Crypto's First Fundamental Trade?
Or how the ETH Merge could finally bring credibility to the circus..
Welcome to more new folks! I am humbled to have been shouted-out by my favorite podcast of all time, the All-In Podcast this week. I think I have been on Twitter like 5 months and already been retweeted by Balaji and now the Besties. Definitely giving me the motivation to continue my weekly drops.
This newsletter is still “pre-viral” (which of course humbly assumes future virality), so I appreciate your early support. At this point, the majority of you are pseudonymous Twitter handles with ENS domains and cartoon PFPs, so I am reading the room loud and clear. You are interested in web3 analysis and don’t give two shits about my wannabe-John-Updike-culture-essayist-ass content. That’s cool, I’ll save that for my Medium page, or just send it directly to my mother’s junk mail.
One thing I would like to reiterate here is that while I am a major web3 bull on the entirety of the space, as well as a macro-optimist on the future of technology and the health and wellbeing of humanity, I am still a realist. I try not to get caught up in any of the hysteria (of which there is much) and give you my thoughts based somewhere in the realm of objectivity.
What does that mean? Well, it means that in its current state I think NFTs are a bubble and most are going to 0 (very bullish on their future use cases though). It means I think “Degen” coins such as SHIB and DOGE with no utility will get left in the dustpan of history, lest some small cohort of sentimental crypto historians keep some in their wallets the same way I kept my Sega Genesis in the closet for many years after graduating to N64, Xbox, and then eventually, sex with women.
It also means I think about things like product-market fit, supply and demand, and (gasp) fundamental analysis. Can you imagine? Someone using the words fundamental, analysis, and cryptocurrency in the same sentence? I know, I know, it sounds ridiculous, but let’s all take a deep breath, look at ourselves in the mirror, and peel back this onion. I am going to go through a couple of harsh truths, and then talk about that shining little beacon on the hill that is the Ethereum merge from Proof-of-Work to Proof-of-Stake.
Crypto, Equities, and the Fed are Tied at the Dip
Possibly due to the fact that the major institutional investment banks and finance media organizations are run by old people, there always seems to be much consternation about interest rates as if there is some debate about their relationship to Equity prices. Pre-2000 (dot-com Equity bubble), the Fed rates were uncorrelated with the S&P. Post-2000, the inflation-adjusted returns of the S&P are directly correlated to the Fed’s interest rate adjustments. There is a good article about it here, but since this is a relatively new phenomenon (..22 years..) I feel like it doesn’t get the credence it deserves. Are people stuck in the past? Expecting to break the pattern at each passing quarter? IDK. Right now, it is the ultimate fundamental. Rates go down, money becomes cheaper, people are feeling frisky (risk-on), money goes into equities (or other assets of interest), and those things go up. Rates go up, money gets more expensive, cash is needed to pay for goods and services, people are less frisky (risk-off), things go down. There are some wild things that could happen in the future but seeing as Crypto was born into existence during this time period it is safe to say it is the only fundamental it has ever known. That goes for Millennials and Zoomers as well.
The correlation of Crypto to Equities is just that Crypto is the next best market to dump excess cash. Once there is sufficient traction in terms of media attention, and a groundswell of participants, risk-on investors staring out-sized returns in the face cannot be deterred. Big money follows big money and now you have 1,000,000% returns over a decade. What makes Crypto both different from, and at the same time obviously tied to Equities, are the insane peaks and troughs it experiences over the seasons. +10,000x followed by 85% dip, +10,000x followed by 85% dip. Crypto is the little-market-that-could, being pumped to the gills with cash like some foie-gavaged waterfowl, before being extricated from such abundance, over and over and over again.
Bitcoin is the most prolific, but of course all of the others fall into the same cadence. During times of risk-off, Crypto is the plump goose on the chopping block, and everyone follows suit and cashes out at the same time. For all the talk about store of value and an internet native currency that will change the way finance is done (which I do believe will happen), this is all still very much pre-utility. Sure, there are 71M+ ETH addresses doing things in the ecosystem (which will be of focus in a minute), but it is not the utility that is driving the price, it is pure speculation based the velocity of participation.
As I pointed out a few weeks ago here, web3 has a weird community-first monetization system. First the community builds arounds a cause or coin, and then the price goes up. This makes speculation purely a popularity contest. Which chain has the most user growth? Things like throughput, blocksize, transactions per second, those are cool features to help build up hype and onboard new users, but the majority of investment dollars don’t care about that stuff, they care about the price. And thus price becomes a function of the velocity of participation, and participation a function of velocity of price.
This isn’t necessarily a bad thing, Crypto fans, but I think it is important for everyone to realize. I will never use the P-word when talking about Crypto, but you can see how others might see it that way. Personally, I see Crypto as a mini-Forex market. The foreign exchange market does $5T in trading volume per day. The entirety of Crypto does about $8B per day. Aside from the fact that Crypto is quite literally a collection of “foreign currencies”, there are other parallels.
The Forex market is so large that individual investors cannot even fathom moving the needle in it. Forex is dominated by big banks and governments, and exchange rates fluctuate as they decide which types of currencies they would like to keep on their balance sheets. It is ultra-macro, and ultra-fundamental, and because of that it is the only area of finance (in my non-expert opinion) in which Technical Analysis (aka chart reading) could really be applied, although I will concede arguments about prices gathering around psychological support levels. In Forex you are a little row boat paddling through the ocean in between the behemoth aircraft carriers and cruise ships and trying to get on the right side of a mini-ripple. Crypto is none of those things. Crypto is a drunken lake party where you are catching air in your jet ski off the wake of a cornering speedboat. In Forex you measure success in pips, or 1/100th of a 1% change in price. In Crypto you measure success in X’s, as in how many times you double your money on a trade.
So while Crypto prices are tied to the overflow of cash from Equity markets which are tied to the Fed interest rates, behaviorally it is just an extension of the Forex market. First, and most obviously they are nothing but currency pairs. And because currencies in general are not Equities in the sense they have an underlying business asset or commodity, they become a little bit more gamified for retail investors. It doesn’t help that the marketing campaigns for Forex trading platforms paved the way for what we see in Crypto today. For years the internet plastered Forex trading platforms everywhere, trying to dupe unsuspecting investors into becoming a day trader. The pitch was 50% technical analysis, 50% blue-tooth cell phone wearing wheeling and dealing, and 100% gambling. The lure was that you could do all of this from your home trading fractions of a dollar.. sound familiar?
I have read many fine, leather-bound books on Price Action Scalping and the most successful people of all time (the ones writing the books!) were telling you that with a mind-numbingly patient and diligent strategy, one in which you must stick to against all agonizing psychological temptation to otherwise change course, your reward will be to win 51% of the time. Nobody wants to hear that garbage, not in Forex, and NOOOOOTTTT in Crypto. Forex (with Crypto exchanges eventually copying the tactics) absolutely preyed upon the folks most susceptible to get rich quick schemes. Under the guise that this is “investing”, and you could “be your own boss”, and “you are really smart for reading that chart”, the human ego could not resist.
Everyone wanted to be the genius trader who made their salary every day before noon and took the afternoon off to go golfing. All of this was happening before Satoshi’s White Paper was even a sparkle in his eye. And before Forex, there was penny stocks (have you seen Wolf of Wall Street?). Crypto (which by my definition for new readers is a subset of web3 in which I am only referring to the tokens/exchanges, not the entire overarching space) copied those tactics to a T under the guise of “decentralized finance” (which I will keep saying - I do believe in). Many, many millionaires were minted, but many others lost the farm. Extractive middlemen appeared where there were supposed to be none. DeFi turned into CeFi, and just like in Equities, or Forex, those centralized exchanges don’t care if the market goes up or down, because they make their cut on both sides.
(Side note - my MBA Capstone project was a business plan for a Forex Bot Marketplace in which developers could build Forex trading algorithms, or bots, which where popular at the time, and sell them on a centralized exchange. These trading bots would cost between $50-$5000 with dubious profitability before eventually going off-kilter and having to be trashed for a new one. Why spend the whole morning trading when the bot could do the work? Plus, with user reviews and rankings, the consumers would know which bots were profitable and which were duds. I got an A+ on the project but I never built the company. Something inside of me knew this was exploitative (the vast majority of bots were a farce) and I couldn’t bear such a slimy career path. I briefly looked into doing something similar with Crypto years later, but the market has since been saturated.)
Anyways, the main thing Forex had going for it was its credibility and stability. Traders could thrive off of the predictability of the ebbs and flows of the market, and when it came time for a Fed announcement, the conventional wisdom was to stop trading at least a few hours before. Such big announcements would always change the tide, and it was important for the directionality to be secure so one could safely climb back into the rowboat. This credibility and stability lead to the credence of Technical Analysis, or chart reading. I don’t want to go into a whole dissertation on pennants, flags, wedges, double tops, and head & shoulders, but just know that it’s a whole thing, and it is very prominent in Forex. It is less prominent in Equities, I think because of the nature of the underlying assets there is more Fundamental Analysis to be done, although it is definitely still used by retail day traders. Due to the parallels between Forex and Crypto, and the way it has all been gamified and targeted to specific types of users, Crypto fanatics have also gone deep into TA.
The problem with TA in Crypto is that it really doesn’t hold up that well. This might be a hot take but I think that all Technical Analysis in Crypto is purely entertainment. There are thousands of YouTubers and Twitter accounts that think every.. single.. triangle.. on the chart is a bull flag. It is absolute insanity. If you peel back this onion and do a regression analysis on their calls, you will find them laughably bad. Yet they continue day in and day out spewing out chart analysis like they haven’t missed the last 20 calls in a row. Peel back another layer and you will see they are only bullish on the coins that they personally hold, and peel back yet another layer and they probably don’t even care as much about price as they do their number of followers (which is their real revenue stream). If anyone reading this is paying for premium access or a service that gives you price calls, or DCF risk premiums, STOP IMMEDIATELY. Anyone worth his salt in making calls will be making money off of them and will have no need to separate you from your Lincolns and Washingtons. Or read this book.
Similarly, Fundamental Analysis (where the investor is doing diligence on the fair market value of the underlying asset including things like analyzing it’s product-market fit, what revenue is it generating, what are the economic conditions of its sector, do they have good leadership, etc), is also lacking in the Crypto space. Many of the Layer 1 blockchains have similar value propositions. They are simply accounting ledgers waiting for programs to be built on top of them. Sure they all have different branding themes like this one is Green, and that one is Fast. But like I said earlier, the differences in things like throughput and security are only means to get developers to build Dapps, and eventually attract users to the chain. However, because of the relatively small size of the Dapp ecosystem relative to the onslaught of risk-on capital coming as overflow from the Equity market, the baseline for what a normal market looks like has been distorted, and neither Technical, nor Fundamental Analysis has truly been relevant to Crypto.
But now all of that all of that is about to change. We are going to see some fundamentals in play as Ethereum merges from Proof-of-Work to Proof-of-Stake. Every experiment needs a control or benchmark from which to test against, and the Crypto Winter has very generously given us what appears to be a some sort of a local bottom in which all the superfluous money has been removed, and trading has slowed tremendously. There are, however, as many as 3,000 Dapps still running on the Ethereum ecosystem. As the second largest blockchain, Ethereum also still has a $200B market cap, with $20B of that being traded daily. So we have a system that has been rid of much of the excess noise, but still has a large enough footprint in which fundamentals can have a noticeable affect, without being overrun again by wild speculation (which will come again eventually).
To catch people up, I will cover:
What is Proof-of-Work?
What is Proof-of-Stake?
What is Gas?
What is the Merge?
What does the Fundamental Analysis say?
To understand what the Merge is we first have to cover the basics, which I have been promising many of you for months now. We all know that blockchains are databases of transactions in which new transactions are adding in groups, called blocks. Each block contains the group of transactions waiting to be fulfilled, a unique code called its hash, as well as the hash for the block that preceded it. Each block as it is mined must connect to the preceding block in order to reach consensus from the network that it is, in fact, the correct next block in the chain. Consensus is required because the network itself does not live on a single centralized server, it lives distributed across every node on the network, with the entire chain being accessible by every user. Now, because computers are fast, and this data is relatively simple to keep track of, it does actually not require a lot of bandwidth. This becomes a security risk for something that is distributed, as bad actors could easily come in and manipulate the system by overpowering other nodes with spam. In order to combat this, the concept of Proof-of-Work is utilized. Essentially this means that to mine a block, the node operator must solve a complex math equation. These equations are computationally very intensive, which requires a lot of processing power from a computer. The electricity that the processor uses to solve the equation is the “work” that they have to “prove”. For this work they are given block rewards, in the form of the token that they just mined.
Over the years, the competition to mine blocks has become extreme. The processing power used in Bitcoin mining alone for a single year is equivalent to the amount of energy that a small country such as New Zealand uses. Ten years ago you could mine Bitcoin on a souped-up home computer, but now there are mining farms that use specialized equipment, and it has become a huge business. The faster you can mine the token, the more rewards you earn. So people have banded together to form mining pools, which distribute the rewards evenly. One of the downfalls of this business model is that they are being paid in tokens. In order for the miners to pay their electricity bills they must sell the tokens they were awarded, which increases the supply, lowers the demand, and naturally hurts the price of the token they mined. Another downfall is that as these mining pools start to turn into large organizations, they become centralized, which places the power back into the hands of the few, and the whole ethos of decentralization falls wayside.
Proof-of-Stake is a system where instead of having miners, you have a network of validators, whose responsibility it is to verify the next block in the chain. By virtue of having a stake, or a large swath of tokens, they are selected to verify a block, and earn some transaction fees. The larger your stake, the more likely you are to be chosen as validator. In order to keep the validators honest, they will lose part of their stake if they approve transactions that are not validated by the rest of the nodes. As long as the penalty is greater than the reward, the incentive is for validators to remain aligned with the network.
The other variable in the Ethereum equation is gas. Gas is the fee that you as the user pay to have your transaction completed by the network. Because Ethereum enables the use of smart contracts and Dapps on its network, it has a lot of transactions that it needs to complete. This means that during peak hours there can be a lot of congestion on the network. If you want to push your transaction to the front of the line, you can do so by paying a higher gas fee.
The Merge, which is expected to take place on September 15th, despite being talked about for the past 7 years, is the moment in which Ethereum changes its consensus network from Proof-of-Work to Proof-of-Stake. This is done by merging the Ethereum blockchain, with the Beacon blockchain, an empty PoS chain that has been running in parallel with Ethereum for about 2 years. Once that occurs, assuming everything goes smoothly, Ethereum will have converted to a fully PoS consensus mechanism.
So what in this information can we ascribe as Fundamental Analysis? Well, first we have to ignore the fact that people will probably trade the news, which is why many centralized exchanges have preemptively said that ETH withdrawals will be paused during the Merge. We also have to ignore the network effects that a post-Merge ETH will engender as speculators flow back into the ecosystem to see what the fuss is about. We also have to recognize the fact that gas fees will not change, nor will transaction speeds. The only thing changing is that ETH miners will stop burning electricity to mine ETH, and thus they will stop dumping ETH back into the market, driving down its price. The reduction in energy cost is expected to be as much as 99.5%, and the reduction of issuance via miners dumping their tokens as much as 90%. Currently, about 4% of all ETH is dumped back into the supply every year, at today’s valuation that is about $8.7B. A 90% reduction of that number is a mere $870M, meaning there is $7.8B ETH annually that will remain in the wallets of the validators. Additionally, there is now more incentive for validators to hold ETH, as they can get paid as much as 4-10% annually via transaction fees simply by staking their ETH. This is a fundamental economic change in the way that a blockchain operates, and is something that has never been seen before. So, it doesn’t matter what speculation is happening on either side of the Merge, it doesn't matter what the Fed rate does the the money supply, the trade in and of itself is sound in its fundamentals.
I wanted to discuss the Merge in this roundabout way by first highlighting what historically drives Crypto prices: speculation. The unit economics of these blockchains never change, and thus the price action of the currencies are determined solely by consumer confidence, investor psychology, and conventional wisdom of the day. In stark contrast, there is now a fundamental change happening to the underlying asset of ETH, which decreases the supply in a very real way. For a blockchain with $20B traded on it daily (during a down period), this change is one of the few things you can point to in Crypto and say definitively that it improves the price performance.
It is very important for Cryptocurrency traders to understand the difference between Technical and Fundamental Analysis, as well as the parallels between the Crypto, Equity, and Forex markets. The Crypto space is filled with scammers, bad actors, and hype. It is a market that has analog and pays homage to the modern markets, but without understanding the inner-workings of those markets, you may think you are doing analysis when you are in fact speculating, or worse, being duped. There will always be bad actors and extractive middlemen, but as the ecosystem grows, the percentage that is a scam will slowly decrease. Because I believe in the future of web3, which is powered by Crypto, I am making it my mission to bring credibility to the space. That starts with all participants critically thinking about what is, or is not, a good investment.
To be clear, there is nothing wrong with speculation. It’s fun, and there are mad gains to be had. But you have to admit that it’s a form of gambling. There are other assets that I think have solid fundamentals in the space and I plan to write some investment thesis one-pagers on them in the coming weeks.
Welcome to doranalytics, where we “merge” web3 with reality!