Insight
October 21, 2024
Last week we highlighted the growing demand for yield from bitcoin investors with the second phase of the Babylon mainnet launch. This project, when complete, would allow bitcoin holders to generate rewards in Proof of Stake (PoS) networks, such as Cosmos. The key to what Babylon and its ilk are attempting to unlock is to enable bitcoin to be the capital (stake) required to participate in the consensus process – proposing and validating blocks – in PoS networks. Bitcoin’s Proof of Work (PoW) consensus mechanism requires miners to expend real-world resources (energy and compute) to create new blocks and be rewarded. PoS consensus mechanisms broadly require capital to be posted (in the form of a digital asset) in the hopes of being selected to create a new block and be paid a reward. While stakers like to think about their rewards as “yield” because they are receiving more of a digital asset they already own, the reality is that staking does not provide returns like most would think about it.
The key to understanding how PoS rewards affect investors, both those who hold PoS coins that stake them and those who do not, is the concept of capital structure irrelevance. This was described in 1958 in the Modigliani–Miller theorem, proposition 1, which states that the value of enterprise is unaffected by how it is financed. While the principle applies to capital structures, equity, and debt, it’s even simpler for crypto networks - the valuation of a crypto asset is irrespective of the number of units.
While both Modigliani and Miller would go on to win Nobel prizes for their work in economics, one could think about this principle in less erudite terms, pizza. Famed baseball player and coach Yogi Berra once said, “you better cut the pizza in four pieces because I'm not hungry enough to eat six." Again, this illustrates the concept of division irrelevance as 4 slices satiate the same amount of hunger as 6 slices.
What does it have to do with crypto networks and valuation? For PoW systems like Bitcoin, all existing token holders are affected by dilution due to coin issuance equally. In the following table we’ve created a fictitious example of a PoW digital asset network. It starts (T=0) with 10 coins held by 4 holders in increasing amounts. We set the price of the coin at $100 each, giving the entire asset value (market cap) of $1,000.
In T=1, 1 coin is mined by a PoW miner, bringing the total number of coins in circulation to 11. Because total valuation (market cap) must be preserved (you might think of this as the law of conservation of valuation), the price of the coin must go down. This of course assumes markets are efficient, which we know in practice in the crypto industry can be something of a stretch. This 10% growth in the supply of coins results in dilution of 9.1% (1/(1+Supply Growth)) for existing holders, meaning they own 9.1% less of the new supply of coins in circulation. Their ownership is also worth 9.1% less because the price of a coin should adjust downward to accommodate the new supply.
For Bitcoin, with a growth in new supply of 0.8% annually, this translates into dilution of 0.8% (a different number but rounded up) for existing holders. Of course, miners, who are the beneficiaries of these new coins, are required to expend resources (energy and compute) in exchange for these new coins. The other way to think about this is that under efficient market conditions, the price of bitcoin should drift downward by 0.8%, the dilution, keeping all else equal. Therefore, for bitcoin’s price to remain flat, it must take in new capital to buoy the price.
While dilution in PoW affects all holders equally, that cannot be said for PoS systems. Because not all holders stake, those that do are disproportionally rewarded, far beyond what might be implied by the total rate of growth of supply.
In the following example, we have a PoS system with stakers and non-stakers (holders). We use 2 steps of block production, half a coin reward that goes to one staker and half a coin reward that goes to the other staker in the next step. The net effect of the total supply growth is the same as in the PoW example, 10%, but the rewards are split between the two stakers.
As can be seen, the holders (non-stakers), are diluted to a similar percentage as would be indicated by the supply growth (1/(1+Supply Growth)) under PoW. However, in the PoS case, the accretion to the 2 stakers is much more than the dilution to the non-stakers. It’s equal to the sum of all holder dilution (9.1% x 3 = 27.3%) divided by the number of stakers (we assume that 2 coins are required to stake). The accretion to each staker is 13.6%, well above the 10% growth in the supply of tokens. Said another way, the cumulative dilution to holders, each borne equally, is divided up amongst stakers, resulting in accretion that exceeds the growth rate in the supply of tokens.
Given this accretion dynamic, it’s no surprise that staking is so popular for PoS networks. The percentage of coins staked on PoS networks varies from 29% on Ethereum to 77% on SUI. Most PoS networks have over 50% of their coins staked, with some earning less than 3% yields (SUI). The activity has become so popular that liquid staking services, such as Lido, and restaking services, such as Eigenlayer, have emerged. These services allow users to stake their coins, earn PoS staking rewards, withdraw a derivative liquid staking token (LST) issued by the platform on a 1 for 1 basis, and use that token to do other things, like generate additional yield through DeFi activities (lending, liquidity providing, and re-staking).
The risk with these activities, however, is multifold. The first is legal/regulatory as the SEC has asserted certain staking services invoke securities laws. The second is technical risks as these systems employ a dizzying array of novel technology, including smart contracts, bridges, and sidechains. Because of the insecurity of some of these systems, DeFi protocols have been the source of some of the biggest hacks over recent years. The third is issuer risk as these platforms/protocols usually issue derivative tokens on numerous networks. Even something simple like the USD stablecoin tether (USDT) is technically 16 different digital assets issued by Tether, all on different networks such as Tron and Ethereum. Most of these protocols advertise these derivative tokens as being “pegged” but what they really mean is "issued on a 1 for 1 basis"; there is no mechanism that “pegs” prices. During the LUNA/UST crash of 2022, stETH (stake ETH issued by Lido) “depegged” in price compared with ETH purely because stETH was leveraged in all sorts of DeFi strategies while ETH was locked earning PoS rewards. There is also price risk associated with derivative tokens, as just illustrated with the stETH example, as well as with the yields themselves, which can be paid in “points”, a protocol’s native token, or some other digital asset. Finally, there is fragility introduced with restaking that uses the same capital to secure multiple networks. A slashing condition on one app chain would result in slashing in the initial stake and thus any other app chains the stake is securing. It may be easier to bootstrap security for an app chain through restaking, but it cannot collectively increase the economic security of the entire system.
How might these risks present themselves in markets? Slashing in PoS systems (removing a portion of assets staked for bad behavior) is pretty rare, but it’s easy to see how slashing a stake that is providing security to multiple chains affects all chains. While cascading slashing risk is one risk, a bigger risk to us is purely leverage across the system that all of this enables. Because these derivative assets like LSTs are then recycled back into the DeFi ecosystem for lending, LPing (liquidity providing on decentralized exchanges), and re-staking, it introduces leverage into the ecosystem, all held together by smart contracts, bridges, and sidechains. We could easily see a situation where a large trader’s capital, recycled through DeFi several times, starts taking losses for some reason that then results in a cascading unwind in this entire “trade.” These times usually coincide with pressure on spot price – the stETH/ETH “depeg” occurred in the wake of the LUNA-induced market crash for example. There isn’t anything to suggest this is imminently at risk of happening, but as a “pre-mortem,” it’s a strong candidate for what could go wrong under certain circumstances.
The big idea that platforms like Babylon have hit upon is that bitcoin is largely idle capital. As the largest, longest-standing, and most secure digital asset, bitcoin is the best collateral in the digital asset industry. The issue, however, is that it doesn’t easily integrate well with other networks, hence efforts like wrapping bitcoin (BitGo, Coinbase, Kraken, etc), Babylon, Lombard, and Solv to name a few, that seek to integrate bitcoin within other digital asset networks. It remains to be seen whether bitcoin investors, who hold the asset for appreciation and inflation protection purposes, will be enticed by the potential rewards given all the risks.
Other options exist, however, for bitcoin holders who wish to enhance returns, some of which should already be familiar to traditional market investors, like options overwriting and lending. The following table outlines the various avenues available, risks, and potential returns for holders to generate additional returns. Each involves various tradeoffs, but we have found that in investing, better information “yields” better decisions, pun intended.
Bitcoin rallied 12.0% on the week, awakening from the lackluster price action seen in the past few weeks. All eyes are focused on the November 5th election as Bitcoin’s favored candidate, Donald Trump, has seen a rise in recent polls, perhaps owing to the renewed enthusiasm for the asset. That early November time frame may prove critical for price action as we have economic data (non-farm payrolls), the election, and FOMC interest rate decisions all within rapid succession.
Bitcoin is now pressing up against the downward trendline set by the recent peaks after hitting the March all-time high. While it remains to be seen if bitcoin can break out of this rangebound trading, if it can, we could see further gains ahead. We would add that the recent move has been fairly narrow within crypto as altcoins have largely not seen any significant price movements outside of a few memecoins, like DOGE.
Large flows into the spot bitcoin ETF complex have accompanied the rebound in spot along with $2.0B flowing into the complex in the past 5 trading days. Open interest on CME bitcoin futures hit a new all-time high as well, rising by 6,449 contracts or about $2.2B notionally. Funds have flowed into the dominant futures ETFs, BITO and BITX, but only $62M cumulatively over that same time, which indicates that much of the new flow into the spot ETFs was likely due to arbitrage activity by hedge funds. The basis on futures contracts has risen along with spot, now approaching 10% annualized for November expiry, making the basis trade increasingly appealing to arbitrage funds.
Investing:
Open Interest in Cash-Margined BTC Futures Reaches All-Time High, Driven by CME - CoinDesk
This Chart Indicates Bitcoin May Be Headed for Record Highs Above $73K - CoinDesk
Robinhood Confirms Plan to Support Bitcoin, Ether Futures Trading Amid Desktop Rollout - The Block
Coinbase Says Bitcoin Liquidity Unfazed After SEC's Lawsuit Against Cumberland - CoinDesk
State of Crypto 2024 - a16z
Regulation and Taxation:
FBI Arrests Alabama Man in the January 2024 SEC X Hack that Spiked the Value of Bitcoin - DOJ
Companies:
Bitcoin Staking Protocol Solv Raises $11M at $200M Valuation - CoinDesk
Blockstream Secures $210 Million To Drive Layer 2 Growth and Expand Its Bitcoin Treasury - The Block
Crypto Firm Arkham, Backed by OpenAI’s Altman, to Launch Derivatives Exchange - Bloomberg
Copper.co appoints Amar Kuchinad as its new Global CEO - Copper
Man Who Accidentally Sent $527M in Bitcoins to Dump Sues Local Council to Retrieve Them - CoinDesk
CoinDesk Buys Crypto Data Provider CCData and Its Retail Arm CryptoCompare - CoinDesk
Crypto Exchange Kraken Launches Wrapped Bitcoin Token kBTC - CoinDesk
Stripe in Talks to Acquire Stablecoin-Focused Fintech Platform Bridge - Bloomberg
BlackRock Wants Crypto Exchanges to Use BUIDL Token as Collateral - Bloomberg
Oct 25 - CME expiry
Nov 1 - Oct jobs report
Nov 5 - US election day
Nov 7 - FOMC interest rate decision
Nov 13 - Oct CPI reading
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