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Bitcoin may need to become high quality capital in DeFi to stay at all-time high prices

02 November 2021
SUMMARY SUMMARY
    • Bitcoin and Ethereum prices remain above $60k and $4k respectively after reaching new all-time highs, some six months after previous peaks. In response, large investors added 185k bitcoin to their holdings in the week of 25 October, bringing their holdings to the highest level in 2021 so far.
    • Despite this demand, it has become clear in the last six months that bitcoin faces competition as Ethereum and other Layer 1 assets become more innovative, with DeFi and NFT use cases, while bitcoin’s primary use case continues to be as a scarce fungible digital asset.
    • For bitcoin to retain its high value in the long term, it may need to bring its role as the highest quality capital in crypto into DeFi. However, this likely requires the decentralised wrapping of bitcoin from it’s blockchain to others. This likely requires a protocol upgrade but would guarantee bitcoin’s continued relevance and supercharge DeFi by providing access to all the value that has on-ramped into crypto via bitcoin.

Bitcoin and Ethereum prices reached new all-time highs in the 18 days since I last wrote a Market Intel Report, of $66,981 on Wednesday 20 October and $4,460 on Friday 29 October respectively. Bitcoin has closed above $60k for 17 of those 18 days while Ethereum has closed above $4k on 11 days. Bitcoin is currently trading over $63.7k and Ethereum close to $4.5k today, Tuesday 2 November.

Bitcoin reached its previous all-time high on 14 April, with the Coinbase IPO. At the time, I wrote that the ‘Coinbase IPO is the end of the beginning for crypto but new growth needs uses beyond trading’. This week I wanted to write a short update on where I think crypto is in this evolution of use cases.

There is no doubt that crypto is increasingly mainstream and the industry is now made up of both native and traditional companies. There is now a bitcoin ETF. DeFi and NFTs have demonstrated new use cases. The shape of Web 3.0 is becoming clearer and attracting ever more assets. A further 4 million Ethereum have flooded into DeFi since mid-April, bringing the total to 17.6 million Ethereum, 15% of the total supply. These are all very positive developments for crypto and I think its potential is now clearer than ever.

But the bitcoin price returning above $60k makes me ask: what use case supports the bitcoin price in the long term? In the six months between the two all-time highs, the main thing that has happened on-chain is that the amount of time investors are holding bitcoin has increased, and that large investors have bought back in after selling bitcoin following its April high.

On that last point, large investors, those who have held at least 1,000 bitcoin, now hold more bitcoin than they ever have done in 2021. As the first chart in the Report shows, they increased their holdings rapidly at the start of year, adding 185k bitcoin to their holdings by the start of February. They then sold and bought through price cycles. Then, in the week of 25 October, they added 142k bitcoin to their holdings.

So investment seems to be the use case for bitcoin beyond trading. This has been clear for some time, and is a confirmation of the view that bitcoin is seen as digital gold, or perhaps institutions are just making a longer term trade on the bitcoin price. Either way, bitcoin usage has not reached the sophistication of Ethereum or other Layer 1 assets.

This lack of innovation in bitcoin means that bitcoin’s other drivers of value have a lot of work to do. I believe these other drivers are primarily bitcoin’s 1) status as the first, most known, accessible, and liquid cryptocurrency, 2) nature as a scarce digital asset in a world of digital abundance, 3) continued power to attract new investors.

Bitcoin will always be the first cryptocurrency, but it may not always be the most known, accessible, and liquid. It likely has a monopoly on being the scarce fungible digital asset, but Non-Fungible Tokens could reduce the value of this somewhat – although bitcoin’s scarcity is guaranteed by Proof of Work while NFT’s scarcity is far more reliant on social agreement. Bitcoin’s power to attract new investors is arguably dependent on the first two drivers, especially if bitcoin stops being seen as the best way to gain exposure to the innovation of crypto.

This sounds gloomy, and in an important way it is: if bitcoin remains an asset that people trade speculatively or hold for its scarcity, then its long term value may be limited given competition from more innovative cryptocurrencies. Bitcoin can still have a very high long term value, but it has become clear in the last six months that it competes for investor demand, and does not always win.

However, I don’t think that bitcoin should compete on innovative use cases. Bitcoin is highly unlikely to be upgraded to have the functionality of Ethereum and other Layer 1 assets. It just isn’t designed for that, technologically or philosophically. And such a change would likely undermine its unique selling point: that it is a scarce fungible asset.

But I do think there is a way that bitcoin can remain relevant. It is the highest quality capital in crypto, and the first use case of Web 3.0 seems to be finance. If bitcoin can be used as capital in Web 3.0 then it will have a future as both a scarce fungible asset and as a useful asset in the more innovative side of crypto.

This is possible today. Bitcoin can be wrapped, creating an equivalent ERC-20 token. 230k bitcoin is currently wrapped. However, this requires bitcoin to be deposited with a centralised third party. That is a fine model – millions of bitcoin are currently held by centralised custodians. But this may prevent the programmatic wrapping of bitcoin that DeFi would likely require. I believe that a decentralised way of wrapping bitcoin is needed to unlock the use of bitcoin as high quality capital in DeFi.

Decentralised wrapping of bitcoin would likely need a Bitcoin protocol upgrade. I do not know the technicalities – I’m an economist! But I can see the economic need for this. It is likely essential for maintaining bitcoin’s long term value and it would also likely supercharge DeFi, as all the value that has on-ramped into crypto via bitcoin would suddenly be available to DeFi.

This may sound radical, but I think that high prices are a good opportunity for a deeper reflection. If you’d like to debate this with me, and you will be in London on Tuesday 16 November, then please request an invitation to our upcoming networking reception! You can also livestream our Links Conference, which is this Thursday 4 November. And, as always, please feel free to email me at marketintel@chainalysis.com.

Philip Gradwell, Chief Economist

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