Nassim Taleb, famous for writing “The Black Swan,” and equally for his mathematical work in trading, was once a Bitcoiner. Recently, he has sold his bitcoin, explaining that it is not today what it should be as far as a stable, usable asset. I agree with him.

To date, bitcoin has not fulfilled its potential as a currency being used far and wide around the world. But that does not mean it isn’t on a journey to reach that point, one that appears much more promising today than at any other time in the asset’s history.

THE JOURNEY TO BECOMING A USEABLE ASSET

For most of the last three years, I have questioned whether bitcoin would actually live up to its use case as peer-to-peer, borderless electronic money. Many of us remember the last six months of 2017, when wild speculators artificially drove up the price of bitcoin in a bout of irrational exuberance, only for bitcoin to start a deep decline that maintained over the next year.

This led to a “digital gold” marketing campaign by Bitcoiners, which I always hated. The call for bitcoin being a “store of value” furthered a narrative that it was not useful for anything else, and jaded my thinking. Had bitcoin simply become a truly speculative instrument with no real inherent value, outside of schillers driving the price up to sell to some sucker who came in later? Was this an elaborate Ponzi scheme where early buyers sell to the next cohort, which is forced to go to Twitter to try to drive prices up again so they can sell at an even higher price?

I wrote about what I thought Bitcoin should be as a usable asset a few years ago, and my disappointment that it was not becoming that. My arguments sounded vaguely familiar to Taleb’s. However, I continued to hold my bitcoin because, despite the fact that I had become a bit disenfranchised, I believed the price would continue to go up, at least to some degree, although at some point in the future, a new blockchain that could securely move global payments at a reasonable price could debut. (Many people believe that Ethereum is the answer, but if you understand how gas prices work, you will quickly see that the cost is too high for it to be efficient, even though it is faster.)

At the beginning of 2020, my mind started to change again on where Bitcoin was going. I was at a conference called “Satoshi Roundtable,” chatting with a few friends who I see there every year. The subjects that continually came up were: One, rehypothecation of bitcoin and its danger; Two, security; And three, use cases of bitcoin.

One of my friends had gone to South America to investigate whether the stories of frequent use cases down there were indeed true. The feedback was “not yet” and “not as much as you think.” This only furthered my suspicion that there is not enough price stability for many people to use bitcoin. Though a few people leaving certain countries to rebuild their futures in Florida were using bitcoin as a way to transport their wealth — though this was not enough practical usage to justify the hype that this bitcoin use case had been receiving.

Typically, low adoption news like this would further have me doubt bitcoin’s use case, but it actually turned me the other way, given my contrarian nature. I concluded that a little use is better than none, and that bitcoin would have to go through a speculative phase to grow to the size it would need to become more useful. Also, you have to apply the law of large numbers to bitcoin to get to a market cap at which the volatility begins to dissipate.

THE LAW OF LARGE NUMBERS

Jakob Bernoulli first proved this theorem regarding large numbers, which many of us know from our studies of statistics. Bernoulli asserted that a small sample size will have a degree of difference from the overall population of study, and as you add more samples to the sample size, the relationship to the broader population converges until the sample is the population.

The trick in statistical samples is to understand how large the sample has to be in order to track the population within a reasonable margin. The law of large numbers is also applied to economics. In this case, the larger a company gets, the more units it has to produce in order to continue percentage growths.

In my discipline, I often applied this to country GDP. Smaller countries have to produce less than larger countries to match their GDP growth in percentage terms. Bitcoin is no different. The larger it grows, the less volatile it will become, as it takes much more dollar notional value buys and sells to move the price in percentage terms. In other words, as the bitcoin market cap increases, percentage movements in either direction will become much less, as it will take increasingly more capital and momentum to move the price. For example, when bitcoin was at $10,000, a move to $5,000 was possible, and represented a 50 percent price change. With bitcoin at $50,000, a $5,000 price move to $45,000 is very likely, but this represents only a 10 percent price change at this level.

As bitcoin’s market cap increases, the law of large numbers dictates that it will be increasingly difficult to move the price, tampering volatility and reducing the potential for price manipulation.

BITCOIN’S PHASES OF ADOPTION

In order for bitcoin to be useful as a digital currency, the market cap must continue to grow. At first, bitcoin was novel, magic internet money. Money for developers. In the early days, I thought the best use case for bitcoin was to transact across borders for developers working on projects together.

Pre-Satoshi’s white paper, I worked at Electronic Arts for a couple of years, and it had studios and third-party dev shops all around the world. It was convenient to work on projects across several time zones and to solve localization issues, but it was inconvenient to send money. Bitcoin solved that problem, but bitcoin used to be too complicated for anyone but a developer to store and transact. As other financial services people started getting into bitcoin and exchanges started to pop up, all of that began to change. We began to speculate on the promise of a digital currency, and with that speculation, along came financial speculators.

In late 2016 and 2017, we began to see a gold rush in bitcoin and other cryptocurrencies, including many scam coins. At conferences and Bitcoin meetups, new characters entered: gold brokers, get-rich-quick scammers, former financial services professionals who were not allowed to transact in securities anymore, people who had been to prison — the list goes on.

They saw cryptocurrencies as a fast cash opportunity and pushed the market beyond its limit in late 2017. It didn’t end well for many, and the next three years were spent recovering, building and regaining legitimacy.

We are still in a speculative stage, but a much more measured one than four years ago. But a speculative stage is needed to grow the market cap to a size where broader transactions become possible. What are we speculating on? That bitcoin will be a broadly-adopted global currency. And this is no different than any other forex investment. But instead of speculation on a country’s GDP growth and economic development making its currency stronger, bitcoin speculation is the bet that the digital economy will grow without the need for financial intermediaries, across borders, and that central bank-based currencies will devalue.

I am making the bet that all of this will happen, and that it is happening rapidly.

As speculation gives to promise, bitcoin makes way for more real-world use. As I write this, bitcoin’s market cap is now $1 trillion, versus $200 billion a year ago.

In 2021, more companies that transact digitally will hold bitcoin on their balance sheets; no differently than a global company holding a certain amount of foreign currency reserves. When the first large company, MicroStrategy, made this play it was big news. Its market cap was only $1 billion, though. Next was Tesla, with a market cap of $670 billion. As more companies make this announcement, the news will have an increasingly smaller effect, with lower market cap companies not having much of an affect on bitcoin price. This is the law of large nmbers.

FUTURE USE

After bitcoin gets to the $500,000 price range, I believe we will begin to see more transactions and daily use. Projects are already built that allow multiple-transaction use cases. BAKKT, Coinbase and Gemini have wallets that allow you to send bitcoin and other cryptocurrencies between friends (like with Venmo) and to merchants. Tesla will accept bitcoin as payment for cars. Paydrop and Wyre allow payments to W-2 and contract workers in bitcoin.

What is preventing mass use of these tools today and transacting more in bitcoin?

This story about cotton might provide some answers.

Source

“We are stuck with technology when what we really want is just stuff that works.” - Douglas Adams (author of the Hitchhiker’s Guide to the Galaxy)

Ethereum was cutting edge when the network went live on July 30, 2015. It reminds me of the Palm Pilot Treo. For those who don’t remember, or are too young to know, for the first time ever, you were able to plug in a device to your computer to download emails, go away to answer those emails, and when you came back to plug your Palm Pilot back into your computer, all those emails were sent. There were even some cool games and other productivity applications contained in tiny cartridges that you could purchase at Best Buy and Staples. I bought Tetris. Shortly after, Blackberry gained popularity due to better functionality, size, speed, and price. It also had Tetris. We all abandoned Palm.

Pay The Tollbooth

Ethereum users need to pay directly for the computational power they use in Ether, known on the network as “gas”. Given you need Ether to power Decentralized Applications (Dapps) and pay developers and miners, it’s important that transaction costs are cheap enough to attract users. And as with all successful scalable technologies, depreciate in cost to stave off competitive networks.

Cost

Ether should be viewed more like data fees on a cellular network, rather than a currency because Ether’s main usage today is still largely transaction-based, and is charged as the cost to move a unit of data across a network. As with cellular technology, as participants join, the network grows, which improves the value of the service, more data is moved, and cost decrease (this is known as the network effect). This means the cost per unit of data will drop significantly. The average data plan for cell phones was $100/monthly 2011, but in 2012, the average bill was $47/monthly, and now, in 2020, the average bill for an unlimited data plan is $30/ monthly. In 2016, on average a smartphone consumed 1.7 GBs of cellular data per month; that number is projected to reach 8.9 GBs in 2021 and some providers offer more than 1T (1024 GB) of mobile data usage, which falls under the unlimited data plans at $35/monthly. As we will explain in this piece, Ethereum’s core design disallows for scalability to succeed and instead created a negative network effect.

Crazed

“DeFi, DeFi, DeFi!”, yells the excited masses. Be careful what you wish for. There is $11 billion in crypto assets locked in DeFi right now. And as DeFi’s popularity continues to grow, Ethereum has become more congested, fees are still skyrocketing. Its demand is its downfall.

DeFi is fueling Ethereum’s growth which is also exacerbating the transaction fees. Coin Metrics reported that Ethereum’s cumulative transaction fees in 2020 are now over $350 million and more than double the aggregated total of Bitcoin’s network fees.

With the many options made available for “yield farming”, or decentralized finance “DeFi” gambling, the Ethereum network has clogged up and transaction prices have skyrocketed. High fees have become the new norm.

We mentioned the risk of this and the high transaction fees in our earlier piece, Ether And Bitcoin Are Not The Same. On June 10th, a user paid $2.6 million in fees to move $130 in Ethereum (ETH). Later that day, another ETH transaction with a large fee came through from the same address, many people are calling foul play. This type of dangerous activity decimates trust from users. This was the foreshadowing moment of future high transfer fees that we are seeing now.

Token trading volume on Uniswap, the largest non-custodial or decentralized exchange (DEX) on Ethereum, has increased from around $1M every day in June 2020 to nearly $1B every day in the beginning of September 2020. Uniswap trading occurs on-chain which made Uniswap too expensive to trade on, which priced out a large number of small-value users of the network.

As of September 1st, using a DeFi protocol costs more than $50 as Ethereum fees skyrocket. Following Uniswap’s UNI token launch, Ethereum transaction fees spiked to almost $1 million an hour, a five year high, and exchanges began passing gas fees to users.

“Making a simple Ether to Dai (DAI) exchange on Uniswap requires $55 in gas fees. Curve estimates a price of $33, while a trade on Mooniswap will cost over $80. Supplying an asset to Compound similarly requires about $57, while on Aave it requires $44.

At these gas prices, using these protocols becomes either impossible or uneconomical. In order for the gas cost on a DEX to be equivalent to a traditional exchange fee of 0.2%, one must trade at least $27,500 worth of assets in a single transaction. A user depositing 5,000 DAI on Compound would need to wait over 40 days to break even on gas — even when factoring in the COMP rewards.” — Cointelegraph

Despite this, numerous DeFi protocols are breaking all volume records. However, the economies of scale do not match, instead, we are looking at the law of diminishing [marginal] returns and diseconomies of scale. In Economics, a “Diseconomy of Scale” happens when a company has grown so large that its costs per unit will start to increase.

Linear businesses and platform businesses respond differently to diseconomies of scale. In a platform business model, the main asset is its network, which allows the platform to scale quickly and efficiently, sometimes exponentially. At times, platform business models can be immune to diseconomies of scale given they can grab close to total market shares if monopolized, but there is a catch: reverse (or negative) network effects and congestion when platforms scale too quickly.

And sometimes, as was the case with the Palm, when platforms scale too quickly, the user experience becomes poor, its value decreases, competitors enter and the platform collapses. Ethereum has reached a threshold of scale and its size is no longer an advantage, but instead, it has become its greatest risk factor.

If you have a developer or business owner of a Dapp that delivers a time-sensitive service, then your business is at jeopardy. You cannot simply wait in line for the congested network, excited about the latest craze, to finally accept your transaction. If you were a prudent businessman and/or woman, you will need to find a new platform.

More notably, the high gas fees meant that the majority of cryptocurrency users would be completely priced out. Considering that the median and average amount of cryptocurrency held by Americans was $360 and $5,447 per investor having to pay upwards of $50 per transaction would be unreasonable. Furthermore, consider that the average size of cryptocurrency portfolios are likely even smaller in other less privileged countries.

However, more stable chains, such as NEM and Algorand, have already come to market as user-friendly blockchains and other competing base-layer protocols like Polkadot, Cosmos, and Blockstack.

At the most basic level, Ethereum’s core design is at odds with the platform’s ability to regulate its gas prices, especially as usage continues to grow. Ethereum cannot remain competitive; Ethereum has failed.

Perverse Incentives

Yield farmers and miners are pushing for higher gas prices and are incentivized for Ether to be used as gas to pay for transactions and smart contracts. Miners have the upper hand as they will prioritize the transaction with the higher gas price. Users compete to be in line for a trade. However, it’s the whales and users who are transferring large amounts that will be at the head of that line, kicking out those investing small sums. High fees are prohibitive for many and to note, fees are not proportional to the amount of value transferred. “Ethereum’s median transfer value has increased to hundreds of dollars since the rise of DeFi, signaling that the network is shifting towards larger players,” the Coin Metric report points out. This exacerbates a system of higher fees and its negative network effects.

It is scalability issues that transformed Bitcoin’s perception from a means of exchange to a store of value, “digital gold”. It would be prudent that ethereum change course in a similarly disruptive way to survive however ethereum’s protocol does not have the capability to serve as a store of value and therefore must continue along the diseconomies of scale curve. The stark reality is that its greatest success factor, its extreme demand, is its downfall.

Didn’t we switch from traditional process transfer avenues such as Paypal and SWIFT, because of their high transaction costs? Why would we use Ethereum when it is even more expensive and carries additional risks?

Smaller investors, casual enthusiasts, and smaller Dapp users are having an increasingly difficult time using ethereum’s high-fee environment. They are priced out and there is hesitation due to its various service issues. This has led to other blockchains gaining ground on Ethereum as many users have looked elsewhere where they are not treated as “second class citizens” for not being able to afford gas (e.g. Tron) for yield farming plays, even if arguably these blockchains have its own idiosyncratic issues.

Reverse Network Effect

The reverse network effect of Ethereum is simple: the more users and protocols that the network attracts, the more transactions that are sent through the network. The more traffic there is on the network, the more congested it becomes; as it becomes more congested, fees go up, and transaction times slow down.

Layer 2 Scaling

Ethereum creator Vitalik Buterin has been vocal about the issues, citing Ethereum’s second-layer solutions will solve the scalability problems. Yesterday at Invest: Ethereum Economy, Vitalik Buterin reiterated his push for users to begin migrating over to layer-2 scaling solutions such as “rollups.”

But it’s important to not hold our breath for a layer-two solution to save the day. Not only has the launch been delayed for years but all users will need to learn how to use these layer-two solutions. As Vitalik explained in a tweet later that day, “[in my opinion] they’re not hard” to learn.” That relative statement here is a barrier to many.

The Ethereum 2.0 protocol upgrade, which will change the consensus mechanism to proof-of-stake (PoS), is very complex and has been long delayed (Ethereum has been looking to shift to PoS since 2014). When it does go live, an investor must pay close attention as market narratives will drive the price action. Given historical precedence, there will be numerous setbacks and disruptive issues, leading to periods of significant underperformance.

“Right now, DeFi spends $500K+ in trading fees per hour because ETH1.0 can’t scale….When DeFi moves to a scaled layer-1, then we can see if it’s mature enough for the mainstream.” — Stuart Popejoy, co-founder, and president of Kadena in Finance Magnates

Further in Popejoy’s interview with Finance Magnates, Popejoy reported that he does not believe that the upgrade to ETH 2.0 will improve the blockchain enough to make it viable for widespread adoption, adding that “the biggest 2020 development in DeFi is the demise of the narrative that ETH 2.0 is a viable future platform.”

Right now, Ethereum users are stuck with ETH 1.0 and its continued path of higher gas fees and poor performance.

“I’ve changed my mind after using a dozen of Defi platforms. So long as ETH 2.0 is not fully rolled out, there’s an obvious opportunity for a highly scalable blockchain to dethrone Ethereum. Paying $10 transaction fee and waiting 15 seconds for settlement is just bad UX.” — Messari’s head of product Qiao Wang

Yield Farming Projects are Securities

Four days ago, SEC commissioner Hester Pierce warned that DeFi tokens could be classified as securities. She noted, specifically referring to the Uniswap token (UNI) and SushiSwap (SUSHI), that each individual case must be investigated.

“This does not necessarily mean that you are outside the scope of securities law. So even if you don’t sell it, you are basically issuing the token. In the end, it might still fit into the securities classification. So people have to be careful, and again, this is one more reason why the SEC has to be out there to provide guidance, because people are trying to figure out how to issue the tokens so that users can use the tokens, and we are not really active in providing the guidance that people need to feel comfortable.” — SEC commissioner Hester Pierce at the LA Blockchain Summit

Given the similarities with traditional equities, there may be a significant reprisal against DeFi from the SEC. This may have a dampening effect. And although DeFi deflation may give users a small reprieve from soaring fees, the long-term prospects of Ethereum succeeding without DeFi protocols is slim to none.

Just like how recent crackdowns by the SEC and CFTC against centralized projects have had a chilling effect on ICOs, exchanges, it looks increasingly likely that the clearly non-anonymous teams of most large DeFi projects will come under heavy scrutiny in the coming years. Furthermore, many DeFi protocols are now closely intertwined in many high profile cases such as the Kucoin hack, where the hacker traded many altcoins for Ethereum.

Investments And Speculations

In The Intelligent Investor, Benjamin Graham wrote: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

The Bitcoin White Paper built in a progressive vision of a future — a daring solution to replace the world financial order. Bitcoin has continued to develop into this vision, slow and steady, which includes its ability to successfully serve as a store of value and safe haven against certain fast-depreciating currencies. It is possible to invest in Bitcoin because it holds these intrinsic properties. Therefore, an investor can have a reasonable expectation that the money allocated towards the purchase may appreciate over a longer time-horizon.

On the other hand, given Ether’s inability to adequately serve as a store of value, it remains a highly risky speculative instrument. Ether traders look to take profit from its subsequent price changes over a short time-horizon. They chase high returns, coupled with high risk. Visions of digital ingots dance before their eyes. Even worse, many are speculating on ETH through the publicly-traded grantor trust, ticker: ETHE. In Don’t Buy The Grayscale Ethereum Trust (ETHE:US) we discuss the massive share price premium versus the underlying assets in the trust, which has and will continue to collapse.

These visions of digital gold riches have been formed without evidence. They are simply pyrite making a fool of all participants.

The current recessionary environment is precipitated by two events. The first is easy monetary policy creating zombie companies and unsustainable corporate debt. The second is a lockdown resulting from a reaction to a new and novel virus termed “COVID-19”, a scarier sounding word than the original “Corona Virus” previously used. In order to save the US markets from an economic death spiral and out of control unemployment, the Fed changed course from slowly increasing rates to quickly lowering rates to near-zero while purchasing more balance sheet assets than any time in history. We will call this “Easier Monetary Policy” to distinguish it from the last 10 years of “Easy Monetary Policy”. Is it working? It depends on who you are…

Tech Titans or Tech Robber-Barons?

Since the March 2020 market crash, the S&P 500 has risen 38%, while the top 5 market-cap tech companies, Facebook, Microsoft, Apple, Google, Amazon (or FMAGA), now make up 23% of the broad market index. Subsequently, the leaders of these companies have amassed more personal wealth than ever before, despite lower GDP and double-digit unemployment. As small businesses close their doors for good, larger entrenched companies have managed to grow; taking advantage of lockdown orders, PPE loans, and easy money flowing into markets. Thus stealing market share from their smaller competitors. Fed policy has certainly helped the very rich.

Small Business

While larger businesses have been able to more easily access federal loans, negotiate for federal aid (such as airlines), and access lower rates in capital markets, small businesses have not. Lower interest rates do not apply to non-rated companies and seekers of small bank-loans. The rates for these businesses have actually gone higher due to their “risk” of not accessing the larger capital markets. The coupon a AAA corporation is required to pay has dropped from 3.04% at the beginning of 2020 to 2.03% today. Meanwhile, small companies cannot even get a loan, at any rate. Fed policy has created unfair competition between large, entrenched businesses and small businesses. In 2019, small businesses in the US employed 45% of private-sector employees. Fed Policy has so far hurt small businesses and their workforces.

Retirees

Inflation has always been a tax on savers and retirees, at about 2–3% per year target. A typical retiree has to earn enough yield to cover both inflation and living expenses (outside of the principal drawdown). Inflation isn’t the only way to tax the retiree through the increase in CPI cost, though. Lowering interest rates is another way to do this. Working backward, The average American spends $38,000 in living expenses after age 67. Fifteen years ago, one would have to have saved $894,117 at the then-current risk-free rate of 4.25% in order to survive on $38,000 a year through retirement. Last year, in order to retire at 67, one would have had to have $1.9 million saved to retire on $38,000 year at a 2% risk-free rate. Today, savings have to be $6.3 million, as 10-year treasuries pay a meager 0.6%. The last estimate is assuming that all the money being printed doesn’t yield a higher rate of inflation, otherwise, $38,000 a year may not buy enough food. Workers planning on retiring at 67 may have to work longer, which doesn’t help open up jobs for the currently many who are unemployed. Fed Policy does not seem to be helping retirees. Probably not job seekers either.

Grading the Fed

Financial policy manipulation from the Fed is probably not the right answer to solve the problems faced by most of the country, as much of the problems were both created by easy monetary policy in the first place, and by local rules regarding business restrictions and shutdowns. The Fed seems to be judging itself by how well the stock market performs, but equity prices typically better correlate with inflation than most other assets. Inflation is easy to create if you have the power to create more money and to buy an unlimited amount of financial assets with that created money. By the standard of higher equity markets, the Fed has done an A+ job. By the standard of wealth creation or even basic economic needs of working-class, retired, soon to be retired, or unemployed people, the Fed has failed.

Investment Implications

Given the Fed’s new mandate to boost stocks, equities should continue to rise higher through the election. This is true for most assets as well, both financial and hard assets. Bonds, though already in very low yield territory, should continue to go up in price, down in yield. Real Estate outside of large cities will further appreciate, as will other art and collectibles. The real loser is the greenback and other currencies whose central planning regimes continued to print.

When the Grayscale Bitcoin Trust (GBTC:US) began trading, many investors made great paper profits from the premium that it carried in the early years. This knowledge enticed the same accredited and institutional investors, as well as others eagerly sitting on the sidelines, to jump into the Grayscale Ethereum Trust (ETHE:US). However, it is not the same because the fundamentals of Bitcoin and Ethereum are not the same. There is no one size fits all investment strategy that encompasses all cryptocurrencies.

Closed-End Funds and Premiums

Many investors do not understand the mechanics and nuances of closed-end mutual funds and trusts. This extends to institutional investors as well. Having launched and managed numerous closed-end mutual funds and trusts, I have learned the granularity of their many pitfalls as well as the opportunities in these instruments.

It is important to examine the premium to the Net Asset Value (NAV) or the price per share compared with the value of the underlying asset. In the case of the ETHE:US, an open-end investment trust, it is Ether (ETH). ETHE:US has recently traded in a range of 6x-10x premium (or 600% — 1,000%) to the NAV. Two weeks ago, on June 11th, grayscale.co reported that the market price per share of ETHE was about $218 and ETH holdings per share were estimated to be $23.03. This means that as a retail investor, you are paying a premium of over 1000% or about $100 for $10 worth of ETH. As a comparison, on Kraken’s cryptocurrency exchange, you can pay $100 for $100 worth of ETH during the same time period. If you were a prudent investor, you would understand that purchasing ETHE:US and disregarding the premium to the underlying spot market is a poor investment decision.

Premiums do not always reflect the future value of an asset. In normal markets, a bond closed-end fund will trade at a premium because the market wants access to the underlying bonds when interest rates go down. It sells at a discount when interest rates go higher. Equity closed-end funds are a little trickier as it is easy to replicate the underlying unless options contracts are involved. However, even with the equity and bond examples, there is a greater premium or discount to future values depending on market volatility.

Premiums often collapse when the market has volatility.

Grayscale funds trade at massive premiums because people just don’t know any better. They buy the trust thinking that it accurately reflects the price of the underlying assets of Bitcoin (BTC), Ether (ETH), and others. We even speculate that recently, retail investors may have been confused with the price of ETH vs ETHE:US, as the price of ETHE:US was as high as $240 on June 11, when ETH was at $220, despite the fact that it was trading at a 1,000% premium to its per share NAV of $23. One thing is certain about these closed-ended instruments: high premiums always collapse, and in this case, investors will be harmed. This has just proven true for any ETHE:US retail buyer on June 11. The ETHE:US premium has collapsed by 60% in the last two weeks to a price of $84.50. This means that you lost 60% of your investment in a two-week period, rather than staying relatively flat if you had owned ETH outright.

Brad Mills explained that “because the price of ETHE rose so high, it started appearing like it was the price of ETH at a discount. Retail investors buying ETHE at $200 aren’t getting a discount at all; rather they are effectively paying $2000 per ETH, when they almost certainly think they are getting a deal on ETH. I think it’s safe to assume the 500–1000% premium is due to a perfect storm: buyers are a combination of FOMO institutional investing, market manipulation by holders of the constrained supply of only 3% liquid ETHE, retail traders getting hosed thinking they are getting a deal on ETH, and maybe a few simple investing for the convenience of not holding keys and tax savings. I think it’s going to end very badly for retail investors and probably a class action lawsuit against Grayscale for allowing this to happen.”

Corporate Structure

The trust structure that Grayscale uses is similar to a closed-end fund but with some annoying nuances. First, closed-end funds are a Regulated Investment Company (RIC), which means that 40% of its underlying assets must be securities. Grayscale Trusts will not work in that structure because none of the underlying crypto assets are securities.

Many people describe trusts working as a casino. I think it is more like a Hotel California. You can put money in to create additional trust shares but you can never redeem them. As Greyscale’s website explains, you can never redeem for the underlying cryptocurrency. You can only sell your shares to the next lucky buyer after your lockup period is over. Closed-end funds do not have these lockups. They also allow you to add structures to enable redemptions.

Finally, trusts are taxed as partnerships, meaning you have to file the Schedule K-1 document, even if you own them in a retirement account. Schedule K-1 forms can lead to more complex and potentially more costly tax preparations each year because some categories of income may be taxed as capital gains, while others are taxed as regular income, and for an investment in an IRA or 401(k), you may also need to pay tax on distributions received. Close-end funds often deliver a more favorable tax treatment to shareholders as well as tax-deferred distributions.

Given the deficiencies in the features of the trust, an investor could be correct about the underlying price action of ETH and yet still lose money.

ETH is a Poor Investment

ETH itself is a poor investment as proposed in our prior paper, Ether And Bitcoin Are Not The Same. The most important part of this paper is explaining the network effect. As the number of users increases and the Ethereum network supporting more dApps grows, then Ethereum becomes more valuable, which improves the network, which decreases gas costs.

Technological advances dictate prices decrease.

It is no different from cell phones. As the network and competition grow, the amount of data transferred increases, while the cost to transfer that data decreases. This is a simple economic theory of supply and demand, examining where the curves intersect. Technology shows greater depreciation of price following demand. Shifts in the supply curve are usually the result of advances in the technology that reduced the input costs of production. This has been true for technologies such as televisions, computers, cell phones, and wired/wireless data. It will also be true for blockchain.

Technological advances that improve production efficiency, such as ETH 2.0, will shift a supply curve to the right. The cost of production decreases and consumers demand more of the product but at lower prices. This has proven true for the price of ETH over the last two and a half years; as the network grew in earnest, prices have dropped significantly despite speculative buying.

An often-heard argument against developers and dApp users demanding lower prices on Ethereum is the fluctuation of gas costs priced in ETH. While the price of ETH is variable, the amount of gas can go up or down as a function of ETH price and network demand. However, this is a failed theory. First, adjustments in gas prices, at best, keep ETH prices stable over the long term, which is an argument against investment and speculation in ETH going higher in USD terms. Secondly, if gas prices can simply adjust to promote users at a lower cost on the network, any true relationship of the price of ETH to the use of the Ethereum network is broken, and the argument that buying ETH is buying the growth of the Ethereum network is void.

Because of this, ETH cannot serve as a means of exchange, unit of account or store of value and therefore cannot be seen as a viable currency. Therefore, ETH is only a speculative asset for speculation’s sake, with no true underlying fundamentals.

ETH Price and Network Growth

As of the date that we are writing this article (June 25, 2020), ETH is trading at $233. If you bought ETH a year ago, you lost 37%. Two years ago, you lost 49% and three years ago, you lost 24%. Of course, many people bought between Oct 2017 and August 2018, losing up to 93%. Retail investors buying ETHE:US a year ago have lost 31%.

During the same time periods, The Ethereum network has grown:

• 3 years ago: 449 dApps
• 2 years ago: 1515 dApps
• 1 year ago: 2854 dApps
• Today: 3479 dApps

It is important to note that Dapp growth began heavily in January 2017, when ETH was $1419.

Ethereum daily gas usage has increased since mid-2017 and has accelerated in recent months as on-chain transactions grew and became more competitive. Ethereum network use has hit a new all-time high, which is why the Ethereum community has recently been debating raising the block size limit. The network utilization chart, which depicts the average gas used over the gas limit in percentage, has currently surpassed 95%. Ethereum’s growing adoption is proving to be its Achilles’ heel.

The issues inherent in gas costs have created congestion, which is a negative network externality. Congestion on Ethereum has led to poor user experience, especially for traders in this highly volatile environment, as their leveraged positions may be liquidated before they can act. Ethereum has created a Braess’ paradox, which suggests that adding one or more roads to a road network can slow down overall traffic flow through it. Ethereum currently has a congested highway as well as expensive toll booths which have created an unpleasant experience with drivers looking for alternative routes.

Valkyrie Funds

Steven McClurg — CIO
Leah Wald — CEO

Valkyrie is a discretionary global macro investment management firm. By analyzing fundamental macroeconomic, geopolitical, and social factors we are able to listen to the markets and effectively manage risk and generate alpha.

Valkyrie believes that shifts in government economic policies, political climates, currency exchange rates, international trade, international relations, and interest rates impact all financial markets. Utilizing this expertise of the global economy and financial markets, Valkyrie has constructed unique portfolios with a dynamic macro edge that includes exposure to emerging asset classes.

Together, Steven and Leah utilize macroeconomic strategy to structure and manage portfolios.

About Steven McClurg (CIO):

Steven McClurg is the Chief Investment Officer at Valkyrie. He was a managing director at Galaxy Digital, through the acquisition of his previous company, Theseus Capital, where he was a founding partner and CEO/CIO. Steven started his asset management career at Guggenheim Partners, a leading global investment and advisory financial services firm, where he was managing director and portfolio manager, including oversight of Emerging Markets and Sovereign Credit.

About Leah Wald (Portfolio Manager):

Leah Wald is the CEO at Valkyrie. She was a Partner at Lucid Investment Strategies, an asset management firm specialized in investing in macroeconomic trends. Prior to joining Lucid, Leah was at Vital Financial analyzing investment strategies for Japan, Asia, Middle East energy, and global macro strategy. Leah started her career working at the World Bank Group reporting directly to the former Vice President of the Africa Region.

By Steven McClurg and Leah Wald

The inordinate thirst of gain that had afflicted all ranks of society was not to be slaked even in the South Sea. Other schemes, of the most extravagant kind, were started. The share-lists were speedily filled up, and an enormous traffic carried on in shares, while, of course, every means were resorted to to raise them to an artificial value in the market. — Charles Mackay, 1841

Charles Mackay, a 19th-century Scottish poet, journalist, and author, wrote about three of the most famous financial bubbles in history: the Mississippi Scheme, the South-Sea Bubble, and Tulipomania in his pinnacle book, Extraordinary Popular Delusions and the Madness of Crowds. The story of Ethereum may become a postscript to this volume.

With Bitcoin’s halving behind us, many speculators in the cryptocurrency trading markets are turning their attention back to the other top alternative coins, and more specifically, back to Ethereum.

The media has touted the superiority of Ethereum’s technology and enticed investors in its native digital currency, Ether (ETH), since Ethereum’s network went live on July 30, 2015. Despite the investor frenzy, Ether has not been able to become an adequate store of value; it has remained purely a speculative instrument.

Ether is a risk-on asset; not an investment.

Digital Tungsten

How can you “store value” in a speculative instrument? An investment cannot be a store of value if it lacks stability. It must be stable enough against future purchasing power that when retrieved in the future it can still be proved predictably useful.

Ethereum does not have one of the greatest value propositions of Bitcoin: predictable scarcity. Instead, the antithesis is the reality. The monetary policy behind Ether issuance is extremely unstable and due to its centralization, there remains an ability to inflate the money supply, such as was seen in the DAO hack in 2016 and diffusing the difficulty bomb, thereby debunking any belief in its ability to be seen as digital gold.

Given market participants do not deem Ether as a suitable monetary asset, then it is more akin to a simple commodity used only for smart contract computation. Therefore, there is no logical reason for an individual or institution to store wealth in it but only to have sufficient amounts for their needs, similar to AWS credits.

Catch 22

Ethereum users need to pay directly for the computational power they use in Ether, known on the network as “gas”. Given you need Ether to power Decentralized Applications (Dapps) and pay developers and miners, transaction costs need to be cheap enough to attract users, and as with all scalable technologies, depreciate in cost to stave off competitive networks.

If you are a trader, you are motivated purely by financial gains. You want the price of Ether to appreciate. However, as the price of Ether increases, it becomes more expensive to use Ethereum. Because the price of gas is high, users drop off, and companies who built on the Ethereum blockchain often go under (often needing to sell Ether to fund their operations), which leads to a depreciation in the price of Ether. When speculators see the signs of this price capitulation, they sell their holdings which further exacerbates the downward pressure. Traders know the phrase “buy the dip” but, on the flip side, there is also “sell the rip”.

Ether needs to be cheap for users yet it needs to appreciate dramatically in order to outperform Bitcoin for speculators. It can’t be both.

Institutional Money

Bitcoin has been correlated to traditional asset classes for the past seven years. There are times of decoupling but in the long-run, the statistical correlation has been clear.

Institutions like family offices that are allocating to cryptocurrencies are predominantly allocating to Bitcoin, due to its clear and understandable narrative, market capitalization, and liquidity (i.e. being able to allocate $5mm without significantly impacting price).

According to a recent survey released by Fidelity, as many as 36% of institutional investors in the US and Europe own crypto assets. 25% of those surveyed stated that they have long-exposure to BTC, whereas 11% have exposure to ETH. Additionally, a majority of the speculative trading volume in cryptocurrency markets has moved away from altcoins to Bitcoin futures in recent years, with the number of institutions buying futures doubling in 2020.

Broad diversification in the cryptocurrency markets is counter-intuitive; virtually all altcoins are correlated to Bitcoin yet Bitcoin has a higher correlation with the equal-weighted S&P index.

Bitcoin acts as a de-facto proxy for the entire cryptocurrency market. Investors are better off taking concentrated bets on Bitcoin, not smaller bets on Ether or other altcoins.

BTC Vs ETH Speculators

Organic demand is driving Bitcoin right now yet seemingly all of the demand for Ether is on margin. Most traders expect Ether to always follow Bitcoin’s price action. However, this has not always been the case and may not be the case for the next bull run as well.

One reason that they are correlated is that they are both risk assets. As an investor, that means that you have the same level of exposure that you already have with Bitcoin but with higher beta with less liquidity, akin to being exposed to small-caps in the stock market.

Before and after the halving there has been a clear de-coupling of Ether and Bitcoin. In the two weeks prior to the halving, Bitcoin’s price rose from below $8,300 to almost hitting $10,000; during this time period, Ether remained relatively stagnated.

While Ether may see periods of significant outperformance against Bitcoin, it is often short-lived due to the propensity of Ether holders to sell for more Bitcoin over multiple hype cycles. Cryptocurrency traders utilize a different strategy and hold a different mentality towards Ether than Bitcoin. Ether traders regularly accumulate Bitcoin “stacking sats” because it is common practice to trade altcoins in order to gain more Bitcoin, given Bitcoin is the primary unit of account. However, Bitcoin investors typically maintain a buy-and-hold “hodl” mentality and strategy, deeming it both a store of value and unit of account.

On-Chain

Unless on-chain scaling succeeds, the utility of the Ethereum network is heavily bottlenecked and users will begin to move to second-layer scaling solutions or the multitude of other competing blockchains.

Ceteris Paribus reported that gas prices on the Ethereum network have quadrupled since the end of April. On March 12th, during the sell-off activity, average gas prices spiked 900% from the day prior. Additionally, yesterday, on June 10th, a user paid $2.6 million gas fee to move $130 in Ethereum (ETH). Less than 24 hours later, after the first transaction for $130 (0.55 ETH) an identical fee amount was processed. Some people in the community have suggested money laundering whereas some experts have determined it was because of a bug. Regardless, this type of dangerous activity decimates trust from users.

Critics may argue that on-chain scaling is problematic in Bitcoin as well. Possibly. However, there is a key difference due to their use cases. For the average hodler of bitcoin, there is less need to conduct frequent transactions, given its ability to serve as digital gold. The average hodler of Bitcoin owns Bitcoin and does not move coins on-chain for months or even years. Therefore paying a high transaction fee every now and then is not a bad trade-off for storing wealth on the most secure public chain in the world. Contrast this with Ether; as a smart contract blockchain, it clearly requires far lower fees to have any form of utility, as the use cases promised by the Ethereum network inherently requires a much larger number of on-chain transactions to be useful.

Network Effects

Ether should be viewed more like data fees on a cellular network, rather than a currency because Ether is charged as the cost to move a unit of data across a network. As with cellular technology, as participants join, the network grows, which improves the value of the service, more data is moved, and cost decrease (this is known as the network effect). This means the cost per unit of data will drop significantly. The average data plan for cell phones was $100/monthly 2011, but in 2012, the average bill was $47/monthly, and now, in 2020, the average bill for an unlimited data plan is $30/ monthly. In 2016, on average a smartphone consumed 1.7 GBs of cellular data per month; that number is projected to reach 8.9 GBs in 2021 and some providers offer more than 1T (1024 GB) of mobile data usage, which falls under the unlimited data plans at $35/monthly.

This matters because in computer networks there exists a trade-off between cost, security, speed, and flexibility. In 2016, Tuur Demeester explained in his Medium piece, “Why I’m short Ethereum (and long Bitcoin)”, Bitcoin’s protocol prioritizes security, to ensure that it can function as a decentralized store of value, whereas Ethereum prioritizes flexibility, compromising on security, speed, and cost. Ethereum developers have attempted to harness the power of network effects (or the demand-side economics of scale) yet by compromising on security, they have bound themselves to an unscalable model prone to hacks and/or self-serving utility-maximizing activities of nefarious actors or Ethereum Killer competitors. In summation, as more users join, the cost of gas increases, the network clogs, there are potential security issues, which decreases the value of the service, leading to poor user experience, and therefore users drop off and move to other blockchains. During that switching process, they often sell their ETH for another coin.

Ether 2.0

The Ethereum 2.0 protocol upgrade, which will change the consensus mechanism to proof-of-stake (PoS), is very complex and has been long delayed (Ethereum has been looking to shift to PoS since 2014). When it does go live, an investor must pay close attention as market narratives will drive the price action. Given historical precedence, there will be numerous setbacks and disruptive issues, leading to periods of significant underperformance.

Furthermore, the difference in the price of Ether 2.0 and Ether itself will lead to market confusion in the short-term, further depressing investor confidence. The perception of Ether being a more speculative asset than Bitcoin will continue to hold true until it reaches maturity (if it does at all). There is a non-zero possibility that in its transition stage, ETC (Ethereum Classic) may see a resurgence in interest as miners are incentivized to keep the PoW chain alive, further splintering a network undergoing an important transition.

This highly fragmented space has created an opportunity for “Ethereum Killers” to compete with Ethereum for the same use cases and has diluted the space across multiple protocols. These Ethereum Killers, such as Cardano and EOS, carry billion-dollar launch values and compete for users’ attention. How can a DApp developer determine which blockchain to build on?

Bitcoin has secured the digital gold narrative and its message to investors has remained unchanged. Ethereum and Ethereum Killers have not been able to create a clean and concise message to investors or consumers and provide a clear point of differentiation from Bitcoin for newcomers to the space.

Investments And Speculations

In The Intelligent Investor, Benjamin Graham wrote: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

The Bitcoin White Paper built in a progressive vision of a future — a daring solution to replace the world financial order. Bitcoin has continued to develop into this vision, slow and steady, which includes its ability to successfully serve as a store of value and safe haven against certain fast-depreciating currencies. It is possible to invest in Bitcoin because it holds these intrinsic properties. Therefore, an investor can have a reasonable expectation that the money allocated towards the purchase may appreciate over a longer time-horizon.

On the other hand, given Ether’s inability to adequately serve as a store of value, it remains a highly risky speculative instrument. Ether traders look to take profit from its subsequent price changes over a short time-horizon. They chase high returns, coupled with high risk. Visions of digital ingots dance before their eyes.

However, these visions are formed without evidence. Like Ether, they are pure speculation.

Ether is both a poor store of value and a terrible cryptocurrency to speculate on.

Valkyrie Funds

Steven McClurg — CIO
Leah Wald — CEO

Valkyrie is a discretionary global macro investment management firm. By analyzing fundamental macroeconomic, geopolitical, and social factors we are able to listen to the markets and effectively manage risk and generate alpha.

Valkyrie believes that shifts in government economic policies, political climates, currency exchange rates, international trade, international relations, and interest rates impact all financial markets. Utilizing this expertise of the global economy and financial markets, ExI has constructed unique portfolios with a dynamic macro edge that includes exposure to emerging asset classes.

Together, Steven and Leah utilize macroeconomic strategy to structure and manage portfolios.

About Steven McClurg (CIO):

Steven McClurg is the Chief Investment Officer at Valkyrie. He was a managing director at Galaxy Digital, through the acquisition of his previous company, Theseus Capital, where he was a founding partner and CEO/CIO. Steven started his asset management career at Guggenheim Partners, a leading global investment and advisory financial services firm, where he was managing director and portfolio manager, including oversight of Emerging Markets and Sovereign Credit.

About Leah Wald (Portfolio Manager):

Leah Wald is the CEO at Valkyrie. She was a Partner at Lucid Investment Strategies, an asset management firm specialized in investing in macroeconomic trends. Prior to joining Lucid, Leah was at Vital Financial analyzing investment strategies for Japan, Asia, Middle East energy, and global macro strategy. Leah started her career working at the World Bank Group reporting directly to the former Vice President of the Africa Region.

A big shoutout to Aaron Tay for all his help writing this piece.

Disclaimer:

The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. All Content in this document is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing in the document constitutes professional and/or financial advice, nor does any information in the document constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. The content in this piece does not represent the views of the United States Government.

By Steven McClurg

Why are stocks rising amidst riots and COVID-19?

Because people aren’t spending.

John Maynard Keynes laid out in The General Theory of Employment, Interest and Money a simple equation that sums up the current situation:

Income = value of output = consumption + investment.

Saving = income — consumption.

Therefore, saving = investment.

An Investment In Cash

During the COVID-19 lockdown, spending was thwarted by store closures and a lack of avenues to consume. Places where people could consume, usually had long lines, further discouraging those who ventured out; if the fear of becoming deathly ill did not discourage you from the get-go. Consumption is an interesting thing because, psychologically, people are driven to create utility out of their earnings. “Sitting in cash” is viewed as a wasteful use of earnings.

“It has been supposed that any individual act of abstaining from consumption necessarily leads to, and amounts to the same thing as, causing the labour and commodities thus released from supplying consumption to be invested in the production of capital wealth.” -Keynes

Absent the propensity to consume, people are pushed towards investment, or what Keynes describes in his formula as “Savings”. This accurately reflects data that retail investors are pushing the markets higher through ETFs and online financial services platforms such as Robinhood. Schwab saw “monumental volumes” with a record of 609,000 new accounts in Q1 and Robinhood saw daily trades up 300% in March year-over-year. Robinhood also told CNBC “over half” of its customers are first-time investors. Securities trading was among the most common uses for the government stimulus checks in nearly every income bracket. This is juxtaposed to the retreating interest shown from hedge funds and professional money managers that control large institutional dollars.

Income 2020

What makes this situation unique from ten years ago is the income part of the equation. Despite high rates of unemployment, most of the unemployed labor force previously made wages of less than $50,000/year. Below that threshold, the extra $600/week in federal unemployment benefits kicks in, essentially pushing income higher on unemployment than while working. Of course, an idle workforce, with higher income and less propensity to consume, increases savings (investment in risk assets).

Simultaneously, personal income in the US increased by 10.5 percent in April, while consumer spending sank by a record 16.4% in the same month and, which is evidenced by the retail index earnings down by retail sales expected to fall 12.3%. In sum, consumer spending collapsed, unemployment surged and yet personal income went up on average in April.

This has led to more money flowing into the traditional markets.

But why would retail buy the riskiest assets, such as stocks, and abhor defensive positioning such as bonds?

Primarily, stocks are easier to access and understand. Additionally, risk does not apply to the equation when money invested is found money. Even more importantly, memories of a stock market that bottomed in 2009 and subsequently rallied is a fond thought and hope of retail speculators.

The general position taken from talking heads of why markets and risk assets are higher is simply due to inflation, resulting from money printing. This satisfies Milton Friedman’s Quantity Theory of Money, which states that if the money supply doubles, prices double, therefore you have experienced inflation across all assets (such as the stock market). However, this theory has been disputed by Keynesians and proven otherwise through the last 20 years of monetary policy, due to the lack of velocity of money in the equation. Money velocity asserts that if you spend $100 at a store, $90 will be spent on other goods and services necessary to run the store, $80 will be spent producing the goods necessary to produce the product, or to sustain the lifestyle of the employee, and so on. We discussed this previously in Monetary Policy And Inflation: Is This Time Different?

We do not believe that inflation will be a direct result of money-printing this time, as it was not a direct result ten years ago. Money spent in consumption or direct investment creates higher money velocity than investment in the stock market or other speculative assets. Stock market investing is not giving money to a company to create and produce. Rather, it is purchasing shares from a previous speculator of the future value of the company. Additionally, the massive collapse in demand in the greater economy, as evidenced by the plummeting consumer spending and unemployment statistics, equates to lower prices for many goods and services. All of these together paint a picture of low money velocity. This matters because the lower the velocity of money, the fewer transactions are occurring between individuals, and therefore the weaker the economy’s health and strength are.

If the current trends continue then unemployment will increase, consumer spending will decrease, and the retail public will continue to use their savings as an investment (in the stock market). Until sentiment changes then, ceteris paribus, the technicals of the traditional markets will continue to be misaligned with the underlying fundamental systemic issues.

Of course, retail investors can only drive the market to new highs for so long. As discussed in “Negative Interest Rates are Coming”, large institutional managers began rotating out of risk assets long ago, and will not come back until more risk is off the table, and P/E ratios (today are equal to where they were October 2007) are once again attractive.

Valkyrie Funds

Steven McClurg — CIO
Leah Wald — CEO

Valkyrie is a discretionary global macro investment management firm. By analyzing fundamental macroeconomic, geopolitical, and social factors we are able to listen to the markets and effectively manage risk and generate alpha.

Valkyrie believes that shifts in government economic policies, political climates, currency exchange rates, international trade, international relations, and interest rates impact all financial markets. Utilizing this expertise of the global economy and financial markets, Valkyrie has constructed unique portfolios with a dynamic macro edge that includes exposure to emerging asset classes.

Together, Steven and Leah utilize macroeconomic strategy to structure and manage portfolios.

About Steven McClurg (CIO):

Steven McClurg is the Chief Investment Officer at Valkyrie. He was a managing director at Galaxy Digital, through the acquisition of his previous company, Theseus Capital, where he was a founding partner and CEO/CIO. Steven started his asset management career at Guggenheim Partners, a leading global investment and advisory financial services firm, where he was managing director and portfolio manager, including oversight of Emerging Markets and Sovereign Credit.

About Leah Wald:

Leah Wald is the CEO at Valkyrie. She was a Partner at Lucid Investment Strategies, an asset management firm specialized in investing in macroeconomic trends. Prior to joining Lucid, Leah was at Vital Financial analyzing investment strategies for Japan, Asia, Middle East energy, and global macro strategy. Leah started her career working at the World Bank Group reporting directly to the former Vice President of the Africa Region.

Disclaimer:

The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. All Content in this document is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing in the document constitutes professional and/or financial advice, nor does any information in the document constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. The content in this piece does not represent the views of the United States Government.

By Steven McClurg

After the Great Recession of 2008, negative interest rates emerged in The Euro Area, Switzerland, Sweden, Denmark, and Japan.

Given our uncertain economic climate and a renewed push by President Donald Trump, we foresee negative interest rates coming to the US.

Why?

US 10-year Treasuries sit at a yield of 65 bps, which means if you buy the bonds today and hold them for 10 years, you earn a whopping 0.65% a year if you hold to maturity. One of the mandates of the Federal Reserve is to maintain inflation at a steady 2% rate, so if they succeed, you lose 1.35% a year (technically negative). What would compel investors to buy bonds then?

One is relative value: It is better than owning 10 year German Bunds at -0.54%. European investors could move their money from Bunds to Bonds for higher yield, but they don’t because the Euro will likely weaken against the dollar at the rate of the spread.

The other reason is the total return on the bond trade, meaning that rates would have to go down enough to appreciate the market value of the bonds in order to sell at greater the rate of inflation. In order to match the rate of inflation, 10-year rates would have to decrease to 0.5%, appreciating the value of the bond by 1.45% (plus holding the bond for a year to earn a total return of 2.1%). Of course, simply buying US Treasuries (UST) and selling them every year after earning a rate of inflation is not a great strategy for 2 reasons: 1) you are not earning real money, and 2) you would have to roll your money into something new at the end of the year, likely bonds with lower yields.

The two largest groups of institutional investors are pensions and insurance companies, which broadly require an 8% and 6% return annually respectively to meet their liability-driven investment strategy (LDI) and actuarial assumptions to remain solvent and pay their beneficiaries. Insurance companies would require 10-year rates to drop to 0.11% within the next year to generate enough total return to make it worth it to invest in bonds. Pensions would need 10-year rates to go to -.08%. To use round numbers, in the next 18 months, rates will have to be between -.25% and -.50% to attract pension and insurance capital.

Pensions are a larger purchaser of equities than life insurance, but most pension models cap out and move to bonds when P/E ratios peak, as they are now, forcing into defensive assets.

Jerome Powell recently stated that he would hold rates positive but the Fed can only control the short end of the curve. Market forces will push the rest of the curve into negative territory. But the Fed may be forced to take the discount rate lower to keep investors coming into treasuries.

Effects on Equities

Equities are overbought. As we write, the S&P is at 2800. We believe that earnings will be close to 120 at best, which at a historical average multiple of 16, puts S&P fair value of 1920. Likely earnings will be 100, and given this is a worse recession than most, pushing a multiple of 15, pricing the S&P closer to 1500. Equities should continue to lose a sizable bid as institutions move to fixed income for safety and the above-mentioned price appreciation. This will have a negative effect on all risk assets, including pushing spreads wider on the lowest quality below-investment-grade bonds.

The last move up in the S&P, from a low of 2200 on March 23rd close, was mostly pushed up by retail. The buy volume for the last 7 weeks has been from retail online brokerages, giving larger institutional investors and funds an opportunity to get out of the equity markets. Now the longs are held by retail, largely weak hands, with no institutional bid. This leads to a greater market capitulation than we saw in March.

Real money has been moving out of equities and positioning for bond investing for the last 6 weeks. This will continue through the summer, pushing equities down and bond yields lower, and into negative territory eventually.

Effect on Banks

The fall in bank profitability can lead to a search for yield, and an increase in risk-taking by banks, which can have a negative impact on financial stability and decrease the beneficial effects of negative rates. The rate that commercial banks can charge on loans due to the lowering of interest rates allows for the ability to stimulate the economy however it also erodes bank profitability by squeezing deposit spreads. This is largely the reason why banks have not rallied over the last 6 weeks with the rest of the broad market.

Generational Bull Market (in Bonds) Won’t Die

Real interest rates have been declining since 1981 when it was north of 15% and the Fed has come to realize in the years that followed 2008, raising benchmark rates far above zero is not compatible with hitting its 2% inflation target.

The Fed’s mandate was holding inflation at 2% prior to the Great Recession, after which, a dual mandate emerged of 2% inflation and low unemployment. Now, a third mandate of maintaining markets has crept in. With low inflation, high unemployment, and weak markets, the Fed will cut benchmark interest rates to boost demand and investment, even if it means interest rates move to negative territory.

Implementing massive interest-rate cuts, and actually going negative, is a crisis response. This is a risky endeavor with a fallout that will plague markets for decades.

Valkyrie Funds

Steven McClurg — CIO
Leah Wald — CEO

Valkyrie is a discretionary global macro investment management firm. By analyzing fundamental macroeconomic, geopolitical, and social factors we are able to listen to the markets and effectively manage risk and generate alpha.

Valkyrie believes that shifts in government economic policies, political climates, currency exchange rates, international trade, international relations, and interest rates impact all financial markets. Utilizing this expertise of the global economy and financial markets, Valkyrie has constructed unique portfolios with a dynamic macro edge that includes exposure to emerging asset classes.

Together, Steven and Leah utilize macroeconomic strategy to structure and manage portfolios.

About Steven McClurg (CIO):

Steven McClurg is the Chief Investment Officer at Valkyrie. He was a managing director at Galaxy Digital, through the acquisition of his previous company, Theseus Capital, where he was a founding partner and CEO/CIO. Steven started his asset management career at Guggenheim Partners, a leading global investment and advisory financial services firm, where he was managing director and portfolio manager, including oversight of Emerging Markets and Sovereign Credit.

About Leah Wald:

Leah Wald is the CEO at Valkyrie. She was a Partner at Lucid Investment Strategies, an asset management firm specialized in investing in macroeconomic trends. Prior to joining Lucid, Leah was at Vital Financial analyzing investment strategies for Japan, Asia, Middle East energy, and global macro strategy. Leah started her career working at the World Bank Group reporting directly to the former Vice President of the Africa Region.

Disclaimer:

The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. All Content in this document is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing in the document constitutes professional and/or financial advice, nor does any information in the document constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. The content in this piece does not represent the views of the United States Government.

By Leah Wald and Steven McClurg

“Lesson number one: Don’t underestimate the other guy’s greed.” -Scarface

We are not buying Bitcoin into the halving.

Bitcoin has rallied to over $10,000 from around $6,000 just a month ago, adding more than $1.4 billion in value. As of the release of this piece, Bitcoin is $8586. Bloomberg, CNBC, along with top technical analysts are covering the price action and attributing the surge to the upcoming halving and excitedly pulling up countdown clocks on their shows. The media is rampant with bull-run hype and moon shooting price targets.

Hope is good for mankind but hope is not an investment strategy.

As an asset manager, ethically protecting and growing endowments, pension funds, and families’ retirement funds, gambling is not a possibility. The halving is a lucrative tradeable event. However, as a value investor, for now, it is not an investable event.

Historicity:

The most prevalent bullish reasoning is citing historical precedent. Prior post-halving rallies have averaged 446 days and triggered prices to rise 81 times and 30 times in the 18-month period after the 2012 and 2016 halvings respectively. However, the fundamentals of the first halving on November 28th, 2012, and last halving on July 9th 2016 are different from our current environment.

The last halving was before the ICO mania, crypto legislation, and before derivatives and other sophisticated investment vehicles entered the market. These instruments provide the opportunity to speculate on the underlying asset but never owning bitcoin itself. This, in itself, affects the price of Bitcoin differently as well as the experiences that traditionally sophisticated investors enticed into joining the cryptocurrency space have.

Paul Tudor Jones learned the hard way today that with a 24/7 market, where traditional rules do not apply, you can awake in the morning to a very unpleasant surprise. A couple of hours ago when Bitcoin experienced a flash crash from $9881 to $7995, it became abundantly clear how owning derivatives, rather than a physical spot, can work against you.

There has been much excitement generated by news and media. Given it is primarily retail participants in the market trading this halving then the emotions and sentiment are going to be more strong of a driver than ever.

Much of Bitcoin’s extreme price action has historically been dictated by FOMO. That is why in 2017, Bitcoin ran up to almost $20k then quickly reversed into a nosedive, in a frenzied bubble.

Sentiment by itself is unsustainable.

But this halving is a completely different event because the world is facing an unprecedented pandemonium over COVID-19.

The COVID-19 Halving:

“This is a crisis like no other,” Kristalina Georgieva, the managing director of the International Monetary Fund (IMF), said at a teleconference last week. “Never in the history of the IMF have we witnessed the world economy coming to a standstill,” she said. “It is way worse than the global financial crisis [of 2009].”

Due to COVID-19, we believe the S&P could drop to 1200.

Bitcoin is correlated with the S&P as a risk asset.

However, there are more statistically relevant correlations to examine given the FAANG stocks make up nearly 28% of the S&P. It is true that these are technology companies however if you run a comparative analysis to publicly traded fintech firms and equal-weighted technology indexes, such as the Invesco S&P 500 Equal-Weight Tech ETF (RYT) to tamper the FAANG weighting, correlations are much higher, between 70% and 80%. We will write our next piece about the correlations we have discovered.

The cryptocurrency market is currently filled with retail investors. Exchanges lost institutional volume and revealed over 100,000 BTC withdrawals after March 12th. Speculative retail investors are buying however they are focused on Grayscale Bitcoin Trust (OTCMKTS: GBTC) alongside small and mid-cap financial technology companies that are not the large institutional names.

Many similar speculators bought in October of 2018 when they thought BTC was “cheap enough”. These same speculators are with us now but the weak retail hands will capitulate when the broader tech market declines.

Given Bitcoin’s high correlation to these small and mid-cap stocks, ceteris paribus, it is in for volatile times ahead. Right now stocks are not a buy and therefore neither is Bitcoin.

The halving may provide a lucrative opportunity for short-term traders to gain from upside action and volatility. And as long as equity markets stay in the green, then Bitcoin will likely continue the upward momentum.

However, as soon as equity markets begin to erode, as we are calling for due to high unemployment, weak consumer sentiment, and unsustainable corporate leverage, Bitcoin will swiftly depreciate with it.

Whilst we said above that the correlation to the S&P is not as statistically significant as to the small and midcap stocks, from an emotional perspective when investors see blood in the streets of the major indexes, this will create bedlam and Bitcoin has the potential to nosedive. This potential alone is enough for a prudent institutional investor to stay out.

The US Economy is Caught in a Maelstrom

Let’s fast forward to after the COVID-19 curve when the markets are truly feeling the pain of the stark reality of the global economy. People are able to emerge from lockdown but the hope that everything will return to a sense of normalcy has disappeared; widespread unemployment and corporate defaults have actualized.

The Bureau of Labor Statistics (BLS) reported that the US economy lost 20.5 million jobs in April and that the unemployment rate has soared to 14.7% with 23.1 million people counted as unemployed. This statistic does not include the 2.3 million people who are have looked for a job in the last 12 months rather than the last four weeks as well as the 10.9 million people who worked part-time. The U-6 unemployment rate, which includes underemployment, surged to 22.8% in April. As we recently wrote, Q2 GDP could lower as much as 40% YoY, creating a much more severe recession than 10 years ago.

If Bitcoin does not appreciate and retain stability then it will not have the crucial elements needed to be a safe-haven asset. This does not bode well for Bitcoin’s chances to be picked over gold, treasuries, the Japanese yen, or the greenback, nor does it provide an opportunity to decouple from the traditional markets and act inversely to their dangerous downward spiral. It is also possible that many investors and traders will be hoping to cash out after the halving in search of these aforementioned safe-haven assets.

If Bitcoin is still ranging around current levels then the retail investors who have remained in the space will begin to think that Bitcoin mining will implode. Then, there will be a big crash. Hopium will be gone. FOMO will be gone. People will get out.

Chinese Bitcoin Miners Move Markets:

McClurg wrote a paper on July 6, 2018, entitled Bitcoin is No Longer an Uncorrelated Asset in which he proved the strong correlation between South Korea’s KOSPI and Bitcoin from 2016–2017 and the Shanghai Composite Index (SSE) from 2016- 2018. He noticed the 2018 relationship between SSE markets and Bitcoin was 72% correlated, as the poorly performing Chinese economy created a risk-off trade in both local equities and digital assets.

At this time, the SSE was the worst-performing country index for the first half of 2018, mostly due to tensions around US-China trade policies, which negatively affected Bitcoin’s price. The People’s Bank of China (PBOC) originally was a cryptocurrency enthusiast in 2013 before doing a volte-face in 2017 when they banned ICOs. Immediately following the announcement of this ban Bitcoin dropped 6%. Actions in China affect Bitcoin’s price.

We posit that the same irrational emotional mindsets “Animal Spirits” that drove the SSE also drove the Chinese miners to hold or sell. Miners are affected by economics similar to any other business.

With the halving in two days, the onus is on the importance of mining. However, the prevalent conversation is around the technical workings of a bitcoin halving. Instead, it is important to understand and prepare for the power miners have in driving up or down prices. And watch for how they may control the price action in the days and weeks to come. The University of Cambridge has reported that 65.8% of bitcoin mining is still based in China, while the U.S. and Russia lag behind at 7%.

Bitcoin’s halving will force weak miners off the network, increasing the power of Chinese miners. As inefficient miners go out of business on Monday, a more efficient mining operation will buy their mining equipment. In China, there are favorable financing options for mining, especially for receiving loans.

There is a historical precedent of miners hoarding coins to drive up prices to ensure that the halving is financially advantageous before selling. Bitcoin is money and miners are running a business. Miners model in the halving in terms of their returns. Miners will sell when they believe it is the right opportunity to sell.

While traders buy and sell Bitcoin, miners only sell. They are not dogmatic. They are capitalist.

However, as the Chinese economy continues to suffer during this global pandemic, miners may need to sell in order to fund operations and this will drag Bitcoin prices with them.

Zhu Jun, the director of the international department of the People’s Bank of China announced last week that “The possibility of a ‘Great Depression’ cannot be ruled out if the epidemic continues to run out of control, and the deterioration of the real economy is compounded by an eruption of financial risks.”

Few companies are spared during an economic recession, let alone depression, there is no reason to believe that Bitcoin mining companies will be the exception, especially given their statistical correlation to the broad market indexes.

Dry Powder

Bitcoin is thinly-traded, volatile, and easily manipulated. Narratives are the market makers. With the emotionality of the cryptocurrency market, it is of utmost importance to remember that there is another person on the other side of your trade. Never underestimate who it may be.

Money management demands the recognition of shifts between asset classes. When an asset class is outperforming, it will be emphasized and adopted. However, when an asset class begins underperforming relative to other asset classes or has too high of a risk-reward for the risk tolerance of a company or firm, it must be de-emphasized or ignored.

Don’t treat a bear market as an inverse of a bull market. You need to take steps to protect your assets. Act accordingly.

Our money is liquid and our powder dry for when Bitcoin presents itself as a buying opportunity. However, a prudent investor is patient. And as a value investor, we are not afraid to miss an opportunity if the price is not right.

Valkyrie Funds

Steven McClurg — CIO
Leah Wald — CEO

Valkyrie is a discretionary global macro investment management firm. By analyzing fundamental macroeconomic, geopolitical, and social factors we are able to listen to the markets and effectively manage risk and generate alpha.

Valkyrie believes that shifts in government economic policies, political climates, currency exchange rates, international trade, international relations, and interest rates impact all financial markets. Utilizing this expertise of the global economy and financial markets, ExI has constructed unique portfolios with a dynamic macro edge that includes exposure to emerging asset classes.

Together, Steven and Leah utilize macroeconomic strategy to structure and manage portfolios.

About Steven McClurg (CIO):

Steven McClurg is the Chief Investment Officer at Valkyrie. He was a managing director at Galaxy Digital, through the acquisition of his previous company, Theseus Capital, where he was a founding partner and CEO/CIO. Steven started his asset management career at Guggenheim Partners, a leading global investment and advisory financial services firm, where he was managing director and portfolio manager, including oversight of Emerging Markets and Sovereign Credit.

About Leah Wald:

Leah Wald is the CEO at Valkyrie. She was a Partner at Lucid Investment Strategies, an asset management firm specialized in investing in macroeconomic trends. Prior to joining Lucid, Leah was at Vital Financial analyzing investment strategies for Japan, Asia, Middle East energy, and global macro strategy. Leah started her career working at the World Bank Group reporting directly to the former Vice President of the Africa Region.

Disclaimer:

The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. All Content in this document is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing in the document constitutes professional and/or financial advice, nor does any information in the document constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. The content in this piece does not represent the views of the United States Government.

By Steven McClurg

There is hope and an expectation that lives will return to normal after the quarantines loosen and “non-essential” businesses are allowed to open in the US and globally. Market participants believe that a $2 trillion dollar aid package is enough to float small and large businesses, as well as the 20%+ who are now unemployed — not to mention freelancers who do not qualify for unemployment and many who are underemployed. In fact, the markets continue to rally on hope and news that the COVID-19 curve is flattening and a vaccine is close.

Hope is good for mankind, for peace of mind, and should be spread to all humans. Hope is essential for building a better world. Unfortunately, hope is not a great investment strategy.

After the Curve

The last two months have created xenophobia and fear of any and all other humans. The Government’s medical advice is to wear masks and stay six feet apart (except for the WHO, who have consistently stated that masks will not protect you). It has become a societal norm to not gather, avoid crowded places, and stay at home. It has also become commonplace for people to call the police and cyberbully others who do not follow their own beliefs and standards on how to stay “safe”.

Humans develop behavioural responses to deeply embedded fears spurred by events — be it from dangers to person, mind, or finances. After the Great Depression, an entire generation hoarded food in freezers and cellars, distrusted banks, pinned money inside their clothes, or hid money in their homes.

After being forced into a COVID-19 lockdown, many generations to follow will behave differently from this point forward.

Industries that have been hit the hardest from February to April of 2020 have been travel, hospitality, food service, and personal hygiene. The travel industry will likely continue to suffer, particularly airlines, which have no revenue at the moment and are quickly burning through cash. The government bailout for airlines is estimated to not last beyond September.

Beyond this summer, people will continue to avoid airports, where TSA lines are long, passengers are flying through from “God knows where”, and the potential for spreading a virus is likely the highest than any other public location. Planes are recirculating air, spreading any disease, bacteria, or virus from any one person to everyone on the plane by the time the flight has landed. The same is true for ships and cruise lines. Airbnb will possibly burn through their cash, despite current fundraising. People will have a hard time trusting random people to clean their vacation rentals over a big hotel chain. Hotel chains are not off the hook either as they will also suffer from people generally distrusting of who might have stayed in that room before.

Restaurants will have a very difficult time re-opening as well. Many are barely breaking even, if surviving at all, by turning into takeout catering services. Psychologically, people will have trouble returning to dine-in, especially with the most profitable restaurants being those that operate on a wait or pack people into close tables. Even when restaurants re-open, it typically takes three months to a year to train staff and get to profitability. Most importantly, restaurants mostly hire people working at, or in some cases, below minimum wage, as servers mostly rely on tip income.

Attitude Towards Working

If a restaurant server was making minimum wage (we will use California’s $12/hour since California is the most populous state), which comes to $24,960/year, or $480/week. On unemployment, the same person qualifies for $240/week plus $600/week extra from the Federal CARES Act, for a total of $840/week, which is $43,680 annualized. At nearly double the wage, there is an incentive to continue not to work, even beyond the term of the CARES Act benefit.

Local businesses will have difficulty hiring back employees when they are allowed to open again. Given that $56,000 is the median salary for the US, at $54,000 annual wage, an American can collect the same amount in unemployment benefits as a paycheck.

Just shy of half of all US wage earners are better off on unemployment insurance under the CARES Act than actually working. Many know this and are asking to be fired. Needless to say, it may be difficult to hire back employees once they are gone, and a V-shaped return to full employment is very unlikely, even if there were jobs available.

Unemployment rates, GDP, and Future Earnings

Official unemployment rates are 16.4%, but we estimate that real rates are closer to 24%, with little reason to decrease. As the economy re-opens, it will be extremely slow, and customers coming out of hiding will be slower. Hirings will be deliberate if there are many lower-paid laborers who want to come back to work immediately (see above).

Higher paid labor will find it more difficult to find jobs. Unemployment will remain higher than 15% for most of 2020, the highest in the post-war period. Unemployment insurance will not last forever, and are covered by the states, who unlike the Federal Government cannot print more money. Large states like New York, California, and Texas have nearly depleted their through unemployment insurance coffers. During the last recession, states borrowed over $150 billion from the federal government to float unemployment payments. This time, states will likely need to borrow $500 billion.

Though lower unemployed wage earners make more through the CARES Act, overall there is less income for discretionary spending among unemployed and underemployed workers. Less available cash alongside low consumer confidence should push GDP down further.

Q1 GDP was down 4.8%, despite lockdowns put in place in only the last 2 weeks of the quarter. The economy was already softening, but the spending halted. Q2 GDP could lower as much as 40% YoY, creating a much more severe recession than 10 years ago. At the growth rate the US experienced in the aftermath of the last recession, it would take 3 years to recover.

Future earnings of the market is already a concern.

Terrible earnings reports have been released every day but the market is only down 12% as of April 18th. With over 20% unemployment and a 40% GDP decrease, earnings could drop as low at 110. If P/E ratios reflect past recessions, we can expect 16x earnings, which means the S&P can drop to 1,760.

Our actions are dictated by emotions; and the markets are a representation of the collective consciousness of all participants. As the market and economic indicators continue to decline, we will also continue to experience a psychological downtrend of emotions including anxiety, panic, anger, and fear. This vicious cycle will exacerbate an already ominous and disastrous situation that will be felt from our pocketbooks to how we help others. Let’s hope for a strong and swift rebound while we also prepare for the tumultuous times ahead.

Valkyrie Funds

Steven McClurg — CIO
Leah Wald — CEO

Valkyrie is a discretionary global macro investment management firm. By analyzing fundamental macroeconomic, geopolitical, and social factors we are able to listen to the markets and effectively manage risk and generate alpha.

Valkyrie believes that shifts in government economic policies, political climates, currency exchange rates, international trade, international relations, and interest rates impact all financial markets. Utilizing this expertise of the global economy and financial markets, ExI has constructed unique portfolios with a dynamic macro edge that includes exposure to emerging asset classes.

Together, Steven and Leah utilize macroeconomic strategy to structure and manage portfolios.

About Steven McClurg (CIO):

Steven McClurg is the Chief Investment Officer at Valkyrie. He was a managing director at Galaxy Digital, through the acquisition of his previous company, Theseus Capital, where he was a founding partner and CEO/CIO. Steven started his asset management career at Guggenheim Partners, a leading global investment and advisory financial services firm, where he was managing director and portfolio manager, including oversight of Emerging Markets and Sovereign Credit.

About Leah Wald:

Leah Wald is the CEO at Valkyrie. She was a Partner at Lucid Investment Strategies, an asset management firm specialized in investing in macroeconomic trends. Prior to joining Lucid, Leah was at Vital Financial analyzing investment strategies for Japan, Asia, Middle East energy, and global macro strategy. Leah started her career working at the World Bank Group reporting directly to the former Vice President of the Africa Region.

Disclaimer:

The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. All Content in this document is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing in the document constitutes professional and/or financial advice, nor does any information in the document constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. The content in this piece does not represent the views of the United States Government.

By Steven McClurg, Leah Wald, and Neil Harounian

The Coronavirus Aid, Relief and Economic Security (CARES) act included a $349 billion loan program called the Paycheck Protection Program (PPP) as a lifeline for small businesses desperate for cash during the COVID-19 pandemic lockdown. We believe that a payroll tax holiday is a better solution to ensure that Small Medium Enterprises (SMEs) receive the economic support that they need.

The importance of helping American SMEs cannot be understated. Sole proprietors and contractors account for around 80% of the 30 million U.S. small businesses. 51% of small business owners will only be able to continue to operate for another 0–2 months, according to a recent Goldman Sachs study.

Payroll Tax Forgiveness Could Be A Better Solution

A payroll tax holiday and/or rebate are better ways of reducing costs to companies in direct proportion to actual payroll. In most states, total payroll taxes (FICA and FUTA) paid by the employer is around 12%.

FICA deductions mostly affect lower and middle-class wage earners, as social security taxes are limited to the first $137,700 of annual salaries. By eliminating this tax altogether, lower and middle-class workers, who are more susceptible to market downturns and unemployment, are better protected as companies receive a higher net expense benefit to keeping them on the payroll.

By directly attributing tax cost reduction to payroll as opposed to through a complicated lending process, small businesses would benefit without letting intermediaries, such as banks, put their hands in the cookie jar and subsequently slow down the process of relief.

Payroll tax holidays have also historically been successful in reducing unemployment faster during an economic recovery. Businesses are much more willing to hire back employees if the cost to do so is lower by 12%. In 2010, with bipartisan support, payroll taxes were reduced by 2 percentage points, which helped reduce unemployment rates from a then high of 9.6% to to 8.1% 2 years later when the scheme ended. At an estimated 21% unemployment, a much bolder tax holiday will be needed.

Freelancers, Gigsters, And Independent Contractors

The PPP attempts to assist those most in need but it still doesn’t affect many essential industries.

Almost 30% of the US workforce are independent contractors rather than W-2 employees, which doesn’t qualify their employers for a tax holiday benefit. However, this group of people work in many essential jobs such as nurses, physicians, truck drivers, and construction workers.

The Brookings Institute recently reported that approximately 10% of the workforce in the US has alternative employment arrangements for their main job. Freelancers pay about 15% in self-employment taxes at the federal level, so seemingly, a payroll tax holiday may not help them keep their jobs. However, if self-employment taxes are forgiven for 1099 employees, they may negotiate their contracts to pass their savings on to their employers.

Problems With The Payroll Protection Program (PPP)

The key factor in the trickle-down economics scheme for PPP is that a portion of the loan that is forgivable is equal to the amount spent on payroll, rent, mortgage, insurance, utilities in the 8 weeks following receipt. Small businesses can receive loans of up to $10 million as long a 75% of the money is spent for payroll and the businesses retain employees or rehire those laid off; i.e. if they receive $100, they need to spend at least $75 on payroll and a max of $25 on non-payroll related items such as an office lease.

Loans originally designed to help the nation’s mom-and-pop shops keep employees on the payroll are instead going to a very different set of companies. Many small businesses that did not receive these loans were forced to close.

Who Didn’t Miss Out on SBA loans?

Large chain restaurants such as Ruth’s Chris steakhouse ($20 million loan, $468 million in sales last year, approximately 5,600 employees), Potbelly ($10 million loan, sales of $410 million last year, 6,000 employees — and, the same day that loan came through, the company paid a $100,000 signing bonus to a new executive), and Shake Shack ($10 million loan, sales of $574.6 million last year, 6,101 employees). Morgan Stanley reported that $243.4 million of the total $349 billion has already been allocated to large, publicly traded companies.

Even a Luxury hotel conglomerate exploited loopholes and was able to receive $59 million in funding through 3 separate entities.

Shake Shack, in a face-saving move, is returning its PPP loan, “so that those restaurants that need it most can get it now,” said CEO Randy Garutti, even as he argued that Shake Shack, with about 45 workers per restaurant, “could and should apply to protect as many of our employees’ jobs as possible.”

The SBA issued new guidance on April 23rd which makes it more difficult for larger, publicly traded companies to access the next round of PPP funding. The update was released after much public criticism over the failures and inefficiencies of the program, as laid out above.

The Big Banks Are The Winners

According to Bloomberg, Banks received an origination fee of 1–5% for these loans that mostly went to large businesses. The origination fee would be $100,000 on a $10mm loan as opposed to $5,000 on a $100,000 loan.

Therefore, banks are incentivized to favor and front-load applications with higher loan amounts because they receive higher fees per application. In a recent NPR investigation, banks issuing the PPP loans have made more than $10 billion in fees. This is because the banks took in the fees while processing loans that required less vetting than regular bank loans and had little risk for the banks. It is important to note that taxpayers are providing the money for the loans, which were guaranteed by the SBA.

Banks are the biggest winners and have prioritized applications that make them the most money. All applications go through a bank, who earns origination fees for taking zero risk.

The next winners are larger corporations that receive favorable treatment from banks and Congress. These are the same businesses that have a larger cushion to weather the losses.

At last, capital does make it to the employees, which is the lifeblood of keeping our economy as stable as possible during this tumultuous time.

But What About The Small Business Owners?

Only about 9% of companies that applied for the PPP loan actually received their loan before funds ran out, per the site COVID Loan Tracker. Small businesses did not quite make it into the queue to save their employees. These are the individuals who the PPP is supposed to be targeted to help. However, small business owners often do not even take a paycheck, rather they receive dividends from their businesses. In doing so, they do not qualify for the rigid PPP requirements for funding and as such may have trouble weathering the economic downturn.

While the original $349 billion was depleted in a matter of less than two weeks, the government has passed a second bill replenishing the PPP with an additional $310 billion. Coupled with the new guidance which limits larger companies from taking advantage of the program, we are hopeful that more small businesses will be able to access PPP funds. But those in need of these loans should act fast — choose the right bank and move quickly.

Resources for Small Businesses Impacted By The Coronavirus Outbreak:

Centers for Disease Control and Prevention — Guidelines for Small Businesses

SBA — Coronavirus (COVID-19): Small Business Guidance & Loan Resources

Treasury Dept. — Assistance to Small Businesses

Dept. of Labor / OSHA — Resources for Small Businesses

Internal Revenue Service — Coronavirus Tax Relief

U.S. Senate — Small Business Owner’s Guide to the CARES Act

On a happy end note, a few organizations (Facebook, Goldman Sachs, and Google) are also seeing the need to assist small businesses and are devoting funds to the cause.

Exponential Investment Management (ExIM)

Steven McClurg — CIO
Leah Wald — Head of Research/Portfolio Manager

Exponential Investment Management (ExIM) is a discretionary global macro investment management firm. By analyzing fundamental macroeconomic, geopolitical, and social factors we are able to listen to the markets and effectively manage risk and generate alpha.

ExIM believes that shifts in government economic policies, political climates, currency exchange rates, international trade, international relations, and interest rates impact all financial markets. Utilizing this expertise of the global economy and financial markets, ExIM has constructed unique portfolios with a dynamic macro edge that includes exposure to emerging asset classes.

Together, Steven and Leah utilize macroeconomic strategy to structure and manage portfolios.

About Steven McClurg (CIO):

Steven McClurg is the Chief Investment Officer at Exponential. He was a managing director at Galaxy Digital, through the acquisition of his previous company, Theseus Capital, where he was a founding partner and CEO/CIO. Steven started his asset management career at Guggenheim Partners, a leading global investment and advisory financial services firm, where he was managing director and portfolio manager, including oversight of Emerging Markets and Sovereign Credit.

About Leah Wald (VP of Portfolio Management):

Leah Wald is the VP of Portfolio Management at Exponential. She was a Partner at Lucid Investment Strategies, an asset management firm specialized in investing in macroeconomic trends. Prior to joining Lucid, Leah was at Vital Financial analyzing investment strategies for Japan, Asia, Middle East energy, and global macro strategy. Leah started her career working at the World Bank Group reporting directly to the former Vice President of the Africa Region.

About Neil Harounian (Director of Capital):
Neil is a VP at Exponential focusing on portfolio success. Prior to his role at Exponential, Neil led corporate development out of New York City for a consulting firm focusing on early stage blockchain startups. Neil started his career out of university at RBC Capital Markets in the Leveraged Finance group focusing on large cap leveraged buyouts. Neil graduated with honors from NYU’s Stern School of Business with a major in Finance.

Exponential: Investing for the New Digital Economy

Disclaimer:

The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. All Content in this document is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing in the document constitutes professional and/or financial advice, nor does any information in the document constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. The content in this piece does not represent the views of the United States Government.

Paycheck Protection was originally published in @exg on Medium, where people are continuing the conversation by highlighting and responding to this story.