Zach Pandl is head of research at Grayscale Investments, the world’s largest crypto asset manager. In this discsussion, he provides an important perspective on what to expect throughout the year. He also had some very interesting insights into the market dive that happened in August and whether something similar could happen again as the Fed tries to remove its restrictive posture on the economy. We also move into his thoughts on crypto, which assets are poised to outperform, and why others may struggle.
Forbes: Let’s talk about the last month. In the beginning, there was the unwinding of the yen carry and panic in markets that followed for about a week. Then markets rebounded. How do you process all that?
Zach Pandl: It was a volatile month, but it really needs to be divided into two periods. One from the end of July to August 5, which was a period of growth scare. Then the period from August 6 to the present, which was a kind of recovery. Most major asset classes declined, but many of them ended up approximately where we were when we started the month. Now some things declined and didn’t fully recover, including carry trade strategies in currency markets–which was a big focus for investors at the start of the month–Japanese stocks and Ethereum.
Then, there were some things that performed well in early August and then continued to perform well in the second part of the month. Those were bond markets, high-quality bonds as a whole, like U.S. Treasuries and closely related assets, and non-dollar currencies. So the yen, Swiss franc, euro and British pound had gains during the month. The lasting themes, I think, coming out of a volatile August are lower rates and dollar weakness. I think that has implications for Bitcoin in the months ahead.
Forbes: Do you think this scare was a one-off or will the market experience something similar if it gets spooked again?
Pandl: I’d like to say first that I feel fairly strongly that the focus on events in Japan and the yen is a bit of a red herring when we’re looking at what happened in markets at the beginning of August. Japan is a challenging subject even for professional macro investors, and I think often the source of confusion. What I think really happened was a true growth scare. There were a few pieces of U.S. economic data that caused that, but the most important was the increase in the unemployment rate in the first week of August. The U.S. unemployment rate has now increased by a magnitude that has never occurred outside the context of recessions. This is something that economists call the Sahm rule after economist Claudia Sahm, who labeled that statistical regularity. That doesn’t mean we necessarily will have a recession, but the data are telling us that we are seeing some of the statistical regularities like an inverted yield curve and a rising unemployment rate that are consistent with recession.Why that had such a big effect on markets is that a soft landing was a very strong consensus prior to this month. There were fears about recession last year, but the economy held up well and so it became an increased consensus and increasingly priced into markets that soft landing was assured. So the rise of the unemployment rate increased the perceived odds of recession again for many investors. It will take a few months of watching the data to ensure that the labor market isn’t deteriorating further. That being said, some of the things that happened in markets were surprising, particularly in equity volatility. The VIX index increased to a level associated with really extreme market events in the past like Covid, the 2008 financial crisis and Lehman Brothers bankruptcy. That probably tells us something about market microstructure—the ability of broker-dealers to manage inventory of equity volatility and manage their client’s demands around a period like that. But it was remarkable. The VIX index rose above 65 intraday in the first week of August and then ended the same week in the 20s. Many other indicators, like high-yield bond spreads, had a similar reversal. So in summary, we had substantive economic news, but probably a market overreaction to that news in the short run.
Forbes: Let’s turn to crypto. I’m interested in whether there’s a bifurcation coming between bitcoin and the rest of the market. We haven’t seen the same type of runaway success in ether ETFs that we did with bitcoin ETFs, and there are some concerns about trends on Ethereum, like lower usage numbers, lower fees, and it’s becoming inflationary again. What are you seeing?
Pandl: First off, in some ways it really has been a bitcoin-dominant period for a while now. Bitcoin dominance is rising across the market, the ETH/BTC ratio is falling. I think it is fair to say that we’ve been in a bitcoin-led period. Will that continue? I think over the very short run, it may because there are so many positives lining up for bitcoin. In particular, the broader macro thesis, the Fed rate cuts, a contentious presidential election in which one of the major party candidates may call for dollar weakness, where both parties have not had a record of fiscal sustainability, and where we’ve seen all this demand for the bitcoin ETFs. All those things together I think, are a very positive macro environment for bitcoin. So bitcoin’s dominance is running relatively high, and I think could increase somewhat further over the short run. Although, as you know, altcoins had a great week last week, and we’ve started to see some of that market come back as well.
The Ethereum ETF launches are only disappointing in contrast to the success of the Bitcoin products earlier this year. The Ethereum products are seeing healthy volumes and, excluding the Grayscale closed-end fund, which uplisted to an ETF, are seeing healthy inflows. So in the context of a standard ETF launch, I think the ether products are doing relatively well.
What about the outlook for Ethereum? I’m definitely not ready to count out Ethereum, and I think there is pessimism in the market largely because of its performance this month. And the performance this month, in my view, is mostly technical in nature. We had rising leverage in Ethereum futures in both the CME and in crypto products, perpetual futures during the month of May, when the SEC approved the 19b4 filings for the ETF products. Leverage positioning seemed to pick up in May in anticipation of eventual approval, and those positions were maintained into August. We had a macro catalyst, the growth scare and triggering of the Sahm rule that caused all markets to fall and Ethereum suffered worse because it had a significant long positioning going into that event.
In my view, the recent underperformance is mostly technical and not something substantive about the health of the Ethereum ecosystem. I will say that Ethereum and Bitcoin are completely different assets and require different education processes for investors. Bitcoin and Ethereum ETFs are giving a new range of investors and financial advisors access to crypto products. But as you and your readers know, these are completely different assets. They’re both blockchains, but we would put them in different categories in the Grayscale crypto sectors framework, for example. Bitcoin is primarily a currency and Ethereum is primarily a smart contract platform. They’re both blockchains, but they serve different functions. And I do think that the education process for Ethereum is taking longer than it did with Bitcoin. It is smart contracts, decentralized applications, tokenization, stablecoins, and DeFi. And I think that’s why demand has been slower to pick up for the Ethereum products compared to the Bitcoin launch earlier this year.
Forbes: One other big difference between the two is that Bitcoin doesn’t have to deal with competitors like Arbitrum, Optimism and Base. You could even throw Polygon into the ring and plenty of others, especially post-Dencun when the cost of using those networks is so low. How does that fit into all this?
Pandl: I think these principles that come from investing in equity markets are the type of things that investors should be bringing to crypto markets, like the nature of competition, whether it is monopolistic or more competitive markets. Bitcoin is dominant and does not face strong competition anymore. Whereas in the smart contract platforms blockchain segment, while Ethereum is also dominant, it faces stiffer competition from a wide range of competitors. Grayscale offers investors access to many of those competitors in single-asset products and in multi-asset products. So we certainly think that there are important investment themes among those competitors. Most recently we launched an Avalanche product just last week. So we think that there is value in the competitors. This may mean something about how investors should approach the smart contract platform crypto sector. Maybe a more diversified approach makes sense in that market segment where Ethereum faces more competition. All that being said, we are strong believers in the idea of network effects, as it relates to these technologies, that bigger is better. In the future there will more likely be a small number of very dominant blockchains rather than hundreds or thousands of small blockchains. That is because of the economics of network effects. Investors and users benefit from the networks that have the most capital, the most applications and the most developers. Today that is still Ethereum. So Ethereum leads others in terms of network effects, and therefore I think it has the ability to maintain its dominant position over time despite fierce competition in that market segment.
Forbes: What made you believe that now is the right time to launch an Avalanche product?
Pandl: All the smart contract platform blockchains of course have their own design choices and it’s going to take several years to determine which of those has the most effective design to bring in users, generate fee revenue, etc. But I think Avalanche has established itself as an effective platform with a solid, well-functioning design. It’s mature and tested enough that we think it is certainly a reasonable place for investors to look. In terms of specific recent catalysts, I do think that Avalanche potentially has applications in the tokenization theme. The Avalanche chain was used in various TradFi tokenization proofs-of-concept in the last couple of years and benefits from a hybrid permissionless and permissioned chain architecture. Tokenization of real-world assets, in my view, is something that is just getting started and should be considered at the experimental stage. We have tens of millions of dollars in some of these products with major financial institutions involved, but I don’t think we can say how this will play out. I think there is potential that the Avalanche infrastructure, which marries permissionless and permission structures, could be a good fit for certain tokenization projects. I think that is why the time is reasonable now to look again at that network.
Forbes: Solana has established itself as the third-most-popular blockchain after Bitcoin and Ethereum. However, it appears that much of the activity replicates events already occurring on Ethereum and other chains. What are your thoughts?
Pandl: Solana provides an excellent user experience. For a newcomer to crypto there are few experiences as easy and as pleasant as downloading a Phantom wallet and getting started with a Solana; it’s fast, and it’s cheap. The applications work relatively well. And in that sense, I think it has been very successful in bringing on new users. I believe also that it has, at the moment, established itself as the number three chain. At the same time, I don’t think user experience necessarily creates long-lasting moats around a project. Other projects can work on their wallet and application infrastructure. And ultimately in my view, true value accrual will come to the Layer 1s that can onboard the biggest real-world use cases where major firms and industries are building on the network. I still think that is an open question for Solana whether tokenization takes place on the Solana blockchain, whether large consumer product companies, Sony or Disney, are building on the Solana blockchain, or whether they choose to build on the Ethereum Layer 1 or Layer 2 ecosystem.
Forbes: What are your broader thoughts on DeFi?
Pandl: It’s hard to talk about this space without discussing the U.S. election and the politics around crypto. I think there are many exciting projects in this space. At the same time, the Biden administration is taking one approach to regulating this marketplace. And I think that it is holding back innovation and adoption given that approach. There were pros and cons, and of course, voters elected these officials to take this approach. So I understand where that’s coming from, but I think the Biden administration’s approach to DeFi is holding the market segment back. Editor’s note – in April the SEC served leading decentralized exchange Uniswap with a Wells Notice indicating a likely enforcement action.
But for DeFi to continue to succeed, we may need to change the regulatory approach. That may mean a Republican win, particularly of the Senate, which would give control of the Senate Banking Committee. It could affect the appointment of certain officials that have a role in the oversight of the industry. I think DeFi is a central part of crypto. It is one of the core use cases of smart contracts, but to see more success in the United States, it needs to be married to traditional financial assets somehow. And you can’t do that without clear regulatory guidelines. So, I think we are waiting on more regulatory clarity for that industry to fully blossom.
Forbes: Let’s talk about AI. To me, the connection between crypto and AI has always been a little fuzzy. Many AI tokens tend to rise and fall with the price of Nvidia, but the connection doesn’t seem to be much more than that they are both tangentially related. What are your thoughts there?
Pandl: There are several specific channels in which blockchain technology can be connected to the AI industry. The first is providing infrastructure. Shared compute networks, I think, are a good example of the kind of thing that is working, and it’s just getting started. I think intellectual property and the challenges of deepfakes is another important issue and one of the most challenging issues with this new technology. I use generative AI tools all day long at work. I have replaced my need for a research assistant in my workflow with generative AI tools. At the same time, I know that when I am querying these tools and I’m paying a customer, none of that revenue is going to the original authors of the material being used. The journalists who wrote the stories about Bitcoin and Ethereum in recent years are part of the data lake that is being queried to give me answers. And so protection of intellectual property is a really important question. Public blockchain technology potentially has applications there as well because it’s the kind of thing that can give us details about the origin of specific data. Again, these projects are all getting started, but I believe there is a potential synergy there.
Lastly, you have a broader category that includes projects like Bittensor, which is trying to take on the AI project from the bottom up with blockchain technology. I think the aspiration here is extremely impressive. Bitcoin demonstrated the value of using a decentralized computer network to develop a money system. What projects like Bittensor are trying to do is use that same idea—the power of decentralized communities to build machine intelligence or AI essentially on the internet and create an open system where anyone can add or consume that technology without going through central authorities. Anyone who has lived in an environment where the money system has constraints around it, where you have capital controls, bank failures, or hyperinflation, understands the value of having an independent open-access money system like Bitcoin.
I believe in the future, and as more and more people are using generative AI tools all day long, more and more people will also come to appreciate the need for an open structure that is not controlled by one government or one company that’s determining what our outputs can look like. That’s what a project like Bittensor is trying to do. You used the phrase “sort of fuzzy,” I understand where that’s coming from. I think of it as there are distinct lanes and there are several early-stage projects, but I do believe in each of these approaches. The products we offer, particularly the multi-token product, are trying to expose investors to that range of applications. Then we have some single token products like a Bittensor Trust, which exposes investors to one distinct element.
One of our broader theses is that correlations within the crypto market will change and decline over time as more investors stare closely at the fundamentals of these assets and try to understand them better. I agree; many correlations seem surprising. Worldcoin going up on Nvidia earnings doesn’t have a lot of fundamental sense behind it, but is a pattern that we see. There are some aspects in which crypto is still an immature marketplace, and I think the high cross-correlation among assets is one example that I think will fall over time as the market matures.
Forbes: What are your expectations for the rest of the year?
Pandl: In our view, the central scenario for bitcoin is quite positive because you have three elements coming together. You have inflows into a new set of products that give more investors access. You have improved U.S. politics around crypto. There are open questions on that topic, particularly where the Democrats come down. But to my eye, things are trending in a favorable direction, and you have Fed rate cuts occurring in a healthy economy. I think it’s that last piece that’s so important. It may be the thing that people miss. Typically, the Fed cuts rates because of a recession. This time, the Fed cuts rates because it has won a long battle against inflation. So these are mission-accomplished rate cuts, which are much different than at times in the past.
Rate cuts in the context of a soft landing, I do think, are the type of environment that will be quite negative for the U.S. dollar and positive for assets like bitcoin. That would be my central scenario, and with those pieces together, I believe we will retest the all-time highs in the coming months. Now there are risk scenarios, and the main risk is the health of the U.S. economy. The positive view is predicated on a soft landing and avoiding recession. And I think that’s where most economists are today. That’s where our view is today. I think that is the central outcome, but we need to monitor the U.S. labor market data closely. If the unemployment rate keeps going up and we see signs of layoffs, we could see a period of economic weakness in which bitcoin and many other assets like tech stocks or credit spreads also weaken in a typical cyclical fashion. My view would be that in a recession, it would be an excellent time to accumulate bitcoin because you’re likely to see easy monetary policy and easy fiscal policy to help the economy escape from recession and prices rebound after that, much likely did after Covid. But we could see downside risks to prices if the U.S. labor market continued to deteriorate and we were to fall in a brief recession. That is the main risk we would see over the next six to 12 months.
Forbes: Do you have any contrarian ideas, other projects, tokens, or use cases that have yet to bubble up to the surface that we should keep an eye out for?
Pandl: First off, while it may not be lost on your readers, crypto, to me, is a no-brainer for most investors to hold in their portfolio. Much of my time at Grayscale is educating investors about how to understand this asset class—the fundamentals of blockchain technology and the statistical properties of the assets themselves. That’s a contrarian idea in the broader financial markets—that crypto deserves a place in almost every investor’s portfolio except for the most conservative investors holding assets. Just for short-term liquidity, I think crypto has a place as a diversifying asset.
The second thing that I would say as a maybe contrarian idea within crypto people is that I think that in some ways, blockchain tokens are less risky than stocks. There are different volatility factors, and all that needs to be taken into consideration. But in one element, at least, they are less risky than stocks because they don’t have liabilities. Public companies can disappear because they have liabilities, debts, buildings, employees, and electricity bills. Their revenue needs to support those liabilities. Blockchains mostly don’t have liabilities. They have revenue, they have activity, they have a set of people around them, but they don’t have liabilities that they need to pay on an ongoing basis, especially when you consider the ones that don’t have a lot of token inflation. And so I think it is at least misleading when many people talk about the risks of public blockchain tokens going to zero. We will be surprised to find that even some of the less successful projects will be around for a very long time for this simple balance sheet to reason that they don’t have liabilities to pay.
What I would like to stress is just how early we are in the mature analysis of public blockchain tokens. Not that many traditional financial analysts are publishing research on valuing these assets. And some of the really basic things, like the structure of liabilities for these projects, are still not well understood. So, I feel very lucky to be able to write about some of these topics in what I think is still a very early-stage market.
Forbes: Thank you.
