Lighthouse Narratives

Our current outlook for the price of BTC and ETH is positive. We see three potential drivers of price movement; the likely upcoming launch of options for BTC spot ETFs, large premiums to NAV for US Publicly traded companies that have bought or plan to buy BTC and increasing access to BTC and ETH spot ETFs for US wealth managers. We see support for these drivers in Blackrock’s positioning and advertisement of BTC as an alternative asset class with attractive risk/reward attributes that is uncorrelated with US equity markets, as well as the upcoming US elections which we view as a net win for the crypto space.

We follow this with a framework for thinking about the historical price patterns of alternative coins (altcoins) which include major crypto currencies that are not BTC/ETH. We think current market hypotheses on what drives alt-season and meme coins are illformed, and offer a different perspective. We close out our insights with a discussion surrounding attractive growth areas in crypto and the fundamental case for owning certain altcoins.

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Increasing Adoption of BTC by Financial Institutions

As outlined in our Q1 Review, traditional finance continues to increase access to BTC ETFs and promote it as an alternative to gold and the dollar. Blackrock’s recent report titled ‘Bitcoin: A Unique Diversifier’, states: “We believe that bitcoin, via its nature as a global, decentralized, fixed-supply, non-sovereign asset, has risk and return drivers that are distinct from traditional asset classes, and that are fundamentally uncorrelated on any long-term basis.”

On Blackrock’s 3Q24 earnings call Larry Fink commented, “We believe Bitcoin is an asset class in itself, it is an alternative to other commodities like gold. And so I think the application of this form of investment will be expanded. Two, the role of Ethereum as a blockchain can grow dramatically.”  

On August 7th, Morgan Stanley became one of the first Major US Banks to let its roughly 15,000 investment advisors sell Bitcoin ETFs to clients. Lastly, in a recent Charles Schwab survey of institutional investors, 45% of respondents said they plan to invest in crypto via ETFs over the next year, up from 38% a year earlier, surpassing the level of interest for bonds and alternative assets.

There is the potential for reflexivity in BTC driven by financial institutions and crypto traders. The mental model of most crypto traders is that the BTC halving cycle spurs an uptrend in BTC’s price beginning 4Q of the year the halving occurs, or 4Q24. This coincides with the growing acceptance of BTC by financial institutions as a ‘unique diversifier’. To the extent that the narratives of these groups are supported by price action over the months and quarters ahead, the narratives may gain legitimacy and support further price action. This reflexivity is further supported by secular growth in access to BTC ETFs, continued adoption by corporates, institutions and pensions, and growth in the number of financial instruments related to BTC.

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Public Markets Funding Corporate BTC Purchases

Corporates have become significant buyers of BTC. Microstrategy (MSTR) recently announced plans to acquire up to $150B of BTC, 10x more than its current holdings and more than 10% of BTC’s current market capitalization. Market valuations demonstrate support by investors for corporate BTC purchases. MSTR trades at a 3x premium to NAV, or an implied price per BTC of roughly $180K. Marathon Digital, the largest US-listed bitcoin miner, began tapping the equity markets to fund BTC purchases in Q3. Its shares trade at a greater than 3x NAV premium. A number of other corporations have begun to add BTC to their balance sheets, with the markets similarly rewarding their stock price. So long as public companies with BTC holdings trade at significant premiums to NAV, capital raising in the equity markets will likely continue to fund BTC purchases.

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BTC Spot ETF Options and the Potential for a Gamma Squeeze

The SEC recently approved options for spot BTC ETFs on Nasdaq, NYSE as well as the Cboe, with trading expected to commence in the coming months. The argument that options will positively impact BTC’s price, and potentially lead to a gamma squeeze, has four legs. Most simply, options increase the number of ways market participants can use BTC, increasing institutional demand, which for a supply inelastic asset typically leads to price appreciation.

Secondly, options are likely to see net buyers versus sellers, a scenario which typically causes dealers to be short gamma. BTC is a speculative asset, and buying options (rather than owning the underlying) is a speculative activity. Dealers that sell options to customers need to hedge their delta exposure. To hedge the exposure from selling a call option, for example, a dealer will buy a quantity of the underlying asset proportional to the option's delta, creating a positive feedback loop that can amplify price movements.

Third, participants will likely skew towards buying call options vs puts. BTC speculation typically happens on the long side. We cannot name a single prominent investor who still publicly believes BTC can go to zero, but many market participants have multi-year BTC price forecasts ranging from $250K to $3M. The need for hedging downside risk in BTC is limited to a few bitcoin miners, many of which have adopted a policy of never selling BTC. Options provide participants the ability to cheaply make long-dated bets on the price of BTC and greater call option buying increases the probability of price appreciation due to the dynamics of dealer hedging, as stated above.

Fourth, BTC’s unique volatility profile increases the potential for a gamma squeeze. Unlike equities, where volatility tends to decrease as prices rise, BTC’s history is that as its price rises, its volatility also increases. This increase in volatility leads to a higher delta for options and dealers must buy even more of the underlying asset to maintain a delta-neutral position, adding to buying pressure as prices are rising. The net effect is the potential for a significant gamma squeeze that happens very rarely in the equities markets. Bitwise has a good report on the topic that delves into the finer details that have been glossed over here for brevity.

There is potential reflexivity around this event. The knowledge of the potentiality of a call option-driven gamma squeeze, and the propensity for speculation in the market, increases the likelihood this phenomena will occur.

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‘Altseason’: Its Psychology and Evolution

Altseason is defined as a period of time that alternative coins (aka not BTC) outperform BTC. The historical cyclical pattern of crypto has been as follows: BTC’s halving leads to a rise in the price of BTC beginning roughly 6 months later, followed in 3-6 months by altseason. This pattern occurred in 2016/2017 and in 2020/2021. BTC’s most recent halving was in April of this year, and, should the pattern continue, it implies a resumption of BTC’s uptrend in 4Q with alt-season beginning in either late 4Q or Q1 2025. The ostensible drivers of alt-season have evolved from psychological/speculative to fundamental(ish), an evolution we expect to continue.  

The psychology that has historically driven altseason seems to fit well with the Thin Ice Theory outlined in the book Inside the House of Money. The Theory observes a pattern where market participants who own an appreciating asset underpinned by a reasonable investment thesis often sell too early. Instead of buying back into the asset at a higher price - human wiring makes this exceedingly difficult - participants look for proxy assets that have relatively underperformed, and acquire those instead. The process can continue until participants are holding distant proxy investments with thin liquidity and little connection to the original trade idea, finding themselves on thin ice.

The longer a BTC uptrend has historically continued, the more times the cycle of selling appreciating assets to buy proxy assets has repeated in crypto markets. In late 2020 and early 2021, BTC began to underperform altcoins. Later in 2021, BTC and altcoins began to underperform what is casually known as ‘shitcoins’. Many of these tokens decreased by over 95% in the subsequent months and years.

In late 2023, BTC began another upcycle, driven by the launch of US spot ETFs. Being a John Holland-like complex adaptive system (CAS), the crypto ecosystem learned from history and altcoins began to rise within a week of the beginning of BTC’s ascent - i.e. altseason happened nearly simultaneously. When the rally in BTC and altcoins began to reach its zenith, memecoins - which were largely quiet until February 2024 - began a ferocious rally, consistent with the Thin Ice Theory. However, the vast majority of altcoins and memecoins remained without a fundamental investment thesis and most have declined more than 40% over the past two quarters, while BTC has declined less than 10% from all-time highs.

Prospectively, we expect fundamentals to play a greater role in the decision making of crypto market participants. There has already been evidence of this over the past month, which contradicts Murad’s assumption of financial nihilism,  and should lead to more rational price discovery and greater price dispersion, which benefits our approach. To the extent crypto markets continue to act in a manner similar to the Thin Ice Theory, this framework positions us well to capitalize on the opportunity.

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The Fundamental Case for an Alt(ish)-season

In 2024, the performance, cost, and user experience of blockchain technology has improved significantly, leading to steady growth in usage. Solana now handles over 50M daily transactions, or roughly 10% of the transactions Visa handles per day, up from less than 15M a year ago. Ethereum’s Dencun upgrade went live in March, helping reduce transaction finality times to nearly one second and costs to near one cent on the blockchain’s that settle to it. Coinbase’s Base blockchain has seen steady growth since then, with daily transactions increasing ten-fold to 5M. Other blockchains such as Near, Aptos, and Sui have also seen significant growth in fundamentals driven by applications.

Network activity is being driven by new and existing use cases. In 2Q24, Blackrock began to tokenize short-term US treasuries onto the blockchain via its BUIDL token, driving growth in a category known as Real World Assets (RWAs). A number of startups have created synthetic blockchain-based dollars - known as stablecoins - backed by Blackrock’s tokenized treasuries. These synthetic dollars have ultra-low transaction fees, can be sent between any two parties with an internet connection, and accrue value to their holders based on the short-term US treasury rate in real-time. Yield-bearing stablecoins are vastly superior to holding dollars in prime brokerage and checking accounts, and we expect them to see exponential growth driven by adoption for payments, investment activities, and AI.

The most unique stablecoin in the crypto market is operated by a project called Ethena. Its stablecoin, USDe, generates a yield that has averaged over 8%. USDe generates its yield via ETH staking rewards, running a carry trade when funding rates are positive, and via short-term US treasuries through Blackrock’s BUIDL token. The stablecoin is seeing increased usage across DeFi as well as on some centralized exchanges. It is also held as a high-yield savings product.

Prediction markets are another use case seeing strong growth. Users make predictions about global events and are compensated if their predictions are correct. This tool is reminiscent of Philip E. Tetlock’s book Superforecasting: The Art and Science of Prediction. The most accurate predictions were the aggregate forecast of a group of incentivized participants. Polymarket - which runs on Polygon blockchain - is the leading blockchain-based prediction market and is seeing exponential growth, albeit off small numbers.

There has been a lot of hype around crypto x AI given the synergies between the two. Projects such as Bittensor are creating AI marketplaces powered by cryptorails. The Bittensor platform enables the deployment of customized AI models, tailored to specific use cases, that customers can access and interact with in a frictionless manner. Sequoia recently stated it is no longer investing in large-language models, as it expects there will be a few dominant models owned by big tech. Instead, they are focusing on applications leveraging LLMs, an area Bittensor is designed to support.

Other AI-related use cases that crypto supports include NFTs to authenticate and prove ownership of generative media, smart contracts for payment and accreditation of data sources referenced by AI-inference, and blockchain-supported AI agent economic transactions and machine-to-machine transactions. This section is a far from exhaustive list of growth in the blockchain space, and doesn’t touch upon gaming, payments, or social apps.

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Election Outcomes and Regulatory Shifts

The upcoming U.S. elections could significantly impact the cryptocurrency market. If Donald Trump is elected, a new SEC chair is likely to be appointed. This change could benefit entities currently under SEC scrutiny on tenuous legal grounds, specifically Lido DAO and, to a lesser extent, Uniswap. Trump's vocal support for Bitcoin—including his musings about designating Bitcoin as a strategic reserve asset— and his choice of Howard Lutnik to lead his transition team should bolster the cryptocurrency and its ecosystem. Such support would positively affect U.S.-based Bitcoin miners and publicly traded corporations holding Bitcoin on their balance sheets. Additionally, BTC is inversely correlated to the dollar. Trump’s plan to expand fiscal deficits will likely lead to further dollar debasement leading to an appreciation in Bitcoin’s price.

Kamala Harris’ advocacy for fostering U.S. innovation in emerging technologies like cryptocurrency and artificial intelligence suggests a more favorable stance toward the industry compared to the current administration. A Harris administration may overturn bills that have previously been vetoed, including legislation that would allow major US banks to custody Bitcoin. This would increase access to BTC for corporations and institutional and HNW investors. A Harris administration may also support a crypto regulatory framework similar to the one outlined in the Financial Innovation and Technology for the 21st Century Act (FIT21), which has passed the House with strong bipartisan support and is supported by the crypto industry.

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A Mixed Equities Environment is not Necessarily a Negative for Crypto

To paraphrase David Einhorn’s recent investor letter, equities have moved to a place where “We will avoid calling this market a bubble, and simply observe that the dividend yield is low and the P/E ratio is elevated despite corporate earnings being cyclically high, if not top-of-cycle.” While the outlook for equities is not necessarily bearish in the near-term - liquidity is ample, financial conditions are loose, the US government is spending record sums, and interest rates are falling as a result of slowing inflation rather than economic weakness. From a valuation perspective, the environment is, statistically speaking, less than favorable.

Despite the mixed environment for equities, we see opportunities in cryptocurrencies and digital asset-related equities. For much of 2024, Bitcoin (BTC) has been uncorrelated with equity markets, confusing many who still view the space as a beta play on Nasdaq. In past letters, we addressed the shortcomings in this logic, showing that analysts overlooked the impact of lurking variables and misconstrued correlation with causation. Most notably, the Federal Reserve had a significant impact on both BTC and the Nasdaq during 2021 and 2022. However, its influence has diminished compared to other factors, such as growth in AI and structural changes in the BTC market, which have led to secular adoption by corporations and institutional investors. The launch of spot ETFs, new options products, potential improvements in custodial solutions, and increased access to ETFs are likely to further boost capital inflows into the asset class.

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