Research Round-Up: August

The Research Round-Up On-Demand

Fidelity Digital Assets’ Research Director Chris Kuiper and Research Analyst Jack Neureuter provide additional commentary and market insights in this short, on-demand video.

Market Commentary

Source: Coin Metrics as of 07/31/2022. 

The price of bitcoin rebounded approximately 20% for the month of July, coming off of the worst month of June in history (down 55%) and the worst second quarter in bitcoin’s history (down 56%). Ether, the native token to the Ethereum network, showed an even stronger rebound of 62% price appreciation for the month of July, particularly driven by increased optimism over Ethereum’s anticipated network upgrade known as “The Merge.” Is this recent mini rally a turning point off of the bottom or merely a bear market rally? In this month’s Data to Watch and Insight and Education sections we take a closer look at where we are on the macroeconomic front, what the digital asset fundamentals might be saying, and some potential scenarios for the rest of the year. 

News and Editorial

A curated list of the most relevant news and developments along with our two Sats.

Bitcoin’s Energy Mix Hits 59.5% Renewable

According to the BTC Mining Council (BMC) the Bitcoin network is running on nearly 60% sustainable energy sources.¹ This makes the Bitcoin mining industry one of the most sustainable industries globally.² The BTC Mining Council also shows a 6% growth in the use of sustainable energy sources from their Q2 2021 report and an increase of 2% from Q1 of this year. They also note that while the mining hash rate is up 137% year-on-year, the actual energy usage is only up 63%, indicating an efficiency increase of 46%.³ The BMC is able to collect data from just over 50% of the mining hash rate, representing 107.7 exahash of the total 214.611, as the forum is completely voluntary. 

Our Two Sats: While many people may still not be familiar with Bitcoin and its value proposition, they have likely heard about its “enormous” energy requirements. Those more involved in the space may know the positive aspects of Bitcoin mining, but to some outsiders the surface level facts lead them to believe it should be curtailed or even outright banned. Therefore, it’s great to see this council attempting to maintain a public relationship and continuing their efforts in education and understanding the real-world effects of mining. While Bitcoiners may believe financial sovereignty is worth any amount of energy expenditure, those who have not found a use for Bitcoin still have a voice in the direction of this new industry and should not be ignored. Overall, we believe Bitcoin will always gravitate towards the cheapest energy possible and that happens to be renewables. It’s not a long shot to believe these mining companies will be investing their funds into renewable research and more efficient methods of mining.

Ethereum Moves Closer To A Final Transition To Proof-Of-Stake 

The Ethereum network is one testnet merge away from attempting the largest Layer 1 upgrade in the history of cryptocurrency.⁴ The process of becoming a proof-of-stake network has been in the works since the launch of the Beacon chain in late 2020. Due to the complexity that comes with such a massive transition, the merge of the proof-of-work chain and proof-of-stake chain has been delayed multiple times. Originally set to be completed by 2021, the community is now aiming for the third week of September with the final phase of the transition set for late 2023. The prior testnet merges of Ropsten and Sepolia successfully completed in the month of June. The third and final testnet merge of Goerli and Prater, known as the Bellatrix upgrade, is set to take place between August 6th through the 12th.⁵  

Our Two Sats: The Merge is a highly anticipated event in the “crypto” community with anyone and everyone at least knowing the end goal. Moving from proof-of-work to proof-of-stake has never been attempted before and has therefore earned the title of biggest upgrade ever attempted in cryptocurrency history. With news of the testnet merge success in June, the price of ether has been on the rebound, closing the month of July up approximately 62% at a price of $1,682.69. This consensus mechanism shift entails an investment thesis adjustment as well. If The Merge is successful, ether will become an interest-bearing asset as well as a deflationary asset. This combination of yield generation and deflation may prove to be quite bullish in the years to come as prospective investors change their minds on what Ethereum was versus what it has become. We’re excited to see how this plays out and hear the narratives around Ethereum change. 

A Costly Exploit Drains Nearly $190 Million

Early this August there were multiple reports of a $190 million dollar exploit happening on the Nomad Protocol.⁶  Nomad is an interoperability protocol that enables cross-chain token swaps. This means that you can swap your BTC for ETH but as a wrapped token, not a native token. Put simply, in the described scenario the tokens you are operating with utilize a smart contract to lock up your native asset (BTC) and return a derivative of said token. A reoccurring problem we have seen with wrapped tokens is the single point of failure that is the smart contract. If an attacker can exploit a weakness in the contract and fake a deposit of wrapped tokens (such as wrapped bitcoin or WBTC), then the contract will willingly allow the user to withdraw the real tokens (BTC). This exploit allowed hackers to systematically drain a large portion of Nomad’s funds leaving roughly $650 remaining in the wallet.

Our Two Sats: Another day, another exploit. It seems every month there’s a new chain with a weakness. Usually, we look back and the exploit seemed obvious, everyone just missed it. However, that is not the case with this attack. This exploit was identified by a third-party audit company, Quantstamp, and reported to the Nomad team, but was never actually addressed.⁷  Cited as “QSP-19 – Proving With An Empty Leaf,” we see the status of “low severity” and a status of “Acknowledged”. Given previous weaknesses and exploits involving wrapped tokens, perhaps it may be time to stop wrapping tokens?

Solana Private Keys Compromised

Solana hot wallet funds connected to the Phantom Wallet are being fraudulently sent to an unknown address, totaling over $6 million stolen already.⁸  The uncertainty around this exploit is creating true fear amongst Solana users as funds thought previously safe may not be. At the time of writing, nobody knows the method of this attack yet, making it tough for investors to be sure of their security setup.

Our Two Sats: This is an interesting story as this attack doesn’t make use of a third-party or smart contract exploit, but the transactions appear to be coming from the users themselves. While the exact method of this attack is still unclear, the current recommendation by the community is for users to send the Solano token to a hardware wallet (cold storage) or centralized exchange. While we await more details, the lesson so far may be the emphasis on some of the risks with these nascent protocols, and certainly the additional security benefits of cold storage where private keys are kept offline and not connected to a network or the internet like these “hot wallets.” 
 

News Quick Hits

• The final testnet merge on the Ethereum network is set to take place later this week.⁹  
• Man who threw away millions in bitcoin wants to use AI and robots to find it in the trash.¹⁰ 
• Bitwage, a bitcoin payroll provider, partners with Casa and Edge Wallet to streamline their onboarding process to a Bitcoin standard.¹¹ 
• Digital Native Millennials and GenZers are more likely to choose employers that offer salaries in bitcoin and continue to grow the trend of accepting all or a portion of salary in “Crypto”.¹²

Data to Watch

Data we are currently keeping an eye on and our commentary.

For this month we are focusing on the more technical and short-to-medium term bitcoin price indicators in this section, while we review the longer-term underlying bitcoin network metrics in our “Insights and Education” section later.

Source: Coin Metrics as of 07/31/2022. 

After slicing below the 200-week moving average in the mid-June rout, bitcoin’s rally in July pushed it back to the moving average where it currently sits. Technical traders will likely be watching this closely to see if the recent rally will continue and push bitcoin meaningfully above this moving average to turn it into support, or if it will fail and become a resistance level. However, historically bitcoin has spent very little time below its 200-week moving average, as seen above. Since May of 2014 through the end of July 2022, bitcoin has only traded below this metric for a total of 75 days out of a possible 2,998 days, or 2.5% of the time over ~8.2 years. While past performance is not indicative of future results or expectations, we also note the 200-week moving average continues to gradually slope upwards. 

Turning to mining fundamentals, we can use the Puell Multiple to get a rough estimate of how profitable mining currently is compared to the yearly average. This multiple is the ratio of daily miner revenue (coin issuance to miners in USD terms) divided by the 365-day moving average of miner revenue. A high ratio indicates current mining is profitable compared to the yearly average, while a low ratio may indicate financial stress for miners. Lows in the Puell Multiple have historically correlated to local lows in the price of bitcoin. 

Source: Coin Metrics as of 07/31/2022.

Insights and Education

A monthly long-form section where we provide a Fidelity Digital Asset’s perspective or educational piece.

In this month’s edition we take a look at the macro environment first, examining both sides of some of the current debates, before tying it to bitcoin and digital assets and what it may mean for the next few months.

Macro: The market’s bets are on loosening ahead, but is that correct?

This past month featured another announcement from the Federal Reserve, which at first glance seemed to be completely expected with the Fed indeed announcing the well telegraphed 75 basis point increase in interest rates. However, risk assets such as equities and digital assets rallied on the news. While one can never truly say why an aggregate market of individual participants acted somewhat collectively in a certain manner, the narrative in hindsight is the Fed’s language of being “data dependent” going forward signaled a shift in policy. In other words, the language opened the door to an end in sight to the current monetary tightening. 

Evidence of investors believing this to be the case can be seen as longer-term bonds yields are down quite significantly, with the 10-year treasury falling nearly to 2.50% after reaching a high of 3.50% in mid-June. With longer-term bond yields down and the Fed continuing to pull up shorter-term yields, a number of yield curve inversions have occurred. As many investors know, an inverted yield curve has a pretty good track record when it comes to foreshadowing recessions. We won’t weigh into the speculative debate of whether or not we are in a technical recession, but for our purposes it is important to consider the probabilities of a current recession in regards to what the Federal Reserve may or may not do. 

A recession may take care of some of the consumer inflation problems the Fed is facing, and simultaneously put pressure on it to shift more focus to the “full employment” part of its mandate, rather than the “price stability” part, which in turn means less tightening and even a pivot to loosening. Indicators favoring this scenario include the recently announced negative second quarter real GDP growth, which is now the second consecutive quarter of negative GDP growth. While this is not part of the National Bureau of Economic Research’s definition of a recession, each time this has happened in history a recession has occurred. Other signs of slowdown and deflation include cooling commodity prices, housing market slowdowns, declining vehicle prices, and credit drying up. Data points contrasting this include a resilient labor market and relatively robust consumer spending, however we note employment is usually a lagging indicator while retail and consumer spending is nominal and therefore doesn’t account for the current high inflation. 

Even if a recession is here or imminent, what happens if inflation remains stubbornly high? Even if demand falls, structural supply chain issues could make inflation much stickier. In this scenario the Fed would be stuck between a rock and a hard place. Note that while the Federal Reserve now considers its target interest rate of 2.50% to be at “neutral” (not restrictive or accommodating) it may take much higher rates (above neutral) in order to slay the inflation dragon. 

For example, the last high inflation episode in the United States throughout the seventies required the Federal Reserve to hike target interest rates up to the CPI level in the first wave and then even beyond CPI in the second wave. Another way to look at this is the Taylor Rule, devised by John Taylor as a mechanical formula to output what the Fed funds rate “should be” according to the inputs of where inflation and the GDP output gap is at.¹³ Obviously the Fed currently follows a more discretionary rather than rules-based approach, but it is instructive to see the magnitude of where the Fed funds rate may need to go given current inflation. We note the data is quarterly, so the most recent data is as of end of March 2022, but even back in Q1 the Taylor Rule was prescribing rates should be at 11% given the high inflation.

Source: Coin Metrics as of 07/31/2022.

What do these possible macro scenarios mean for digital assets?

Digital assets such as bitcoin continue to be viewed as risk assets, as can be seen in the still high (albeit starting to moderate) correlation between bitcoin and the S&P 500: 

Source: Coin Metrics as of 07/31/2022.

It seems unlikely this correlation will go to zero or even flip negative in the near-term given the emphasis on the macroeconomic environment and how market participants continue to treat and trade digital assets. 

Therefore, many people think the first scenario of a Federal Reserve pivot to loosening would likely be favorable to digital asset price action. However, what may be more important than Fed loosening or tightening might be the reaction of market participants, particularly in terms of whether the loosening turns investors back towards a speculative and risk-seeking stance or not. For example, even though the Federal Reserve was aggressively easing during the 2008 crisis, no amount of monetary stimulus could seem to shake the fear out of investors as risk assets kept selling off. Going back to our scenario analysis of a recession, we therefore could see risk assets underperform even if the Fed eases as a result of a large enough economic downturn that saps all of the speculative energy from investors.  

Continued tightening by the Fed in order to first take care of inflation might be a headwind. However, it may be possible the massive drawdown digital assets already experienced has the effect of pricing some of this in, and continued tightening might not have as large of a negative effect on bitcoin or other digital assets as compared to equities, which currently sit approximately 15% below all-time highs versus bitcoin still sitting 65% underwater. This idea is also supported in our charts above in the “Data to Watch” sections, which shows technical indicators may be near bottom or “value” zones. 

Is this recent rally the start of a new bull run? 

The 20% bitcoin rally in July is certainly impressive, and after a huge drawdown and washout in leveraged players and centralized lenders, many are wondering if the bottom has already been put in and this is the start to a new bull market. As we have noted above, the rally is largely due to the noisy macro picture, but we can also look at on-chain metrics to see if it is accompanied or supported by the fundamentals. 

Active address counts have held up after falling in the most recent sell-off, but is still far below previous highs and has not shown any meaningful uptick with the price rally: 

Source: Coin Metrics as of 07/31/2022. 

We see a similar story with other on-chain metrics like transaction volume, and note in particular that fees remain very low – a good thing for those wanting to transact on-chain but past bull markets have also been accompanied by an increase in fees. 

Overall, our assessment is that the recent price rally is not particularly well supported by on-chain fundamentals yet. While they are not showing negative signs of deteriorating, or a change in bitcoin’s fundamental thesis, they are not exhibiting any extra support. 

The Big Picture

This analysis has so far been focused on the short-to-intermediate scenarios for digital assets. But long-term we do not see anything changing in the thesis for a scarce, digital asset that is not concurrently a liability for some other financial entity. Whether or not we are in or entering a recession, or whether the Fed continues to focus on inflation in the short-term, does not change our opinion that eventually the Fed and other central banks will once again turn towards financial easing and debasement, following the financial repression playbook in order to get sovereign debt and government liabilities under control. We therefore continue to see bitcoin as a hedge against this debasement scenario with the optionality of further technological advancements.  

Contributors:

Christopher Kuiper, CFA, Director of Research, Fidelity Digital Assets

Jack Neureuter, Research Analyst, Fidelity Digital Assets

Matthew Hogan, Research Analyst, Fidelity Digital Assets

Daniel Gray, Research Analyst, Fidelity Digital Assets