Research Round-Up: August 2023

The Research Round-Up On-Demand

Watch Now: Fidelity Digital Assets℠ Research Analysts Matt Hogan and Daniel Gray provide additional commentary and market insights in this short on-demand video.

Market Commentary

Digital asset price activity in July was mostly uneventful. Both bitcoin and ether were down about 4% over the course of the month. However, both assets were beneficiaries of upwards price movement on July 13 after a U.S. judge ruled that Ripple Labs did not violate federal securities laws by selling its XRP token on public exchanges, which we explore further below. Year-to-date, bitcoin and ether’s prices are up 77% and 55%, respectively.

In other news, the Federal Reserve’s launch of the FedNow instant payment service has raised questions over potential impacts to digital assets and central bank digital currency (CBDC) plans, asset tokenization firm Securitize launched a tokenized real estate investment trust (REIT) on the Avalanche blockchain, OpenAI CEO Sam Altman-backed Worldcoin launched its WLD token amid controversy, bitcoin holders continue to accumulate despite the bear market, and Ethereum active validator counts are accelerating.

In this month’s newsletter, we’ll recap some observations from recent events that our research team attended, summarize the top developing news stories in the digital asset space, and highlight some data points that we are focused on.

Notes from the Field

Summaries and thoughts from the latest conferences and events attended by Fidelity Digital Assets℠ Research. 

ALTSCHI 2023, Chicago IL

ALTSCHI is an education-focused alternative investment conference designed to bring the investor community together for dialogue and discussion on the most relevant topics facing investors and managers today.

The event was comprised of a mix of panels, keynote speeches, and roundtables, with most speakers and attendees focused on private markets and ongoing macro challenges from rising interest rates and falling valuations. Despite these challenges, many voiced their optimism for opportunities in the current market environment. Additionally, the event saw plenty of discussion on the future of portfolio construction and how investors are increasingly seeking allocations to alternative investments for portfolio diversification during these uncertain times.

Discussion of digital assets made up only a small portion of the event, but it was not ignored entirely. We especially enjoyed a panel focused on how technology and artificial intelligence are set to transform financial services in the future. The panel comprised of Nate Maier of the State of Wisconsin Investment Board, Yussef Gheriani of IHT Wealth Management, Sarah Schroeder of Coinbase Asset Management, Brendan Marshall of Flow, and Geralyn Hurd, President and Co-Founder of K1X. The panelists provided practical insights on the fundamental changes already taking place in the digital asset space including the democratization and tokenization of real-world assets on-chain and extrapolated how artificial intelligence (AI) could potentially be a useful tool to aid in the construction and management of portfolios going forward. Additionally, the panelists alluded to the role that digital assets and cryptocurrency could play in facilitating payments for AI services in the future and, while purely hypothetical and still potentially years away from implementation, it is an exciting prospect nonetheless to imagine the potential synergies these two groundbreaking technologies could have on the financial services industry.

News and Editorial

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

Judge Rules Ripple Labs, Inc. Did Not Violate Federal Securities Law in Sale of XRP Token

The 2020 case brought against Ripple Labs and executives Brad Garlinghouse and Chris Larsen has kept digital asset industry watchers anticipating a ruling on whether the U.S. District Court in the Southern District of New York would rule that the XRP token was an unregistered security. On July 13, Judge Analisa Torres ruled on the motions for summary judgement in favor of Ripple, stating that programmatic and other sales of XRP did not meet the definition of being a security or investment contract because, “purchasers of the tokens did not have a reasonable expectation of profit tied to Ripple’s efforts.”¹ It is important to note that this may not be the final decision, but a procedural motion on claims that can still proceed to trial.

However, Judge Torres did find that the initial sale of tokens to institutional investors did meet the definition of an investment contract as those primary token market investors did have reason to expect profit from Ripple’s efforts. That decision in favor of the SEC’s allegations enabled the regulator to also declare a partial victory.

Legal experts have expressed mixed reviews of the ruling where they questioned the discrepancy of both the analysis and the outcome relative to investor protections between institutional and retail investors. It should also be noted that this ruling was not followed by a judge presiding over the Terraform Labs case who was coincidentally sitting on a different floor of the same courthouse, highlighting the difficulty involved with establishing consistency among legal interpretations of similar cases.² Following the release of the summary findings, XRP and the broader crypto market traded higher as some market participants speculated this outcome would be long-term bullish for the broader digital asset market.

Our Two Sats:

In this landmark case, the Ripple defendants and their supporters seem to have come away more optimistic than the SEC and its advocates. This case was closely followed by industry insiders in part because it featured disclosure of the “Hinman Documents” produced by the former SEC Director of the SEC’s Division of Corporation Finance. Hinman expressed his views in a 2018 speech that Ethereum had become sufficiently decentralized to no longer be considered a security even if it had met the definition at the time of launching the token.

News of the ruling sent XRP’s price higher and led to discussion about the potential to be relisted on centralized exchanges. Some speculated that the ruling would be a positive reference point for Coinbase in their own court battles with the SEC. However, the facts of each case are unique and it would be premature to jump to broad-based conclusions. This court case serves to reinforce the notion that the digital asset industry is still in its early phases and regulators have only recently started attempting to understand how to best regulate it.

Fed Launch of Instant Payment Service FedNow Raises Questions About Potential Impacts to Crypto and CBDC Plans

The Federal Reserve has implemented a new real-time payment network that will provide members with settlement of funds on a 24/7/365 basis with the capability initially being deployed with 35 institutions.³ Other countries have had real-time payment systems in place well in advance of the U.S. including the U.K., India, Brazil, and the E.U. The new network has incited dispute with some, arguing this is long overdue and will benefit smaller institutions and their customers. Others have raised concerns that FedNow will compete with similar networks operated by companies in the private sector. The Fed has intentionally tried to quell fears over whether the launch may pave the way for an effort to replace cash.⁴ Those expressing doubts about the network have also speculated that the timing of the FedNow launch was intentional to deter interest in stablecoins, while potentially making it easier for the central bank to issue a digital currency. It is also worth noting that the House Financial Services Committee (HFSC) just moved the stablecoin bill out of committee on July 28, a landmark move after a year of legislative negotiations.

Our Two Sats:

FedNow was created to address friction in the traditional U.S. banking system. The network does seem redundant to other offerings in the market, but differs in that users have direct access to the central bank for settlements. Common peer-to-peer payment applications’ use of credit to show the current status of their funds have led users to incorrectly believe that those digital payments are settled immediately. In reality, it can take days for the final settlement to be achieved between the institutions that could be facilitating movements across the accounts being debited and credited.

It is unclear as to why FedNow’s launch was accelerated. While the total amount of stablecoins outstanding has fallen over the past year, there is little doubt that the ease of use for facilitating transactions outside of banking hours has alerted people to the fact that there are viable options outside of the traditional banking system. In November 2021, the Treasury Secretary Janet Yellen and the President's Working Group released a report and recommendations related to stablecoins: “Stablecoins that are well-designed and subject to appropriate oversight have the potential to support beneficial payments options. But the absence of appropriate oversight presents risks to users and the broader system… Current oversight is inconsistent and fragmented, with some stablecoins effectively falling outside the regulatory perimeter. Treasury and the agencies involved in this report look forward to working with Members of Congress from both parties on this issue. While Congress considers action, regulators will continue to operate within their mandates to address the risks of these assets.”⁵

Whether the FedNow network sets the stage for a rollout of a CBDC in the U.S. remains to be seen. FedNow may have been introduced early to influence perception about the Fed’s ability to react to challenges in the banking system, but it does not seem to be the rails upon which a CBDC would be launched. Keeping in mind that FedNow allows the U.S. to catch up to other countries in terms of 24/7/365 real-time payments, it is obvious that the project was not undertaken to compete as a CBDC. Fed Chair Jerome Powell communicated earlier this year that the U.S. central bank was not close to making any decisions related to a CBDC and also noted in testimony to the U.S. House Financial Services Committee that any U.S. CBDC would not be designed for individual retail accounts.⁶ On the other hand, Secretary Yellen has been openly calling for progress and a strategy for developing a U.S. CBDC in case it is decided that is in the national interest.⁷ Taking all of this into account, it is clear implementation of a U.S. CBDC can not be ruled out, but it seems FedNow is not the right tool for that job.

Securitize Launches Tokenized REIT on Avalanche Blockchain

Asset tokenization firm Securitize has issued the first tokenized security in Europe under the E.U.’s pilot regime for digital assets.⁸ The tokens are issued through the smart contract network Avalanche (AVAX) and represent equity in the Spanish real estate investment trust Mancipi Partners, made possible through a test environment under supervision of the Spanish General Secretariat of the Treasury and International Finance (CNMV). Mancipi Partners, a REIT specializing in commercial real estate for healthcare founded in 2023, issued the tokens using infrastructure provided by Securitize with plans for secondary market trading of the tokens to begin in September. This rollout was made possible through the E.U.’s creation of a constructive environment for regulatory compliant experimentation under the Digital Finance Package (DLT) Pilot Regime⁹, which went into effect in March of this year.

Our Two Sats:

The E.U. is demonstrating the benefits that can be realized by prioritizing pace over perfection. The temporary DLT Pilot Regime has provided a regulatory-compliant testbed that will allow market participants, regulators, and legislators to gain insights and perspective that may help shape future developments. Securitize has been exploring tokenized asset issuance in multiple jurisdictions, even going as far as being the first company to issue tokenized assets in both the U.S. and E.U. The E.U. seems to have recognized that the competition to attract blockchain industry capital and infrastructure will likely be won by regions that show commitment to providing clear rules of engagement.

Sam Altman-Backed Worldcoin Launches Polarizing WLD Token Despite Controversy

Worldcoin, a project co-founded by OpenAI CEO Sam Altman, has announced the launch of its WLD token after years of delays.¹⁰ The project, backed by global technology company Tools for Humanity, uses iris-scanning "orbs" to create a unique World ID for users to achieve what is called “proof-of-personhood.” The project plans to distribute tokens to more than two million people, who have already been verified. Worldcoin aims to have orbs in over 35 cities in 20 countries and increase the number of orbs to around 1,500 by the end of 2023. Those verified will initially receive 25 WLD tokens, with periodic grants to follow. There will be a total supply of 10 billion WLD tokens, 80% of which will be reserved for users, operators, and the ecosystem, with the remaining 20% for the Worldcoin team and backers.

WLD token's value surged by 88% following listings on multiple cryptocurrency exchanges, including Binance, Huobi, Bybit, and OKX. Potential applications for the protocol and its verified credentials range from uncollateralized lending programs to universal basic income models and the metaverse. Despite its ambition, the launch of WLD was met with much criticism from the crypto community. Ethereum Founder Vitalik Buterin outlined four main risks related to Worldcoin's methods, including privacy concerns about the misuse of iris scans, accessibility problems related to geographic limitations of Orb scanning devices, centralization, and security risks, including phone hacking and the selling or renting of IDs. Despite claims that the project complies with local laws, including Europe’s General Data Protection Regulation (GDPR), the U.K.’s Information Commissioner’s Office (ICO) is investigating if the project has completed the necessary Data Protection Impact Assessments for processing high-risk biometric data and has a clear lawful basis for personal data processing.

Our Two Sats:

Worldcoin's launch, however controversial, underpins the interest in and need for innovative identity verification methods as more of our everyday life shifts into the virtual world. The project's approach to this problem by establishing so-called proof-of-personhood using iris-scanning is unique, but comes with many privacy and security concerns. Despite seemingly progressive and promising use cases, these concerns are likely to be significant barriers to adoption. Worldcoin and similar projects may ultimately depend on their ability to balance innovative technology and service offerings with strong security measures, respect for privacy, and regulatory compliance. In the meantime, privacy and security-oriented digital asset users will likely find comfort in their pseudonymous presence on other networks.

News Quick Hits

• Crypto firm Flashbots becomes a unicorn after completion of a $60 million Paradigm-led funding round with plans to continue development of its maximum extractable value (MEV) network, SUAVE.¹¹
• Bitcoin Lightning wallet Phoenix has introduced a technology called “splicing,” which aims to reduce fees.¹²
• Gnosis has launched a Visa card that allows users to spend their funds from self-custodial wallets anywhere the payment is accepted.¹³
• Discussions over legislation to create a comprehensive U.S. framework for stablecoins have stalled.¹⁴
• A code bug left decentralized exchange Curve Finance vulnerable to a $70 million exploit, but the damage has since been contained.¹⁵

Data to Watch

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

Small Wallets Continue to Accumulate Bitcoin

On-chain data shows smaller wallets continuing to buy and accumulate bitcoin. This shows a positive trend of adoption from users even as bitcoin’s price fell from an all-time high of roughly $67,000 in November 2021. In 2014, roughly 96% of addresses held more than 10 bitcoin. In November 2021, roughly 86% of addresses held more than 10 bitcoin. Today, that number has fallen to around 82% of addresses, down 14% in nine years and 4% since the November 2021 all-time high. At the same time, the number of smaller addresses, addresses that hold fewer than 10 bitcoin, have risen 319%, starting at roughly 4% in the beginning of 2014, to 14% as of late 2021 and 18% at the time of writing. In the chart below, we can see the distribution and accumulation of small wallets, wallets that hold fewer than 10 bitcoin. While the earlier days of Bitcoin’s existence allowed for larger amounts of bitcoin to be held by individuals because of significantly lower prices, it is important to see the number of small wallets still accumulating. This indicates that bitcoin is still being distributed among those that value it, even as full coin prices remain unaffordable for the average investor.

Proof-of-Stake Active Validator Count is Accelerating

In last month’s Research Round-Up, we wrote about Ethereum Active Validator count. This month, we will expand more into what affects this metric and how Ethereum is undergoing an increase in validators joining the network. There exists a queue system for validators both entering and exiting the Ethereum network that aims to protect the network’s stability and security. This queue system controls changes in the number of validators per epoch, a 6.4-minute interval, by setting a ceiling for how many validators can join or leave. The epoch churn limit is found by dividing the number of active validators by the churn limit quotient, 2^16 or 65,536. At the time of writing, there are roughly 698,924 validators. Dividing the active validators by the churn limit quotient gives us 10.

This means that the network can add up to 10 new validators per 6.4-minute epoch and up to 10 validators can also leave the network in the same time span. According to on-chain metrics, validator count has been accelerating over the past 14 months. Using the previous three churn limit periods, the average time between a churn limit change was approximately four months. It has been roughly a month and a half since the churn limit was last increased. The validator count is 66% of the way to the next increase, which would continue the trend of acceleration if it crossed 720,896 validators by September 19, 2023.

Mining Bitcoin vs. Buying Spot Bitcoin

An interesting theory touched upon in our latest Halving piece revolves around whether it is cheaper to buy bitcoin or produce it via mining—and how that answer is always changing. Historically, the price of producing (mining) bitcoin has gravitated toward its market price and any outbreak of this pattern has led to opportunities elsewhere. Using a Difficulty Regression Model proposed by Glassnode, we can quantify the estimated all-in-sustaining-cost of producing new bitcoin and estimate the average production cost. Using this model, we see that the current spot price of bitcoin is 20% higher than the average cost to produce bitcoin. Meaning, it is currently cheaper for miners to produce bitcoin than it is to buy spot bitcoin. This could lead to miners offloading bitcoin as they secure profits, creating sell-side pressure. As more traditional finance vehicles are created to enable arbitrage opportunities between mined bitcoin and spot bitcoin, the market may experience less long-term volatility. However, this does not mean there can not be any irrational trading causing wild swings in the shorter-term.

In Case You Missed It

Digital assets are unique in that they not only generate traditional market signals based on price or trading, but also an entirely new set of signals based on the on-chain data that can be viewed by anyone via their underlying transparent ledgers. These signals can be valuable for all types of investors, but the challenge lies in determining what signals to use, how to match the signal to the correct investment time horizon, and then how to correctly interpret the data. In our Q2 2023 Signals Report, we have collected what we think are the strongest signal indicators, grouped them by time horizon, and provided an overall assessment of the conditions for each time horizon.

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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

Max Wadington, Research Analyst, Fidelity Digital Assets