DIGITAL ASSETS - BEGINNING OF THE END OR END OF THE BEGINNING
OCTOBER 2022
PRESENTATION- 28 MINS
MALE RESPONDENTS: Michael Metcalfe and Swen Werner

Thank you very much, Henry. Let me also say it's an absolute pleasure to be here in person, honestly primarily because if I was presenting remotely like poor Swen is it would be 3:00 in the morning for me. It's far better to be here. Look, as Henry said, many of you will be familiar with our research agenda which goes back decades, but we're starting with something that is completely new for us, which is the beginnings of our work in digital assets. The way that we're going to do this is, I'm going to start and talk a little bit about the macroenvironment for crypto assets, and then Swen is going to dive into the detail. I'm going to actually start with a slightly tongue-in-cheek meme that we published. Actually, it was back in November of last year, which was just kind of questioning. Crypto assets had gone to the moon. Where would they go next? I should stress, that wasn't a forecast. We have a meme in our charts that we publish on our insights platform every week, but in all seriousness what I'm going to try and get to is what we've learned from that journey, because I think there are some really important lessons for crypto assets, both narrowly and more broadly. I'm going to go through the first three points before I hand over to Swen. I think the first one is this question about, crypto assets are still incredibly large, but volume doesn't seem to solve for the problem of volatility, which still is significantly a problem. The other thing that I think we've learned very clearly is that... Obviously, many crypto assets and many applications of blockchain are obviously disruptive technologies, but what we've very clearly learned this year is that being a disruptor doesn't necessarily mean that you're a diversifier in terms of an investment. It isn't all bad news though, I should just stress. I've got two talks today. One is about the macro outlook for traditional aspects, and one is about crypto. Very easy to be super-gloomy on both, but I'll always try and find a little bit of hope for you. I think that the last thing before I hand over to Swen would be this idea that actually right now, Bitcoin in particular looks to be in safer hands today than it's been in the last five years. I'll be using data there. Henry mentioned the partnerships that you try and find through data, whether it be price stats, media stats. That's actually using a brand-new one that we only minted about three months ago with a company called Glassnode. So, let me get into it. Let me just start. I guess we have to start with the bad news. This is the crypto winter, of course. We've seen big drawdowns in crypto assets before. That's not new. What is new is that because Bitcoin had got so big, in terms of the drawdown that we've seen in market cap it's almost $900 billion in terms of the destruction that we've seen in just Bitcoin, which of course is about half of all crypto assets. Just to put that into perspective, it's really interesting now that the financial narrative in traditional markets is currently talking about systemic risk. Just look at the... Henry mentioned this idea of Bitcoin going through a stress test this year. What we're currently seeing in terms of loss of market cap, I've just compared it there to either Lehman or LTCM. Those of you who will remember '97/'98, LTCM, what we've seen in crypto is almost four times the size of that in current 2022 dollars. So, this has been a very sizeable stress test, arguably one of the biggest stress tests we've seen of any asset market so far. That's just the depth of the issue, I suppose, that we're facing in terms of this critical correction that we've seen in crypto assets. This has been a little different, even though we've seen volatility before. The interesting thing about it is that unsurprisingly, this massive correction has not been lost on the media. Looking at and measuring the media sentiment towards an asset, I think it's important in traditional assets. It's important in economics, actually, and I'll talk about that a little bit later, but it's particularly important in crypto because retail investors are really important. The media attitude to crypto assets is significant, perhaps more significant in crypto than it is in other asset classes. With our partnership with MKT, we're able to measure media sentiment quite precisely. What you see here, and it's very intuitive, I don't think I'm showing you anything here that will be surprising to you, is that the intensity of negative coverage in the media on Bitcoin reached an all-time high. We've only got data going back to 2015, but it reached an all-time high over the summer. The important thing now, though, actually... The important thing now is you can see it's just beginning to stabilise at a more historical level. So, yes, there's been a bit of a media panic, but it's beginning to ease back. This is obviously an important thing to monitor going forward, is how intensely negative is the media coverage. Going to the title of the slide here, there is this question that when you've had such a sizeable correction in crypto, is it the beginning of the end or the end of the beginning? This was a critical correction that we'd seen, and so if media sentiment really leaned against it heavily and continued to do so, that would be a problem. The fact that it's backed off, I think, is important. Look, I think the other thing to stress is, even though we've seen this massive correction in the market cap of Bitcoin, it is still huge. Look, I think regulators are obviously still trying to think about what Bitcoin is. Is it a currency? Is it a commodity? Is it a security? There are many different ways that you can rank Bitcoin against traditional assets. Here, I've personally decided here that it's more like a security, it's more like an equity. I don't think it's a currency for a number of different... That's a presentation in its own right, I suspect. Bitcoin still ranks... It's certainly within the top 20 US equity securities, so it's still huge. We've got the ranking there on the right-hand side. Let's not think, even though you've had this massive destruction of market cap, that Bitcoin somehow still doesn't have critical mass. It is still one of the world's largest securities which, given it didn't exist a few years ago, is pretty remarkable. You just need to let that sink in. It's very easy to think, oh, this has just been a speculative fad that's going to go away. I think you can still argue it's too big to ever go away. So, it's still large, but the one thing that we have learned, and I think going back and thinking about the kind of narratives that people put around Bitcoin, even after the last crash in '17/'18, is that I think there was this assumption that the bigger Bitcoin got, the less volatile it would become. The more that Bitcoin got accepted, it would therefore begin to stabilise. I think that the idea behind that was sound, in the sense that... So, this chart here looks at... It actually looks at stocks in the S&P 500 and just compares their realised volatility, which is on the vertical axis there, against market cap on the horizontal. Generally, generally what happens is that the bigger you get, the less volatile you become. Even in the traditional asset space, and you can see where Bitcoin was at the start of '19 there, and where it is today, you can see Bitcoin is a bit of an outlier here in that it's big and it's volatile. You'll also note that it isn't completely alone. There are stocks within the S&P 500 that are as volatile and almost as big. The interesting thing is, that dot there, which is right next to Bitcoin, I don't know if anyone wants to have a guess at it? It's actually Tesla, which I think is perhaps quite telling. We shouldn't think that volatility in its own right makes Bitcoin unusual. There are traditional assets and securities that are the same. I think that's also in part the challenge that Bitcoin faces, because there's another part of the Bitcoin narrative that we were used to was this idea that the bigger it would get, the less volatile it would get, and also the idea that it would be a diversifier for investment portfolios. I should just note, this is something that our academic partnerships at State Street, we've already been doing quite a bit of work on this, and I'm just highlighting a paper. We've actually got two of the authors of the paper sitting here in the front row, so Megan and Dave, along with Mark Kritzman, our academic partner, looked at whether adding Bitcoin to your portfolio would bring diversification. The challenge that we find, actually, is that even though certainly back in the early days of '15 and '16, maybe even in '17, it did look like Bitcoin wasn't so correlated with the traditional assets, but that certainly isn't the case today. Just to show you a couple of different views of this, so if you look at the 26-week correlation, one-year correlation, or even just going back three years, you see that there are pretty significant positive correlations between Bitcoin movements and either the S&P or tech index in particular. What's worse, and this is something that we're using our... Some of the analysis that we would use for traditional markets, is that the particular kind of diversification we want to look at is what happens when equity markets go down? That's when you really need diversification in particular. So, what happens when tech stocks sell off? Does Bitcoin offer you any protection? So, unfortunately, and if you look at the last three years, on the weeks where the NASDAQ is down, actually the correlation with Bitcoin is over 80 per cent. So actually, in those weeks, it makes things a lot worse. One other part of the Bitcoin narrative just to highlight as well, and I think to be fair this was always going to be a bit of a reach, was the idea that because Bitcoin in theory is scarce because of the finite amount that can be mined, that it would also serve as an inflation hedge. One of the really useful things that we have at State Street right now obviously is our access to price stats, which gives us daily readings on inflation. That gives us the ability to look at this question of whether it's an inflation hedge in a lot more detail than you could just looking at the official data. The chart on the far right there in the green looks at the weekly correlations between changes in online inflation and changes in Bitcoin. What we've found, and demonstrates very clearly this year, as inflation has gone up actually Bitcoin hasn't offered you any inflation protection in the slightest. So, here's the challenge for Bitcoin. It isn't a diversifier. It's a tech play, that's what the correlations are telling you, and nor is it an inflation hedge. So, I think we're kind of... We're learning what Bitcoin is and what it isn't. The one thing I would say, actually, interestingly - this is just putting my traditional market analyst hat on for a second - is that the fact that it's connected to risky assets actually is quite helpful for thinking about the signal from Bitcoin back into traditional markets. The one thing I found in London is that one of the first things our traders are talking about is the performance of Bitcoin over the weekend, and what that means for trading on a Monday. Sure enough, certainly so far this year, that signal has proved a very useful guide to showing how the S&P is going to perform on the first day of the week. The 24/7 nature of crypto assets is actually feeding back through into traditional assets. We shouldn't think of these two markets as being separate. They're increasingly linked. The reason they're increasingly linked is, I think that certainly for retail investors they're thinking about crypto assets as being in the same pool as traditional assets. As a demonstration of that, I'm looking at two different datasets here. One is from the Investment Company Institute, which is looking at retail investor demand for equity and bond mutual funds, and then I'm looking at the net inflow into Bitcoin as captured by the change, the weekly change, in the realised market cap. It looks at the amount of capital going in. The most interesting thing about this chart, and you can see that certainly in 2020 and particularly in '21, there are times when these things move together. The most important thing is, they're on the same scale, which I think is pretty remarkable. What it tells you is that from a retail investor point of view, it seems to be that all of a sudden Bitcoin is playing in the same space as traditional asset markets. What that means is, it's great when there's a liquidity wave pushing through and there's lots of money going into all asset markets. That's great, but of course when the wave crashes, like it did this year, it also means that you suffer from the outflows, and that's exactly what's happened. So, retail investors have been exiting Bitcoin in particular, and that links in to some of the media sentiment that I talked about. I should just highlight before I leave this chart another bit of academic work that we've done on this. You can see that this is the State Street approach to digital assets. We're using some of the expertise that we've developed in traditional assets and trying to apply them. We also have a new academic partner at State Street Associates, Antionette Schoar. She's talking at some of our other conferences in this roadshow, and one of the things that she found in the retail space - I think it's really interesting - that quite often we think of the retail investor as a contrarian investor that you should bet against. Actually, what she found in the crypto space is that retail investors are very much momentum-driven, and that their flows do signal... Provide a useful signal for prices going forward. So, monitoring this kind of information I think is really important. It's the kind of thing that we're going to be looking at through our partnership with Glassnode. The main point here is, this explains the non-diversification properties of Bitcoin, because it's the same wave. It's global liquidity, that crypto is now part of that pool and so when global liquidity gets drawn out, so crypto asset markets suffer in exactly the same way that traditional asset markets do. That leads me to my final point. If retail investors have been selling, who on earth is left holding Bitcoin now? Again, this is an interesting bit of work that we've done with our partners at Glassnode, which is to look at the kind of entities or groups of wallets that currently hold Bitcoin, and their proportion of how much of Bitcoin supply they hold. So, I picked out something that they call illiquid entities. In general, these entities are accumulators. We don't know whether they're long-term investors or not. Sorry, we don't know whether they're long-term or institutional investors. They're probably not, but they have the same characteristics. Those characteristics are; these are typically long-only entities that over time have consistently accumulated Bitcoin. They haven't sold very much. They typically don't sell, and when they hold, they hold for a long time. They have the properties of institutional investors, and their holders right now, they account for more than 77 per cent of all outstanding Bitcoin supply. So, in other words, Bitcoin is in much safer hands today than it was... Look where we were in 2020. That was down almost at 70 per cent. I actually think this is quite an optimistic chart in the sense that it shows that Bitcoin is being accumulated by people that are typically long-term investors, and I think that's a relatively positive thing. Before I turn over to Swen, I should just say, just to summarise my part of it, Bitcoin has survived an LTCM/Lehmanstyle stress test. Given that there's no central bank in the middle of it to act as lender of last resort, I think that's pretty impressive, as big as the correction has been. I think we've also learned some pretty important lessons. The first is that volume does not reduce volatility. It's always probably going to be a volatile asset. That's just something we have to accept, but it's not a surprise. We know that Bitcoin is going to be volatile. We now have learned that some of the claims about it being an inflation hedge, some of the claims about being a diversifier, simply aren't true. That's helpful because the people that are holding Bitcoin now know that. It's very clear. What it is, is it's a very correlated and very leveraged, highvolatile tech play, which will be appealing to some investors. Like I said, that final optimistic point is that right now the people that hold Bitcoin are typically people that keep it, which is encouraging, albeit it maybe does beg questions about how liquid Bitcoin will be going forward, given that the wallets that accumulate it typically don't sell. Now, I've focused so far a lot on Bitcoin, and of course Bitcoin is really just... It's maybe even less than half the story. So, I'd like to hand over to Swen Werner now, who's going to broaden us out a little it .Swen, over to you.

Hi, and thank you very much for that overview. Obviously, I'm challenged to follow your speech. What I'm responsible for at State Street is really building our core digital customer infrastructure. I'm also responsible for our digital payment solutions work, which for instance concerns CBDC and stablecoins, these kinds of instruments. I just wanted to pick up on something that Michael mentioned, which was around this notion of traditional markets and crypto markets being more closely aligned than maybe sometimes we realise. That's something that I want to talk about, so if we could go to the first slide, please. The crypto winter is starting from also the conversation here, and really about the... From a historic perspective, obviously I'm not telling you anything new, the fact that the assets are volatile, we have seen similar downturns in the past, isn't anything really new. Also, I'm going to be looking at the sentiment at the moment. We are engaging with a number of fintech partners that, for instance, we use, and building out our services. At the moment, I think everyone who has invested in these kind of instruments probably wasn't too concerned or shocked about this. So, in that sense I think there wasn't really the key interest. If we go to the next slide, please. If we see this one in particular, today as an organisation there are multiple instruments already in the market like exchange traded funds, private structured funds, for instance, that invest in crypto or use, for instance, derivatives in order to create a portfolio that mirrors the investment of crypto. What we've seen so far is that, if you want, there's an important aspect also when you think about the allocation to these portfolios. The interest of the institutional investors in these kind of investments has actually grown relatively stable, even during the recent downturn. That has an impact, if you think about this from a market behavioural perspective over time, that on that side you have obviously the traditional retail investors. There was little regulation in terms of how that activity is provided. Now, as these instruments come into an asset manager structure, for instance, a fund product, then these organisations will be looking to partner with regulated custodians, and then that bring an increased level of regulatory oversight. Increasingly, you have to think about, if you want in these markets the interaction between on the one side unregulated retail investors, because for many cryptocurrencies it is totally possible and feasible that you maintain your own personal account on a device, and you're not in need of any intermediary service. Then the other side, you would have, let's say, a fund product that is then using a regulated custodian, and suddenly you have an interaction between a participant on the one side who is not subject to tradeable data, e.g., the exchange of the beneficiary information, and then the other side you would have that. So, therefore going forward there's a question very much from an operational but also from a trading perspective; to what extent the crypto markets in a certain way have to go a different path, because otherwise you would continue to see, if you want, at least a possibility where there could be direct interaction between retail and institutional, and that is something from a regulatory perspective that would be very difficulty. If you go to the next slide, why I am saying all of this? The key thing for us is that when we're looking at digital assets, and that's actually becoming clearer and clearer, the work that we're doing for instance right now around building custody solutions for cryptocurrencies, it's just a use case, obviously on the expectation that the underlying technology and principles will be used more broadly when it comes to, for instance, organising financial instruments and the like. There's numerous examples, but really there are some lessons to be learned if you want what makes cryptocurrency markets efficient, and to what extent actually some of the thinking has to come into the tokenised market, and vice versa. Maybe if you go to the last slide, I'm going to stay there for a few more minutes to explain. If you go to next slide, that overview. Can you go to the next slide, please? Perfect, thank you. This is this idea of, when we're talking about cryptocurrencies in particular as distinct, for instance, from the efforts around tokenisation of financial instruments. That's actually something that increasingly is almost the wrong way to think about. In fact, many cryptocurrencies now are, you could call it, nomadic assets. There's this concept where you could, for instance, tokenise a Bitcoin, and then trade another token that represents that Bitcoin on another chain. There are multiple ways to do this, sometimes also referenced as a wrapped token. The initial idea is we needed, if you have an investment as an investor in a particular cryptocurrency, and then you want to do something on another chain, you need someone to connect this. That is... There is an infrastructure done through smart contracts and swift tokens. What you now increasingly see is also that you could have a Bitcoin which is native to the Bitcoin network sitting on another chain, say Ethereum, and this then allows you to create some very interesting market models, for instance DeFi concepts in terms of staking an additional currency now can be used in multiple different chains, but you do not have to give up and therefore sell on your original investment. You can hold on to this, and then on the other side you would trade a token that is now very specific to particular investment activity or spreadsheet. If you think about today, you would have a certain, let's say, bond, and you would on one hand side use as collateral, on the other hand side use as investment, then you're relying on the particular intermediary, on the infrastructure that is set up, to handle the respective workflows. In cryptocurrencies, through that concept you basically create a unique asset that is unique to a particular use case, and because it's linked through smart contracts your underlying investments are here, and it can go backwards. That is, I think, something that increasingly also explains a little bit the aspect that also Michael referred to a couple of years ago. Bitcoin was quite dominant in terms of the overall market share. In terms of the valuation, it has come down quite a bit. So we are seeing at the moment already, I'll say, way over 100 public blockchains, and the ecosystem still works where all of these chains can work together. These kind of concepts that you have to move away from very few chains, so they have all these tokens on this, the market has become now much more diverse. So, you would have these bridge tokens, we can have side chains, you can have relay chains. There are multiple ways to deal with this where also the idea is now being proposed, for instance, not to create these specific assets for a specific temporary investment type, but also to create a unique blockchain for every use case. Because of the smart contract concept, that ecosystem can actually work and integrate relatively seamlessly. Really, the key, if you want, impact from all of this is really, we have to start to think multidimensionally. You can almost no longer think about Bitcoin as a single entity. You have to also ask yourself, is that asset actually represented on different blockchains? They will have their different flowcharts and process methods in that set-up, and the risk and the operational activity supporting that Bitcoin being issued on a different platform will be very different, and it will also represent quite different re-investment opportunities. This is actually the interesting thing, where on the one side the efforts in traditional business to organise financial instruments collide, or align if you want, with cryptocurrency markets, which have developed quite interesting and relatively flexible tokenisation offers. I think in those aspects it will come together, and then also when you think about the investment decisions and portfolio management decisions going forward, that will be different than to say if you were to invest in a Bitcoin, would you then also see additional interest or a return opportunity to, for instance, have that Bitcoin then also represented as a different token on a different blockchain? Maybe with that I will leave, and I thought we leave some time for some questions. Hopefully, you will have a great experience of the rest of the event.