Research Round-Up: February 2023

The Research Round-Up On-Demand

Watch Now: 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

As we close out the first month of 2023, digital assets are off to a strong start, bouncing back from one of the worst years in their history. Ether is up just shy of 40% so far this year, benefitting from some of the macro factors outlined below. Bitcoin's price was up approximately 40% in the month of January, a monthly return that hasn't been seen since October 2021 (that was also up 40%). This has also been the strongest January since 2013 when bitcoin was up 44%. While the reasons for the price move are always myriad, it is interesting that there was not one single event or catalyst to point to with the move. However, we note bitcoin has done this before in the past and we are not surprised given the conditions that had been forming -- namely the increasing number of illiquid coins (coins that haven't moved in over a year) and the continued outflow of coins from exchanges. Both can contribute to lower supply and create conditions ripe for higher moves. We also think a big part of the move was the futures market as we have observed a large number of shorts getting liquidated over the past few weeks. We expand on some of these metrics in more detail in our Data to Watch section below.

In terms of the broader macro picture, we also think the perceived softening of central banks could be contributing to the positive move in digital assets and risk assets in general. This was especially evident with the Federal Reserve FOMC meeting on February 2, which was perceived by market participants as quite dovish, leading to a small rally in the price of bitcoin to approximately $24,000.

With inflation looking like it has peaked and on the decline for the time being, market participants are expecting the Federal Reserve to continue to slow its rate hiking pace. Although historically rate pauses or cuts have not been associated with rising risk assets immediately (usually because the cut is due to economic activity slowing), we do think institutions and other asset allocators in the longer-term may once again turn to bitcoin if central banks ease aggressively as they have done in the past.

News and Editorial

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

Consensus Controversy? Bitcoin Community Divided on Debate over NFT Project Ordinals

This month welcomed the debut of the Ordinals project¹ which allows for the storage of non-fungible tokens, or NFTs, on the Bitcoin blockchain. The project leverages text or images called “inscriptions” that can be added to the smallest units of bitcoin, known as satoshis or sats. This enables the creation of unique digital artifacts (NFTs) that can be sent across the Bitcoin network like any other transaction. Upgrades to the Bitcoin protocol Segregated Witness², or SegWit, and the more recent Taproot upgrade of 2021³, may have helped lay the foundation for things like this. While it wasn’t the intention of these protocol upgrades to allow for NFTs on the Bitcoin network, they both increased transaction capacity per block, making it easier and relatively cheap for NFTs to be stored on the Bitcoin blockchain.

This project has sparked debate in the Bitcoin community on whether the Bitcoin blockchain should be used for anything outside of digital payments. Pseudonymous founder(s) of the network, known as Satoshi Nakamoto, only intended for the network to be used for digital payments specifically, and saw anything outside of that scope as an unnecessary hindrance to scalability. Ordinal opponents and Bitcoin traditionalists alike have argued that these NFTs will crowd block space and drive-up transaction costs by directly competing with the conventional payment transactions the network is accustomed to. However, Ordinal proponents have asserted that Bitcoin does not have to be confined to just one-use case, and that the fee mechanism that Bitcoin uses should allow users to dictate how much they are willing to pay to have transactions processed that are most valuable to them.

Our Two Sats:

Who ever said Bitcoin was boring? Sure, it may not be as programmable as some of its more application friendly counterparts such as Ethereum or Solana, but that doesn’t mean developments and experimentations are not being tried. This development isn’t a debate on how the community views or receives NFTs, this is a debate over what the true use case and vision for the Bitcoin protocol should be. Some might argue that allowing the free market to dictate transaction fees should be the source of truth, regardless of whether that applies to transactions or inscriptions. Miners are incentivized to pick transactions with the highest fee to “weight” ratio, which will become increasingly important over time as block subsidies decrease and they become more reliant on transaction fees for profitability. Since miners are free to choose which transactions they want to include in each block, they can willingly choose to omit or include inscriptions from their blocks depending on their philosophical or subjective stance toward them or based on fees.

This debate drills down to the fundamental philosophy of what the Bitcoin protocol is, and what it stands for. Friction creates fire, and healthy discourse in the community is a net positive as it promotes development and collaboration among community members, regardless of their respective stance on the issue at hand. Only time will tell which way this debate goes (or it may just fizzle out if interest wanes or the block fee market gets more competitive and prices inscriptions out), but one thing is for certain, we look forward to following along with these developments.

KZG Ceremony for Ethereum Goes Live

The KZG ceremony, which went live on January 16, is a public event for the Ethereum community spanning several months. The purpose of the ceremony is to generate some secret value that will be used in Ethereum's KZG commitment scheme. The commitment scheme ultimately enables robust layer 2 scalability through data availability sampling, by allowing validators to verify the correctness and availability of data on the blockchain without needing to download all the data. Alleviating validators from the requirement of downloading every piece of data while still verifying its correctness means that we can have more data in each block, and therefore more transactions executing on L2's. To create this commitment scheme, a “trusted setup” is required, which uses randomness to generate the secret value needed. If done correctly, the trusted setup carries a 1-of-N trust assumption. This means that if one participant honestly completes the KZG ceremony, then the result is completely secure. The secret input value of the ceremony remaining unknown is important for the security of layer 2 rollups by ensuring that the proofs used by layer 2’s are unforgeable. Once danksharding becomes enabled, the success of this ceremony will determine the degree to which we can trust the data being posted by layer 2’s. The Ethereum community plans to split the event into phases such that those with varying degrees of involvement can be prioritized along the way. The first phase is open to the public and mostly consists of individuals using the KZG ceremony’s website⁴ to generate randomness and submit their secret.

The subsequent phases are specifically for individuals that create their own implementations as well as those that have special ways of generating randomness. This is being done for the similar reason that the Ethereum network uses multiple client implementations. It can remove any single point of failure such that if one secret-generating mechanism fails, there are many others that will not. Currently, the ceremony has ~30,000 contributions from the Ethereum community in a span of about two weeks.⁵

Our Two Sats:

“Don’t trust, verify;” is an ethos that most of the digital asset community rallies behind. That’s what makes this “trusted setup” a polarizing topic for many. However, there are many pieces of this ceremony that we can verify ourselves, specifically that the program facilitating the ceremony, known as the sequencer, has acted appropriately and that our individual contributions have been included in the final output. Given the above, we could rephrase our ethos to encapsulate the idea of the trusted setup by saying “trust 1 person out of X and verify.” Currently, the value of X is 30,000 individuals and growing. It does seem unimpressive that the mechanism enabling a robust scaling solution for Ethereum requires any amount of trust, but it is believed by many that if carried out correctly the security of this setup can be probabilistically guaranteed. The greatest advantage of this ceremony is that it puts the task of minimizing the trust required in the hands of the entire Ethereum community. Since every individual can reliably trust themselves, we encourage everyone, especially the skeptics, to participate in the ceremony and help the largest known trusted setup become a success.   

Crypto Contagion Continues as More Industry Players are Faced with Financial Distress

This past month there was continued fallout in the digital asset industry with another bankruptcy filing⁶ and large losses reported at related financial institutions.⁷ In addition, the current macro environment presents challenges related to borrowing money due to higher interest rates and investors having an overall lower appetite to take on risk in the industry, which means raising fresh capital or striking deals with creditors can be especially difficult.

Our Two Sats:

These bankruptcy filings are part of the domino effect of 2022 events. It was revealed that many industry participants had exposure to companies that collapsed last year. Withdrawal suspensions, freezing of assets, and bankruptcy filings have been widespread, but these near-term challenges may prove to be a benefit for the overall industry in the long run as the industry matures and excessive leverage is flushed out of the system, forging a more robust ecosystem.

News Quick Hits

• Senator Ted Cruz introduced a proposal to require vendors on Capitol Hill to accept cryptocurrency as payment.⁸
• Bank of America says CBDCs are the future of money and payments and have the potential to revolutionize global financial systems.⁹
• 1.5 million Texas homes could be powered by the energy bitcoin miners returned.¹⁰
• Ethereum hosted 338% more transactions than bitcoin during 2022¹¹, but Bitcoin still dominates by web searches.¹²
• SEC rejects yet another ARK and 21Shares spot Bitcoin ETF listing, citing failures to convince regulators that the ETF could protect investors from market manipulation.¹³
• New York State Assembly introduces a bill that would allow state agencies to accept cryptocurrency as a form of settlement for payments charged by the state.¹⁴
• El Salvador settles $800M debt despite concerns of default because of its bet on Bitcoin.¹⁵

Data to Watch

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

Trading Volumes Sinking to New Lows?

Since the beginning of 2022, exchange volume has been trending downwards. When the 30-Day moving average is below the 365-Day it shows that exchange-related activity is contracting. This trend is indicative of lower investor interest in bitcoin or that users are generally avoiding centralized exchanges. The lower volume could be a significant reason for the price appreciation recently as an absence of users willing to sell their bitcoin means buyers must pay a higher price.

Shorts Liquidated

Here you can see evidence of the January price action partly driven by the derivatives market as a huge spike in short futures contracts corresponded to price increases. The most notable short liquidation happened on January 14 when $123 million dollars of shorts were liquidated, followed by two secondary short squeezes.

Golden Cross in Progress?

We typically don’t pay attention to a lot of the technical analysis surrounding digital assets such as bitcoin given our view that investors need to understand the core investment thesis and why it largely revolves around long-term adoption. However, we do find some of the moving average analysis can be beneficial as bitcoin has exhibited large trends or momentum driven partly by waves of adoption. One such measure is the long and short moving average crossover. Commonly referred to as a golden cross or death cross, depending on which direction the metric is heading, this signal has, on a backward looking or historical basis, been relatively accurate in terms of price movement given its propensity to make long positive or negative trends. Anytime the shorter moving average (50-day) crosses above the longer average (200-day) this is considered a “golden cross.” If the opposite happens, it is called a “death cross.”

We recently analyzed how this well-known technical analysis metric performed within the last three years. Using data from the chart below, we were able to calculate the approximate percentage returns and losses if an investor had bought and sold bitcoin using only the moving average crossovers as described above. In 2020, the 50-Day moving average crossed above the 200-Day average twice, with the price growing more than 500% in the following year. There was then another pair of crosses in mid-2021 and then a final death cross in early 2022 with price falling roughly 50% after that. Fast forward to today and we are on the cusp of seeing another golden cross. Whether this is the start of another year long bull-run is uncertain as bitcoin takes on other macro-economic uncertainties. Pairing this signal with the knowledge that the supply issuance will be cut in half again in early 2024 means we could be in for additional volatility.  

Halving or Halvening?

Whether you refer to it as the “halving” or “halvening” matters not. What does matter is the block reward for minting new bitcoin is cut in half roughly every four years, dropping today’s rate of newly minted bitcoin from 900 per day to 450, thereby decreasing supply growth and the regular amount of coins miners are usually selling into the market to cover their mining costs. While history doesn’t always repeat and past performance is never a guarantee of future performance, history can sometimes rhyme. Around this time in the past (70% of the way through the halving cycle) has also concurrently been near the bottom for the respective price cycle as well. The current estimate for the third halving is April 2024. Time will tell if the recent positive price action is indeed climbing out from the bottom as in the past, or if the future will be different this time and we are currently in a bull trap.

Bitcoin Miners Receive Some Much-Needed Relief With Price Appreciation

Bitcoin’s hash rate has set another new all-time high, reaching 311 EH/s and climbing just over 13% in the month of January alone, according to Coin Metrics. This comes as no surprise as bitcoin mining became profitable again as price rose roughly 40% over the same period. The bitcoin price rally must be a sigh of relief to miners who suffered relentlessly higher hash rate and higher difficulty adjustments through most of 2022, despite the price falling. It is also a relief to network participants given a common concern is miner profitability and Bitcoin’s ability to sustain miners, incentivizing the overall security budget. However, we think the bigger picture overall is that miners have shown us time and again that they’re here for the long-term and short-term price action won’t dissuade them from continuing their endeavor.

Ether Net Issuance Goes Negative, Again

Ether net issuance has once again gone negative. Charted below is the inflationary and deflationary history of ether’s net issuance. Simply put, the total supply of ether is shrinking. This is due to an increase in network usage causing more fees to be burned by the network than the network issues for its security budget. Since this metric is largely based on continued use of the network and user adoption to maintain a high burn rate, it will be interesting to see how this shifts over the following year as a major update known as the “Shanghai” upgrade is set to roll out sometime before the second quarter. One of the main parts of this upgrade aims to lower fees for layer 2 participants which can presumably cause the burn rate to fall.

In Case You Missed It

In our 2023 Look Ahead we reflect on some of the biggest developments in the digital asset space in 2022 and, more importantly, contextualize what we think they could mean for this year and beyond.