Bitcoin: Any Signs of Exuberance?

US Bitcoin spot exchange-traded funds (ETFs), the fundamental drivers of the markets since the beginning of the year, fi-nally caught a break as the 5-day streak of continuous outflows stopped this week. The largest digital asset rallied back above the USD 70’000 mark soon after. The initial retracement was primarily led by a combination of net outflows from the wrappers and a dramatic rise in Bitcoin’s perpetual futures funding rates across various exchanges. The fundamental situa-tion is unchanged, constrained supply, increased demand, and an improving US net liquidity picture. With the halving-led supply constraints in plain sight, the market mood seems optimistic, and investors are keeping an eye out for any signs of exuberance.

ETF Demand

Bitcoin’s newfound role within a portfolio context, underlines the growing convention of the asset as a store of value, and the reasons behind the rally are pretty clear. An overwhelming demand for the physically-backed wrap-pers amid a low market depth backdrop. The market mood has been consistently improving since the beginning of the year. Derivatives markets are gaining traction, with a clear call skew across most expiration dates for options contracts in on-chain platforms. Open interest for dated and perpetual futures alike has risen considerably, and institutional investors are beginning to take a second look at the asset’s potential within a portfolio; whether as a store of value, a return-enhancer, or an alternative asset with diversification potential. US Bitcoin spot exchange-traded funds (ETFs) emerged as a key gauge for Bitcoin’s institutional demand, bringing much needed transparency to the market. The added transparency from the wrappers will likely provide relief to some that could only get exposure over proxies, namely publicly traded companies that were accumulating Bitcoins in their treasury. The 11-fund cohort has amassed over USD 60bn in assets under manage-ment, with total net inflows of roughly USD 11.5bn. The funds’ trading capabilities have been consistently improving, with clear displays of efficiency in terms of tracking errors, slippage, and spreads. Expense ratios have become increasingly competitive in the rest of the world as a result of the approvals, with fees becoming one of the few differentiators across physically-backed Bitcoin exchange-traded products. The 20-day moving average for the flows stands above USD 200mn. Bitcoin’s weekly issuance of roughly 6’300 tokens is dwarfed when contrasted against the ETFs’ token demand in the past weeks, which is about 30’000 tokens. US capital markets have demonstrated their appetite for the asset class, as evidenced with some of the wrappers breaking all sorts of records in terms of volume, flows, and assets under management since in-ception. That said, demand has been the fundamental driver, and last week was clear evidence of the fact, that as soon as it comes, it might go, and so will prices.

Supply-side Dynamics

Token-supply illiquidity has broadened, leading to heightened implicit costs in centralized ex-changes, easily evidenced by the broader gaps between bid and ask spreads and the increasing slippage. As of now these exchanges hold around 8% of the total circulating supply, a ratio that has been consistently decreasing. The low-liquidity backdrop stems from the fact that Bitcoin holders have been accumulating their tokens, with almost 80% of the supply il-liquid for the past 6 months, and 70% for a year. On another note, the growing token demand that the ETFs’ authorised participants require to fulfil the issuance of new shares is also impacting supply while putting pressure on prices. Supply constraints are likely to favour the long-biased investors, as rising demand has only been draining the additional token li-quidity from the markets. With the halving in plain sight, and expectations that the block height of 840’000 will be reached by the 19th of April, the aforementioned supply constraints are only likely to increase. The halving will ultimately result in a deceleration of the supply growth, and as of now supply grows by around 6’300 Bitcoins on a weekly basis, after the halv-ing the number should be closer 3’000. Problem is, ETFs have demanded, on average around 30’000 tokens, on a weekly basis, close to five times more than what the blockchain is issuing. Miners will play a key role ahead of the event, and con-sidering that over 15% of the hashpower might go online, only the more efficient ones will be able to adapt. Rising prices and decreasing energy costs have been improving miners’ profitability schedules. Higher profitability translates into less outflows of newly minted Bitcoins into exchanges, because of the decreasing the need to sell the actual tokens to cover their fiat-based costs, resulting in another angle of potential supply constraints. Past performance is certainly no indicator of future performance. Nonetheless, throughout the past “halvings”, and perhaps given the correlation with a higher prof-itability, Bitcoin miners have opted to accumulate. Bitcoin’s supply will continue to play a fundamental role in any price de-velopment.

US Macroeconomics

Bitcoin is crypto’s risk-off asset, crypto investors tend to favour the Bitcoin when global liquidity conditions deteriorate, as evidenced by the shifts in the asset’s dominance relative to crypto’s market share. Nonetheless, Bitcoin’s behaviour has fol-lowed more closely that of risk-on asset classes, in the past. Improving US liquidity conditions in the 4th quarter of 2023, played as much of a fundamental role over US equity markets, as on Bitcoin. The decommissioning of the reverse-repo pro-grammes in the US has been of fundamental importance for the broader liquidity picture, as net liquidity has been increas-ing since late 2023. Bitcoin continued to rally, despite a scaling-back of expectations of a rapid reversal of US monetary pol-icy, underpinning the soundness of the fundamental backdrop. Interest rates remain high, but the growth in net liquidity has taken the driving seat. There is no doubt that rising interest rates casted doubt over crypto, as the nascent technolo-gy’s broader ecosystem’s development, was highly contingent on private investors’ capital. There is no doubt, either, that the attractive yields “low-risk” assets were offering, also heightened the opportunity costs towards risky investments, as evidenced by the adoption of US Treasuries, and the USD 6tn that beset US money market funds.

The sole reason for the impact behind spot ETFs has been relative to Bitcoin’s role as a store of value, and its benefits with-in a portfolio context. This factor has built solid fundamentals around the allocations towards Bitcoin, as a potential re-turn-enhancer or as an alternative asset with diversification qualities. Truth is the asset found its way into a portfolio con-text, underpinning the added need for physically-backed investment vehicles that accurately track the prices of the asset, with a clear redemption mechanism. This need has essentially led spot investment vehicles to hold over 1mn tokens, or around 6% of the circulating supply; and this is only likely to grow. That said a key aspect of holding assets in a wrapper is that these tend to be slightly sticky, given that investment managers do not rebalance portfolios on a daily basis, but rather on a bi-annual frequency. Wrapper demand has been a key driver of prices, as of late, given that the category has been de-manding around 30’000 Bitcoins on a weekly basis, which is unlikely offset by the weekly issuance of around 6’300 tokens. All in all, we see a very sound fundamental backdrop for Bitcoin, with the upcoming halving likely exacerbating the effects of the ongoing supply squeeze.

About the Author

Authored by Manuel Villegas, Next Generation Research Analyst, Bank Julius Baer

Note: Investments in digital assets are exposed to elevated risk of fraud and loss and to price fluctuations.