Crypto Long & Short: The Market Gets Smarter
  Weekly insights, news and analysis for the professional investor By Galen Moore, Director of Data & Indexes June 13, 2021 Sponsored by  Prices as of 06/13/21 @ 8 a.m. UTC If you were forwarded this newsletter and would like to receive it, sign up here.
Friends:
Welcome to the second post-Noelle edition of Crypto Long & Short from the CoinDesk Research team. If you're new here, welcome. It was a busy week in technology and regulatory news with potential to move cryptocurrency markets: Bitcoin was at once in various jurisdictions banned (China), seized (U.S.), approved as legal tender (El Salvador) and green-lighted for technological improvement (Taproot). This week's Briefing looks at why some of that news did move markets, why some didn't, and what that tells us about the market's growing sophistication.
Weekly wax: For a week laced with contradiction, moving faster than human thought, the jazzy bass guitar and hyperspeed drum programming of "Feed Me Weird Things," the 1996 debut album from U.K. electronic musician Tom Jenkinson, aka Squarepusher, is the right soundtrack. Fortunately, it's out in a 25th anniversary reissue from Warp Records. You can buy the record and support the artist here. (It's also on Spotify.)
- Galen Moore, Director of Data & Indexes
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THE BRIEFING Markets show improved understanding of crypto's unique risk profile I find it useful to think about risk in cryptocurrencies across three dimensions: market, technology and regulation. Like dimensions in space and time, they don't exist independently; they intersect.
This week was about regulatory and technology risk. It's been amusing to watch commentators swing from wringing their hands about centralization of Bitcoin mining in China to wringing their hands about a Chinese government crackdown on Bitcoin mining.
Both risks are overemphasized. Mining is, alongside validation, Bitcoin's system of governance. And Bitcoin commoditizes governance: It takes governance's corrupting power and turns it into a "toothless commodity," which anyone with an internet connection can supply. The only advantages in this race are cheaper energy and faster processors. North American miners have shown they can compete on both fronts.
Right now, any Chinese "crackdown" on cryptocurrency mining is North American miners' digital golden opportunity. And if Sen. Elizabeth Warren's comments represent Washington's intentions toward North American mining, that will be someone else's opportunity. (A Paraguayan legislator this week made friendly regulatory overtures. Notably, Paraguay controls 45% capacity of Earth's second-largest hydroelectric dam, and uses precious little of it.)
This week, the cryptocurrency markets displayed a more sophisticated understanding of regulatory and technology risk: shrugging off mining thunder from Washington and Beijing, and staggering at the news that U.S. federal law enforcement had found a way to seize bitcoin from Darkside, the criminal collective that held Colonial Pipeline's systems for ransom.
It was the largest such seizure yet from a single, (presumably) sophisticated organization. Had the FBI cracked Bitcoin's cryptography? The market reacted as if it had. A three-letter agency finding a way to crack hard problems in cryptography would indeed take the legs out from under Bitcoin and all cryptocurrencies (among other things). But that's not what happened.  Hours after disclosing it had recovered bitcoin sent to the Colonial Pipeline attackers, the FBI was named in a Europol press release describing a multinational operation in which law enforcement agencies stood up an encrypted-messaging service and marketed it to criminals as a Trojan horse. Inexplicably, these masters of deception seem to have entrusted this stool pigeon with their Bitcoin private keys.
The increasingly crypto-curious world has a thing or two to learn about how this works. The New York Times and The Wall Street Journal this week ran stories noting that bitcoin is "actually traceable" and citing "cryptocurrency's reputation as hard-to-trace." Law enforcement has long understood that crypto is not only traceable, but permanently traceable. Some waggish federals have referred to bitcoin as "prosecution futures," journalist Nathaniel Popper noted in his 2016 book, "Digital Gold."
The distinction between the U.S. government cracking SHA-256 (which it created) and setting up a sting via an off-chain service provider illustrates perfectly where the regulatory risk in cryptocurrency truly exists. The market's reaction to the seizure news — and its non-reaction to a mid-week dip in Bitcoin hashrate or the news (some of it false) of Bitcoin bans in two Chinese provinces (Qinghai and Yunnan) — shows an improving understanding of this distinction.
Washington and Beijing would find it difficult stop Bitcoin mining, at least legislating it directly. As long as at least one computer is "running bitcoin," Bitcoin runs. If bitcoin's price rises, more miners will turn on, motivated by rewards and providing security commensurate with the value of the network. Stop up the entrance to her den, and the honey badger will be sighted in another part of the forest.
Greater regulatory risk exists in government's power to control crypto exchanges and other off-chain service providers. Crypto's weird, fragmented liquidity performed admirably on May 19. That may not be the case in the next drawdown, depending how exchanges are regulated. There is also risk of slow progress on crypto-friendly regulation, such as banking oversight and a bitcoin ETF approval.
It's not that mining is untouchable. Regulatory risk at the entrances and exits can have a negative effect on mining, by depressing the price. It's important to distinguish between that and a regulatory risk that affects the security of Bitcoin itself.
The market seems to be gaining a better understanding of that distinction – between technology risk and regulatory risk in cryptocurrencies. That's a sign of improving efficiency, at least for the time being. In the vacillation between retail- and institution-driven market cycles, that dynamic could change quickly.
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CHAIN LINKS JPMorgan's emerging markets research division came out swiftly with a note on El Salvador's law making bitcoin legal tender. TAKEAWAY: Bitcoin isn't going to change El Salvador's economy, but in a country where 25% of GDP is remittances, money transmission fees add up to real money, some of which will now be in Salvadorans' pockets instead of Western Union's. On the other hand, if other "similarly situated" nations don't follow El Salvador's lead, it will be easier to isolate the "Tom Thumb of the Americas" over its Bitcoin adventure, with potentially disastrous local results.
A Senate Banking Committee hearing on central bank digital currencies (CBDCs) generated more headlines about Bitcoin mining, as Democratic Sen. Elizabeth Warren of Massachusetts took aim at Bitcoin's carbon footprint. (Meanwhile, a Bank of England director made comments favorable to CBDCs.) TAKEAWAY: The market shrugged off Warren's thunder, as well it should: There's less risk to bitcoin in restricting mining than there would be in restrictions on cryptocurrency on/off-ramps. (See today's Briefing.)
Interactive Brokers plans to offer crypto trading by end of summer and State Street Bank has opened a crypto division. State Street EVP Nadine Chakar will lead the new unit, reporting to COO Lou Maiuri. TAKEAWAY: These moves are not speculative.
Bitcoin miners signaled approval for Taproot, a software update that adds privacy, programmability and data efficiency features, paving the way for activation in November. TAKEAWAY: Taproot sits between Bitcoin's status as a mutable technology and as a digital version of "gold." Watching its roll-out and subsequent adoption (or not) will say much about the future of the original cryptocurrency. See last week's Briefing for more.
Twitter founder Jack Dorsey teased an integration of Lightning Network, allowing fast, cheap payments using Bitcoin over the social network. TAKEAWAY: Three months ago, I would have dismissed that as a publicity stunt. At that point, Lightning's adoption as a percentage of the Bitcoin network hadn't grown at all in two years. Since March 1, it's grown from 1,101.4 BTC in capacity to 1,470.1 as of Wednesday, as the red line on the chart below shows. (CoinDesk parent Digital Currency Group is an investor in Lightning Network.)
Backwardation in CME bitcoin futures and continued low bitcoin dominance indicate a lack of institutional demand and continuing bearish tendencies in cryptocurrency markets, JPMorgan analyst Nikolaos Panigirtzoglou writes. TAKEAWAY: The tea leaves always carry alternate interpretations. For example, bitcoin dominance recoveries have for the most part taken place during bear markets.
The Ethereum 2.0 network received a record-breaking number of new deposits in May, rising from about $12 billion worth of ether at the beginning of May to over $13 billion as of last Tuesday. TAKEAWAY: Enthusiasm for Ethereum's transition to proof-of-stake (PoS) is likely driven in part by ESG concerns over mining. Also, the interest payments that come with staking deposits on Ethereum are emerging as a potential "base rate" of sorts for the decentralized finance (DeFi) sector. (Stay current on Eth 2.0 with my colleague Christine Kim's weekly newsletter, Valid Points.)
Offshore crypto exchange Binance saw its CFO, Wei Zhou, depart this week and Silvergate Bank cut off a dollar on/off-ramp introduced in December. Its U.S. division, Binance.US, was unaffected. TAKEAWAY: Binance.US is a CoinDesk Bitcoin Price Index (XBX)-eligible exchange. Binance is not.
White House national security adviser Jake Sullivan said ransomware is a "national security priority" and the "cryptocurrency challenge ... lies at the core" of it. His comments came just before the DoJ announced it had seized part of a bitcoin ransom in the Colonial Pipeline attack and Europol uncovered a Trojan horse used to infiltrate criminal organizations. TAKEAWAY: Yes, bitcoin is traceable. Please see today's Briefing.
CFTC Commissioner Dan Berkovitz highlighted derivatives products built on decentralized finance (DeFi) protocols with a rhetorical flourish, calling them "a Hobbesian marketplace," lacking intermediaries and investor protections. TAKEAWAY: Most DeFi enthusiasm focuses on contracts that look more like securities: lending services and automated market makers. Applications like Augur and UMA Protocol, which allow peer-to-peer construction and trading of synthetics, are a smaller segment.
China's crypto "crackdown" phase continued: the provincial government in Qinghai announced a mining ban and the Ministry of Public Security reported 1,000+ arrests on charges of money laundering facilitated by cryptocurrencies. TAKEAWAY: The PRC has embraced some centralized aspects of crypto (CBDCs), while selectively cracking down on some decentralized activities, letting others thrive unchecked. Ultimately, its posture may have the greatest impact geopolitically, as U.S.-aligned nations like El Salvador lean toward both bitcoin and Beijing.
Miner-extracted value (MEV) is a DeFi-fueled phenomenon in which the miners that process transactions on Ethereum front-run transactions processed through decentralized finance applications. A report out this week examines what will happen to MEV once Ethereum 2.0 moves to Proof of Stake (PoS) and makes Ethereum mining obsolete. TAKEAWAY: MEV will likely rival staking as a source of income for Eth 2.0 validators, the report finds, bringing their potential APR to 12.86%, as opposed to a non-MEV APR of 7.5% from staking alone.
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Podcast episodes worth listening to: 
A message from Coindesk  How is hashrate calculated? What does thermocap represent? What do hashrate ribbons say about bitcoin price cycles? This research note looks at Bitcoin miner metrics and how investors can use them to glean insight into the asset's price and network fundamentals. Download the free report here.
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