Crypto Long & Short: Why Bitcoin's Taproot Upgrade Matters
  Weekly insights, news and analysis for the professional investor By Noelle Acheson, Managing Director of Research May 9, 2021 Sponsored by  Prices as of 05/9/21 @ 12 p.m. UTC If you were forwarded this newsletter and would like to receive it, sign up here.
Hi all!
If you're feeling particularly confused this week, you're not alone.
We have signs of a grown-up market with our first mega M&A deal, Goldman Sachs putting more resources into the industry and other large banks talking about crypto services. On the other hand, we have meme tokens defying gravity, cryptocurrencies that had been left for dead coming back to life, and the unleashing of what looks like another wave of innovation with the launch of a new global computing platform.
Is crypto mature or is it still in diapers? The answer may be both, or it may be neither. I don't know.
I do know, however, that it is fascinating to watch, and that there can be no steeper learning curve than this one, even for those of us who have been doing this for some time.
In THE BRIEFING below, I pull on the confusing thread that is the dogecoin surge and the growing concern this will hurt the industry. I also talk about an upgrade to the Bitcoin protocol that brings even more value than just some technological improvements. And I unexpectedly find myself talking about sports, something I generally try to avoid (because I'm not good at it).
Read on …
– Noelle
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THE BRIEFING (Note: We use Bitcoin with uppercase B for the blockchain and bitcoin with lowercase b, or BTC, for the asset.)
Let's not forget that Bitcoin is a technology You might have noticed some green squares floating around Twitter. Like the laser eyes, they are part of the insider signaling that creates a sense of cause and belonging. Unlike the laser eyes, they are not directly about the price – they signal support for the proposed Taproot upgrade for the Bitcoin network.
Why is this important? It's not just the benefits the upgrade brings, which are significant. Taproot is important because it reminds us of what Bitcoin is.
The good stuff
Before we dive into why this matters, let's look at some of the main benefits of the proposed upgrade:
1 – Increased privacy. This does not refer to Bitcoin addresses or enhanced anonymity; it refers to types of transactions. Taproot will make complex transactions, such as those requiring multiple signatures or those with delayed release, indistinguishable from simple transactions in terms of on-chain footprint.
2 – Lower fees. The data size of complex Bitcoin transactions will be reduced, which will lead to lower transaction costs.
3 – More flexibility. A new type of signature will enhance smart contract functionality in Bitcoin, making it easier and cheaper for users to set more complicated conditions for a transaction.
4 – Lightning boost. Taproot will make transactions on the lightning network cheaper, more flexible and more private. The lightning network is a layer 2 solution that enables faster and more scalable payments that periodically anchor in aggregate form to the Bitcoin blockchain, offering eventual Bitcoin security while amplifying speed and potential throughput.
A meaningful step
With all of the above, Taproot is the most significant upgrade to the Bitcoin network since the block size increase of 2017. The relative infrequency of Bitcoin upgrades highlights one of its main features: it is robust.
Making any amendments to Bitcoin is hard. There is no one in "charge" who can decide what changes get pushed through. And achieving consensus among such a diverse and dispersed group of participants is a challenge, to say the least. That Taproot is more or less unanimously supported highlights what a big deal this upgrade is.
What has turned out to be contentious, however, is the method of the upgrade. In March, a compromise was reached in the form of a "Speedy Trial," which gives miners a series of two-week blocks in which to signal support for Taproot.
This kicked off last Saturday, with the most recent difficulty adjustment. From that moment, Bitcoin miners had until the next difficulty adjustment (two weeks later) to signal support for the Taproot upgrade in their mined blocks. If 90% of processed blocks signaled support, the upgrade would get "locked in" for activation in November.
On Tuesday, however, it became apparent that this signaling round wasn't going to be successful. With almost 25% of the window's blocks processed by around mid-day, 20% had not signaled support, so the 90% threshold was out of reach.  This is not a big deal – rather than rejection of the idea, it's more likely that miners hadn't yet gotten their heads or their software tweaks around the necessary steps. The next two-week window of signaling opportunity is coming up, and if that is also unsuccessful, the network tries again, and so on until Aug. 11. If by that date 90% signaling has not been achieved, Taproot goes back to the drawing board.
The real benefit
So, the Taproot upgrade will boost Bitcoin's functionality and potentially broaden its market. That's good for its prospects and its valuation.
But here's the most important impact for the investing market overall: it reminds us that Bitcoin is a technology.
Many investors see bitcoin as a store of value. Others are drawn in by the volatility. Most tend to overlook one of its most defining features – it is a relatively new technology, with all the upside that implies.
When you buy gold, you don't wonder how it will evolve while in the vault. Bitcoin, on the other hand, does evolve. It did so in 2017, and it will most likely do so again this year.
"Technology" implies risk, though – things can go wrong, code has bugs and/or unintended consequences. That's why it is key that Bitcoin's upgrades are few and far between, because they need to be carefully vetted and tested. Also, since there is no central body to decide on Bitcoin upgrades, they need to be agreed on by all the key stakeholders, and consensus is always extremely difficult to achieve.
This is a good thing. There's over $1 trillion of market value riding on the Bitcoin network now, not to mention the valuation of all of the businesses built to support the network, so the risk needs to be minimized to an almost negligible level.
Taproot drives home that bitcoin may be an excellent store of value, and it may provide good returns for speculators – but the cryptocurrency also represents the opportunity to get in early on a transformative technology investment. It's like being able to take an early stake in a hot startup, but with much more liquidity and less paperwork.
So Taproot will not only improve Bitcoin's usability, which could have the effect of broadening its market and therefore potentially its value as well. It also reminds us of one of Bitcoin's core characteristics, which seems to have gotten drowned out in the prevailing market-driven narratives of late. Bitcoin is still a new technology, and its potential upside comes from more than its supply schedule, its inflation resistance and its decentralization.
Dogecoin is getting people worried
You may be sick of hearing about it, but we can't not talk about dogecoin this week. It does feel like the sentiment has morphed from "Hee hee this is fun!" to "Oh no, we're going to get into trouble." It's like having a party at your parents' house when they're away for the weekend, only to have it spin totally out of control.
The concern is not unfounded: a price increase of over 15,000% so far this year, on objectively poor fundamentals (concentration of ownership, relatively weak security and narrow fully synced node distribution for starters) is fine until someone gets hurt.  When (if?) that happens, will the out-of-pocket investors cry foul and demand intervention? If so, will the intervention materialize? What could the regulators do? Insist that investors only invest in things with solid fundamentals? Such as?
Could they insist that even more warnings be sprinkled about? What would these warnings say, and would they just be on dogecoin? If so, why? If not, would people even listen?
I suppose the authorities could publicly speak out against such speculation. Oh wait – they did that.
This is the regulators' dilemma: They have to protect the investor, but they also have to encourage markets and innovation. How can they do both in a market fueled by sentiment? Do they restrict the sentiment, or the market? How would they go about doing either effectively?
Part of the intensification of the attention frenzy is the appearance of Elon Musk on "Saturday Night Live" (which has not yet aired when I am typing this, but will have aired by the time this newsletter lands in your inbox), which he teased along with the epithet "The Dogefather." So we're expecting some Shiba Inu references, which, given Elon's power among the meme crowd, could move the price even more.
Should the regulators go after Elon for talking about dogecoin? Public figures often talk about their investments – should that be banned? When does that morph from protecting the public to restricting speech? At the risk of sounding ingenuous, Elon is not out there touting dogecoin's fundamentals; should he be banned from talking about things he finds fun?
When the economic value of an investable asset is driven entirely by collective enthusiasm as well as meme amplification on social media, then what, really, can regulators do? How do you dampen said enthusiasm without trampling on fundamental human liberties, which will ignite the crypto crowd even more?
What's more, it seems like both access to the asset and its potential use case are broadening. Crypto exchange Gemini and multi-asset brokerage platform eToro now offer dogecoin trading. The Oakland Athletics have become the first Major League Baseball team to sell tickets for dogecoin. And the American Cancer Society now allows dogecoin donations.
If all these questions are giving you a headache, imagine how those of us that need to explain this feel. It's enthralling but also disconcerting, and reconciling the two is a struggle.
Personally, I believe that the fears that the regulators will come down hard on the crypto industry are overblown. Yes, people will lose money when the dogecoin market corrects, and that's a huge pity. But that happens outside of cryptocurrencies, too. And U.S. regulators are no doubt aware that interfering with personal choice and financial freedom generally doesn't end well.
As SEC Commissioner Hester Peirce said in a recent appearance on CoinDesk TV, "If [investors] are just having fun, they can do that as well, but don't come complaining to the government if you lose your money."
A mainstream marriage
Sports are mainstream. Crypto assets are not (yet). So the deepening relationship between the two is an intriguing development that will help crypto reach more mainstream markets, and help sports teams and athletes appear more "cutting edge." And, of course, there's the potential income.
The overlap mainly comes from two intriguing trends:
Both saw a handful of examples this past week:
I'm starting to get the uncomfortable feeling that I may have to begin learning about team sports in order to keep you up to date with potentially market-moving trends. This could end up reshaping my weekends.
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CHAIN LINKS Galaxy Digital has agreed to buy BitGo, the U.S.-regulated crypto custody specialist, for $1.2 billion in stock and cash. TAKEAWAYS:
Goldman Sachs (NYSE: GS) was in the crypto news twice this week: once when it announced a new desk that will offer trading in bitcoin derivatives (non-deliverable forwards), and then again when it emerged as a lead investor in the latest raise for crypto data aggregator and index provider Coin Metrics. TAKEAWAY: In our write-up of the Coin Metrics raise, we quoted a Goldman Sachs executive as saying, "Our clients will greatly benefit from Coin Metrics' institutional-grade data insights and emerging risk management tools." Could this be a teaser of more services to come?
Investment management firm VanEck has filed with the SEC for an ether-based ETF. TAKEAWAY: If approved, this would be the first ether (ETH) ETF in the U.S. That's a big "if," though, since the SEC has yet to approve a BTC ETF. Canada, on the other hand, has several BTC and ETH ETFs. Might the SEC approve a BTC and ETH ETF at the same time? It's possible, but the organization has spent years getting familiar with the bitcoin markets – its surveillance, price transparency, liquidity, etc. – and it's not clear that it has the same level of knowledge about ether's markets, which are complicated by the upcoming technology shift to Eth 2.0.
Square's Cash App (NDAQ: SQ) generated $3.51 billion of revenue from its bitcoin operation in Q1 and $75 million of gross profit, both up approximately 11x from Q1 2020. TAKEAWAY: This kind of result is likely to make other payments services sit up and take notice. PayPal has already started down this road. Who's next?
Among large Wall Street banks, it seems Citi (NYSE: C) is next. The global financial institution is reportedly considering launching crypto trading, custody and financing. TAKEAWAY: This is a reminder that institutions are increasingly asking their traditional banks for crypto services. There are several institutional-grade crypto-first services that have good track records, but let's face it, many institutions are going to prefer to deal with a name they already know, trust and have accounts with. This is unlikely to divert business away from the current roster of institutional crypto services; rather, it is likely to continue broadening the pool of participating deep-pocketed investors.
Digital Currency Group (DCG), the parent of investment manager Grayscale and also of CoinDesk, has authorized the purchase of up to $750 million worth of the Grayscale Bitcoin Trust (GBTC), up from a $250 million level previously announced. TAKEAWAY: This is a smart move for two main reasons: one, it should act as a boost to the market of GBTC as well as to investor interest in the product, which has effectively dried up as a result of the post-lockup trading discount to NAV; and two, if the trust gets converted into a redeemable ETF, as Grayscale has said it intends to pursue, then there's a nice profit for DCG.
Listed fintech company Mogo (NDAQ: MOGO) revealed that it has bought approximately $405,880 worth of ETH and almost $600,000 worth of BTC as part of its plan to allocate up to 5% of its cash and investment portfolio in cryptocurrencies. TAKEAWAY: Much has been written about the role of BTC in corporate reserves – a while ago, I wrote about the likelihood of companies starting to hold ETH as well. So far, few companies have revealed ETH balance sheet positions, Meitu being a notable exception. I expect we'll see more of this in the coming months, although I maintain my position that ETH is better suited to a working capital holding than a store-of-value treasury asset.
S&P Dow Jones Indices has launched its first three cryptocurrency indexes: SPBTC (which measures BTC's performance), SPETH (the same for ETH) and SPCMC (a combination of the two). TAKEAWAY: This is a notable move in that a known name, trusted by institutions and product issuers, is investing resources in the crypto markets in the form of indexes that could broaden the range of crypto products in the markets.
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