a strong bull market for crypto.

This is a pivotal moment with the removal of these traumatic, horrible occurrences in the capital markets and blockchain space from the past couple years, coupled with positive things like the halving and regulatory clarity – all unfolding simultaneously.

2. The Most Neglected Asset: Revisiting Bitcoin Programmability

Bitcoin is the most neglected asset in the world. What if I told you that an asset with:

• $900 billion market cap (60% larger than Visa)
• $26 billion of daily trading volume (250% more than Apple)
• 50% annualized volatility (20% less than Tesla)
• 220+ million holders globally (# of countries with populations of 220+ million: Six)

… was ignored and exiled from the world’s “leading” financial institutions for 10 years? Would an ETF satisfy you?

No. Not when Bitcoin continues to be one of the world’s most under-served and under-financialized assets, relative to its size and scale.

Bitcoin is one of the most distinctive assets in the crypto ecosystem. Its market cap and volumes are ~2.5x greater than Ethereum. The Bitcoin network serves as a digital Fort Knox. It’s a fortress backed by ~500 times the computational power of the world’s fastest supercomputer. There are over 200 million Bitcoin holders vs. 14 million Ethereum holders globally. And Bitcoin still stands alone in a sea of regulatory gray – recognized, classified, and treated as a digital commodity.

If Wall Street’s financial system won’t build for Bitcoin, then Bitcoin will have to build a financial system for itself.

If blockchain technology can help bank the unbanked, the most obvious route is through Bitcoin’s global distribution in Latin America, Africa, and Asia. This already encompasses millions of people. If we expect trillions in value to eventually flow on-chain, there’s no network more secure or resilient than the Bitcoin network. As Bitcoin reaches a billion people and more, they’ll want to do more than store and move their assets. Capital and technology rarely stand still. This time is not different.

1) Bitcoin is a technology

As much as Bitcoin has been neglected as an asset, it may be even more neglected as a technology. Bitcoin has lagged behind in scalability, programmability, and developer interest. My first attempt at building on Bitcoin was in 2015, during the earliest days of J.P. Morgan’s crypto R&D. There was little to explore beyond colored coins and sidechains. Those were early ancestors to today’s NFT renaissance and Layer-2 rollups.

The verdict at the time was: it’s too damn hard to build on Bitcoin. Ask David Marcus, former President of PayPal and Co-creator of Meta’s Diem stablecoin. He’s now building Lightspark, a Bitcoin payments company. David tweeted recently: “Building on Bitcoin is at least 5x harder than building with other protocols.”

As money and technology, Bitcoin’s blessings are its curses:

• Resistance to change: This anchors Bitcoin’s robustness, but also its sluggishness. Upgrades are difficult to approve and can take 3-5 years to install.
• Simplicity in design: This makes Bitcoin less exploitable, but also less flexible. The Bitcoin blockchain’s UTXO model is well-fit to serve a simple transactional ledger for payments. Yet, it’s mostly incompatible with complex logic or loops you need for more advanced financial applications.
• 10-minute block time: This helps keep the Bitcoin network synchronized with 100% uptime since 2013 (a rare achievement), but disqualifies it from a large swath of consumer experiences.

Today I’m seeing signs that Bitcoin’s developmental malaise is a temporary, non-structural condition. A decentralized financial system may finally be emerging with Bitcoin at its foundation. Its potential is similar or greater than DeFi on Ethereum today, albeit following a different evolutionary path.

2) Why now?

Over the past several years, Bitcoin has unlocked a new developmental trajectory:

• Taproot upgrade (Nov 2021): An upgrade that expanded the amount of data and logic that Bitcoin transactions can store.
• Ordinal inscriptions (Jan 2023): A Taproot-enabled protocol for inscribing rich data to individual satoshi’s (2.1 quadrillion in total). This enables a metadata layer for non-fungible tokens.
• BRC-20 tokens (Mar 2023): A type of Ordinals inscription that enables deploy, mint, and transfer functionality.

The unleashing of fungible and non-fungible assets kicked off the first waves of DeFi and NFT activity on Ethereum in 2016-2017. Early signs of that same growth are now bubbling to the surface. Bitcoin average fees per transaction rose 20x in 2023, driven by Ordinal inscriptions.

Bitcoin is bound to take its own path, but it’s clear that a new design space has opened up for Bitcoin builders.

Larger macro trends have ignited a psychological shift within the Bitcoin community and renewed appetite from Bitcoin investors for decentralized finance on Bitcoin:

• Layer-2 adoption: Layer-2’s like Arbitrum have dominated new DeFi activity over 2023. This shows it’s possible to scale blockchain capacity and programmability without changing the base layer.
• Acceptance by traditional institutions: Bitcoin broke through a major regulatory hurdle with its ETF approval, pulling capital flows and entrepreneurial mindshare back into its ecosystem. BlackRock and Fidelity are activating the slow-but-powerful engines of Wall Street. Trading houses are licking their chops and looking for every marginal source of Bitcoin liquidity. This could soon draw them into DeFi, especially with new institutional DeFi gateways like Fordefi.
• Failures by crypto-native institutions: When counterparties like FTX, BlockFi, Celsius, and Genesis fell, it was crypto’s homegrown Global Financial Crisis. An entire generation of investors has soured on trusting their Bitcoin to centralized financial services.

In hindsight, it will be obvious: Technological unlocks and macro trends are converging towards a breakthrough moment for DeFi on Bitcoin. Now is the time to seize that moment.

3) The Half Trillion Dollar Opportunity

The prize for enabling DeFi on Bitcoin is tantalizing. Beyond the social and economic importance, every early builder and investor should ask: What if it works? How much is DeFi on Bitcoin worth?

Ethereum, valued at ~$300 billion, hosts much of today’s DeFi activity. DeFi applications built on Ethereum have historically ranged between 8% and 50% of Ethereum’s market cap. They currently stand at about 25%. Uniswap is the largest DeFi application on Ethereum, valued at $6.7 billion or ~9% of all DeFi apps on Ethereum.

If DeFi reaches Ethereum’s proportions on Bitcoin, we could expect the total value of DeFi applications on Bitcoin to be worth $225 billion (25% of Bitcoin). Over time, it could range between $72 billion and $450 billion (8% and 50%). This assumes no change in Bitcoin’s current market cap.

The leading DeFi application on Bitcoin could eventually be valued at $20 billion (2.2% of Bitcoin), ranging between $6.5 billion and $40 billion. This would place it squarely in the top 10 most valuable assets in the crypto ecosystem. Bitcoin is nearly back to being a trillion-dollar asset. Yet, it still holds an untapped half-trillion dollar opportunity.

4) Looking Ahead

Over the past three years, a wave of progress towards Bitcoin programmability has been building on the horizon. Examples include: Stacks, Lightning, Optimistic rollups, ZK-rollups, Sovereign rollups, Discreet Log Contracts. More recent proposals include Drivechains, Spiderchain, and BitVM.

But the winning solution won’t break through on its technical merits alone. The winning approach to enabling DeFi on Bitcoin will need the following:

1. Economic alignment with Bitcoin: Any programmable Bitcoin layer should tie directly to Bitcoin’s economic value and security. Otherwise, users may see it as hostile or parasitic to Bitcoin. Alignment can take the form of bridged BTC as L2 collateral and gas payments. It can also involve using the Bitcoin network for settlement and data availability.
2. Viability without base layer changes: Some proposed solutions need a hard or soft fork of Bitcoin. This means a system-wide upgrade. Considering how rare these are, it’s unlikely that these will be early contenders. However, some are worth pursuing long-term.
3. Modular architecture: The winning solution needs to be upgradeable enough to incorporate new technical advances. We already see the state of the art shifting in on-chain custody, consensus design, VM execution, and zero-knowledge applications. Semi-closed systems with proprietary stacks won’t be able to keep up.
4. Trustless bridging: Bridging assets from one chain to another is incredibly hard. If done right, it’s as challenging as interplanetary transport, given the potential mishaps involved, from latency mismatch to debilitating exploits. Few decentralized bridges have been attempted and validated in the wild. One example is tBTC, which continues to evolve its design and decentralization.
5. A relentless ground game: Two audiences matter for growth. 1) Current Bitcoin holders and 2) Future Bitcoin builders. Both are dispersed in esoteric ways. Exchanges hold approximately 10-20% of the total supply of Bitcoin. Around $10 billion of Bitcoin sits in various tokenized forms on Ethereum. Developer mindshare is spread across a multi-chain, multi-layer stack. Onboarding both groups will need a “meet them where they are” mindset.

Bitcoin’s age of neglect may finally be coming to an end. In the post-ETF era, Wall Street is finally realizing the obvious about Bitcoin as an asset. The next era will be about Bitcoin as technology and the re-ignited excitement to build for Bitcoin.

3. Protocols With Fundamental Traction

We believe we’re at an inflection point in this asset class – that traditional and more fundamental frameworks will be applied to digital asset investing.

Our approach is to create a sustainable, repeatable investment process, and as part of that we believe the most consistent way to generate outperformance is by investing in tokens that have fundamental reasons to outperform bitcoin and the broader industry.

A defining thesis for us is that tokens are a new form of capital formation and are replacing equity for a generation of businesses. Tokens underlying protocols that have product market fit, are guided by strong management teams, and have a path to sustainable unit economics will perform best in the coming cycle.

We believe this approach will generate significant risk-adjusted returns relative to market indices, as investors begin to understand how to value digital assets.

Below are a couple case studies on areas we are excited about with specific examples of investible protocols in those categories.

1) Bitcoin Activity Picking Up

Activity on Bitcoin is picking up – not just the trading of the asset itself with last month’s launch of bitcoin ETFs, but also a surge in new use cases, many of which are enabled by layer 2s that are bringing programmability to an otherwise rigid Bitcoin protocol.

For most of Bitcoin’s historical arc, it’s been characterized as “digital gold”, and many would still consider that its primary value proposition – both now and in perpetuity. Recently the idea of extending Bitcoin beyond being just a store of value has started to gain traction, and it’s exciting that we’re beginning to see base layer innovations like ordinals, the bitcoin version of NFTs, which were introduced early last year.

The data indicate that Bitcoin protocol transaction fees have been skyrocketing this year on the back of enduring user engagement with ordinals.

Due to the limited throughput of the Bitcoin blockchain, miners are incentivized to prioritize transactions that pay higher fees. So, in order for inscriptions to compete for blockspace, they are paying more in transaction fees, hence why Bitcoin transaction fees have been picking up along with ordinal inscriptions. The increase in fees and user activity is an exciting development for two reasons.

First, the higher fees from more complex transactions are translating into higher earnings for Bitcoin miners. This helps further secure the Bitcoin network, especially as miner block rewards decrease over time with each halving. At some point, transaction fees will need to grow enough to supplant the decreasing block rewards in order to sustainably incentivize miner hashpower securing the network.

Second, the user activity is exciting to us because it indicates organic user demand to use the Bitcoin protocol in novel ways beyond just digital gold or permissionless value transfer. Bitcoin is the most valuable, widely adopted, secure and decentralized cryptocurrency, and thus arguably the best candidate to act as a global settlement layer, and yet there is only a relatively small crypto economy built on it today. There is enormous value creation potential if even just a fraction of the $850bn+ capital base is deployed as liquidity in decentralized finance applications.

If the demand for these newer applications and use cases continues, much of that activity will have to occur on Layer 2 networks that can support higher transaction throughput and complexity, such as Stacks.

2) Revenue-Generating Protocol Case Study : Stacks

Stacks is a generalized smart contract network that brings Ethereum-like smart contract programmability to Bitcoin (analogous to a Layer 2 like Arbitrum on Ethereum, discussed in previous blockchain letters). It uses a consensus mechanism called Proof of Transfer, which essentially anchors Stacks to Bitcoin and allows it to benefit from the security of the most time-tested blockchain network. Bitcoin can be bridged over to Stacks and used in applications, and Stacks stackers earn bitcoin-denominated yield for securing the blockchain.

Bitcoin is at a special moment in time in its history given the convergence of multiple factors that are driving increased interest: heightened activity in ordinals, the launch of spot bitcoin ETFs, and the anticipated halving in April, to name a few. Users are voting with their feet, and they have indicated they want new ways to use the Bitcoin protocol, a heretofore large and underutilized capital base.

Stacks’ mission to bring innovation to Bitcoin is thus both exciting and timely. Interestingly, in this moment in time, Stacks is also the only live-generalized smart contract Layer 2 on Bitcoin today, which contrasts with the Ethereum ecosystem where there are dozens of competing Layer 2s jockeying for market share. While there may be multiple viable Bitcoin Layer 2s over time, given its first mover market positioning, we believe Stacks has a competitive edge for quite some time against any new competition that emerges – and we expect they are coming.

An important upcoming event to look out for is the Stacks protocol’s Nakamoto upgrade in April. This should meaningfully improve the Stacks user experience by increasing the network’s throughput, lowering transaction costs and improving security. One of our core themes is that blockchain is currently going through its “dial-up” to “broadband” moment with the growth of layer 2s and hyperscale blockchains, and similar to the unforeseeable breadth of internet businesses that were created after internet speeds accelerated, improvements in blockchain infrastructure may catalyze a proliferation of new use cases. Thus, we believe that the Nakamoto upgrade may spur more innovation on Stacks, creating a more vibrant ecosystem for DeFi, NFTs, et. al. using Bitcoin as the base layer.

Monthly transactions and fees have spiked over recent periods on the Stacks network, further evidence of user demand for new use cases on Bitcoin. We believe this trend will inflect after the Nakamoto upgrade and as attention on Bitcoin continues to build post ETF launch and into the halving.

3) Growth of Decentralized Exchanges

The most frequently used blockchain applications today relate to trading, whether on centralized exchanges like Coinbase and Binance or decentralized exchanges like Uniswap and dYdX. Trading is a core human activity that has been around for millennia with inevitable demand. Even during last year’s bear market period of low volatility, trading venues continued to generate meaningful revenue.

Within the broader exchange category, decentralized exchanges (“DEXs”) have been major share takers from centralized exchanges (“CEXs”). There are multiple long-duration secular tailwinds driving the growth of the DEX end market that make it attractive in our view.

After the collapse of FTX, trust in centralized exchanges took a major hit and the industry still faces some of the negative reverberations today. While nature is healing and centralized exchanges have tightened up their business models and regulatory compliance practices, traders have also moved to decentralized trading venues at an increasing rate where asset custody is more secure and orderbooks are more transparent.

The second secular tailwind is that, within trading, perpetual futures have been growing at a much faster pace than spot trading. This is because of the higher capital efficiency that comes with futures, much like in traditional markets. As a result, the relatively new market for decentralized perpetuals has been steadily increasing relative to perpetuals offered on their centralized counterparts. Perpetual DEXs now account for 3% of CEX volumes.

We believe that DEXs have the potential for greater market share capture as they offer many benefits to traders, including better flexibility and control over assets, privacy, security, and potentially lower trading costs.

4) Revenue-Generating Protocol Case: dYdX

dYdX is an on-chain decentralized exchange for trading perpetual futures or “perps”. dYdX is the market share leader, with over 40% volume share of the perps DEX market, and we believe this dominance will continue.

As fundamental investors, we care about sustainably positive unit economics. One key reason we believe dYdX is interesting is that its unit economics have inflected positive over the last year. The business model is straightforward. They collect commission fees, roughly 2.5 basis points of volume, and they pay for customer acquisition costs. dYdX makes a profit of roughly one basis point of volume for a healthy 40% margin.

The second reason is that there was an inflection in capital allocation put in place late last year. dYdX began returning capital in the form of staking rewards (analogous to equity dividends) to token holders in conjunction with its v4 upgrade in December. dYdX protocol profit is now getting distributed directly to token holders, making the token value accrual concrete.

From a protocol valuation perspective, dYdX is attractive. With that dividend yield, it currently trades at a roughly 15% dividend yield, which is attractive relative to any other traditional asset and especially cheap in the context of a high margin business with double-digit, month-over-month growth.

Putting this all together, over the next year, you can pencil out a reasonable scenario where the dYdX protocol is worth over $10 billion or more than 3x upside from today’s market cap. During that time, token holders will continue to benefit from that dividend yield in addition to the potential price appreciation of the underlying protocol as it continues to grow.

4. Bitcoin Halving Impact

The money supply function of the Bitcoin protocol is the polar opposite of paper money. Bitcoin’s supply and coin distribution ruleset is based purely on mathematics – predictable and transparent by design.

“Total circulation will be 21,000,000 coins. It’ll be distributed to network nodes when they make blocks, with the amount cut in half every four years. First four years: 10,500,000 coins. Next four years: 5,250,000 coins. Next four years: 2,625,000 coins. Next four years: 1,312,500 coins. Etc. . . .”

—Satoshi Nakamoto, The Cryptography Mailing List, January 8, 2009

The next halving is projected to occur on April 20, 2024. The mining reward will decrease from 6.25 BTC per block to 3.125 BTC per block.

In our view, it’s relatively straightforward: if the demand for new bitcoins stays constant or increases and the supply of new bitcoins is cut in half, this will force the price up.

1) Halvings Impact On Price

Efficient Markets Theory would hold that if we all know it’s going to happen, then it has to be priced in. Paraphrasing a line attributed to Warren Buffet on the dogma, “The markets are almost always efficient, but the difference between almost and always is $80 billion to me.” Thus, even if we think everybody knows something, it doesn’t mean there isn’t a ton of money to be made.

“Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards”
— Warren Buffett, 1984, as cited by Davis, 1990

If the demand for new bitcoins stays constant and the supply of new bitcoins is cut in half, this will force the price up. Previously, there has also been an increased demand for bitcoin before the halving event because of the anticipation of a price increase.

Over the years we have stressed that the halving is a big event – but it takes years to play out.

In our November 2022 blockchain letter, we published an analysis on halvings impact on price by studying the change in the stock-to-flow ratio across each halving. Below is the chart that we included in that analysis, which also forecast what could happen next.

Bitcoin was at $17,000 when we made this forecast. The model forecast that bitcoin would be just over $35,000 at the next halving in April 2024. At the peak of the post-halving rally, which would be in August 2025 based on the average duration of previous rallies, it could hit $148,000.

The current price of bitcoin is currently outpacing our projection of $35,500/BTC at the halving date, now 60% above that forecast.

2) Development of RWA

An area that we have been researching and investing in is RWAs or the tokenization of real-world assets on the blockchain. We believe that certain assets represented as tokens may benefit greatly from living natively on blockchain-based rails. Such benefits include enhanced liquidity, democratized ownership, better security and transparency, and lower cost compared to legacy systems.

A growing niche within RWAs is tokenized U.S. treasuries, especially as interest rates have risen over the past couple years. The total value of tokenized treasuries is up 7.4x since the start of 2023.

In addition to the benefits listed above, global accessibility is a huge unlock enabled by RWAs. I was in Asia and met folks in Korea and Singapore who were talking about their ability to access tokenized U.S. treasuries seamlessly through DeFi.

Source:https://panteracapital.com/blockchain-letter/the-absence-of-bad-things/

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