Research Round-Up: July 2023

The Research Round-Up On-Demand

Watch Now: Fidelity Digital Assets℠ Research Analyst Jack Neureuter provides additional commentary and market insights in this short on-demand video.

Market Commentary

Digital asset price activity started heating up in June with a wave of applications for a spot bitcoin ETF. Bitcoin’s overall price rose 13%, while ether’s price rose around 3.5%. However, the percentage increase from the day before the ETF filing to the end of June shows just how volatile the bitcoin price movement can be. Since June 14, bitcoin’s price has gained 21.5% and ether 17%. This leads to about an 85% year-to-date bitcoin price appreciation and 62% year-to-date ether appreciation.

In this month’s newsletter, we summarize the top developing news stories in digital assets and highlight some data points that we are focused on.

News and Editorial

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

Wave of Spot Bitcoin ETF Filings Renews Hope in Crypto Markets

A series of new spot bitcoin ETF filings hit the tape in June, causing many to wonder whether ETF issuers are optimistic that this round of filings may be more successful than previous ones. Blackrock, the largest ETF provider in the world, filed for a spot bitcoin ETF on June 15. Shortly after, a series of refiles followed including Bitwise, WisdomTree, Invesco, and Valkyrie. Just one spot bitcoin ETF, planned to be issued by Ark Investment Management and 21Shares, was awaiting approval or denial from the SEC prior to the new Blackrock filing. Included in the most recent wave of filings is language pertaining to “surveillance sharing agreements” in which ETF issuers and the exchanges through which the underlying spot bitcoin will be traded would agree to allow regulators transparency into the trading of the underlying assets.

Our Two Sats:

It seems hope for a spot bitcoin ETF has become the latest narrative from which crypto markets have found positive sentiment and momentum. Regulators have largely shown concern with respect to two key elements of digital asset markets: custody and potential for market manipulation. Some participants in the digital asset ecosystem feel that reliable custody exists from several reputable providers across digital asset markets and that the main concern is transparency in the underlying spot crypto market. This renewed hope for a spot bitcoin ETF can be witnessed in the shrinking of the discount to net asset value (NAV) for the Grayscale Bitcoin Trust, tightening from as low as 44% in early June to under 30% at the time of writing. The shrinking of this discount is indicative that some market participants may be viewing the likelihood of a spot bitcoin ETF approval as being more likely over the past month following the new series of filings. As of now, the two known timeframes to watch for more ETF news include the SEC’s response to the Ark and 21Shares filing sometime in August, as well as the Grayscale lawsuit, which is expected to resurface in the Fall.

North Carolina Treasury Will Research Holding Bitcoin as Inflation Hedge

On June 28, a bipartisan bill, HB721, passed the North Carolina House of Representatives that would require a study to review the benefits of holding gold bullion and “virtual currency […] such as Bitcoin” as an effective hedge against inflation and systemic credit risks.¹ The bill directs $50,000 of funds for the study. The study includes understanding the “process of acquiring, securely storing, insuring, and liquidating” assets held on behalf of the state.² The bill also intends to study if bitcoin can “reduce overall portfolio volatility, and increase portfolio returns over time.” The bill must still pass the Senate floor before being signed into law.

Our Two Sats:

The desire to find a solution to US dollar inflation has received bipartisan support. As US Treasury yields rise and the country braces for a potential recession, North Carolina representatives are looking for a haven. With HB721, North Carolina representatives seem to be acknowledging the impact bitcoin could have on a portfolio and its potential as an inflation hedge. Section (iii) of the bill explores the possibility of a privately managed depository or the creation of a State-administered depository in North Carolina to serve as a custodian. This could serve as a more secure and transparent way to store bitcoin through a government-backed custodian for companies in the industry in the US. As for North Carolinians, adopting bitcoin could help to protect the state’s finances during times of economic uncertainty. Even if the bill is not passed, we think this shows a step in the direction of possible future acceptance. With this bill, North Carolina’s representatives are looking to think outside the box and create a state that promotes innovation and economic growth.

Arbitrum Network Halts Due to Sequencer Running Out of Gas

Arbitrum, an Ethereum layer 2 scaling solution, experienced an unexpected halt in its network on June 7, 2023. The halt was attributed to the sequencer, a component responsible for ordering and batching transactions before they are posted to the Ethereum mainnet, running out of gas. Essentially, the sequencer did not have enough funds in ETH to pay for the gas fees required to batch and submit transactions to the Ethereum network. During the halt, users were unable to submit transactions on Arbitrum. Developers quickly addressed the issue by refueling the sequencer with ether and correcting the bug that caused the depletion of ether, allowing the network to resume normal operations after a few hours.³

Our Two Sats:

While layer 2 solutions, like Arbitrum, are crucial for scaling Ethereum and reducing gas fees, this incident shows that they are not without their own set of challenges. This specific event highlights a few issues that are common throughout Ethereum’s scaling landscape.

Firstly, single points of failure significantly degrade the liveness of these platforms. Liveness in this context refers to the guarantee that transactions will make their way to the Ethereum base layer, which provides users with the confidence that their transactions will not be reverted. Secondly, the ability for developers to quickly find and fix the bug that caused the sequencer to run out of gas was a benefit for users in this instance. However, this quick upgradeability comes with its own risks that users need to be aware of as changes to the codebase can be pushed at any time without any delay. For example, if a change to the code is done maliciously or carelessly, it could significantly increase the risk to users of the platform instantly.⁴

The difference in risks of layer 2 vs layer 1 users is still quite large. Although layer 2 platforms have seen significant growth recently, the Ethereum mainnet (layer 1) still proves to be the most pristine execution environment for which users are still willing to pay.

EigenLayer Launches Ethereum Re-staking Protocol on Mainnet

The Ethereum mainnet has seen the launch of EigenLayer, a collection of smart contracts that let Ethereum validators re-stake their ether to secure other networks. The debut took place on June 14, 2023, and its initial staked ether maximum was quickly achieved. Creating a network with the right level of security from the start is a persistent problem that new digital asset networks face. EigenLayer seeks to address this issue. Re-staking ether is the suggested solution, allowing current validators to choose to validate alternative networks using their already-staked ether. The idea that new and current networks might use EigenLayer to borrow from Ethereum's security is a paradigm shift in the ecosystem for digital assets and will fundamentally alter the staking environment.

Our Two Sats:

Allowing validators to get additional compensation for providing security to other applications in the form of staked ether is an obvious value-add to the ecosystem. Re-staking, however, has already established itself as a hotly debated subject within the Ethereum community, with many participants emphasizing the additional threats this may pose to Ethereum's security paradigm.⁵ Even while it is still in its early phases, the protocol is now mostly experimental with less than 15,000 ETH being re-staked. The most intriguing aspect of this issue will be figuring out which specific applications will demand Ethereum's shared security the most and the cryptoeconomic effects that follow.

SEC Enforcement Actions Result in Wave of Token Delistings

A surge of token delistings have occurred in the wake of the recent enforcement actions from the SEC against crypto exchanges Binance and Coinbase. Robinhood announced its plans to delist three tokens, Cardano (ADA), Polygon (MATIC), and Solana (SOL), that the SEC is alleging to be securities.⁶ Users were informed that if they do not withdraw or sell these tokens by June 27, Robinhood will convert them into cash on their behalf. Algorand (ALGO), Decentraland (MANA), Dash (DASH), and Polygon (MATIC) were among the four digital assets that eToro said it will be delisting.⁷ Additionally, defunct crypto lending platform Celsius is looking to convert its altcoin holdings into BTC and ETH due to regulatory worries and to "maximize the value of its assets."⁸

Our Two Sats:

Regulatory actions continue to have real market structure and pricing ramifications. Many seem to be deciding that the potential benefit is not worth the danger of supporting tokens that the SEC considers securities. Unfortunately, many non-BTC and ETH token prices have dropped significantly, likely due to recent regulatory measures and subsequent delistings. Accordingly, bitcoin has seen a rise in its dominance by percentage of total market capitalization among digital assets.⁹ It is also important to note that ether is not included in these regulatory measures. It is unclear whether these enforcement actions on altcoins will relate to ether's security status. With time, the courts may begin to bring some clarity to this topic.

News Quick Hits

• MakerDAO purchases $700 million in Treasury bonds, growing holdings to $1.2 billion¹⁰
• U.S. House Financial Services Committee will vote on digital asset and stablecoin legislation in July¹¹
• Bitcoin miners send record $128 million in revenue to exchanges¹²
• Riot Platforms adding 33,280 bitcoin miners in anticipation of 2024 halving¹³
• Digital asset investment products see largest weekly inflow since July 2022, totaling $199 million during the week of June 19¹⁴
• Brooklyn Bathhouse reveals that it is using Bitcoin mining rigs to heat its spa¹⁵

Data to Watch

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

Current Cycle Continues on Similar Path to Prior Ones

The current drawdown from bitcoin’s previous all-time high in November of 2021 continues to display characteristics like those seen in cycles of the past. In the prior two cycles, bitcoin traded down for roughly a year, followed by another year of sideways price action. Thus far, the price of bitcoin traded down 75% over the course of roughly one year and has trended slightly upwards in 2023 while still being down over 50% from the previous all-time high. Past performance is certainly no indication of future returns, but this cycle has seen price action that is reminiscent of prior ones so far. For these reasons, this is a chart that we have and will continue to monitor moving forward.

Exchange Balances Have Fallen Roughly 25% since the Third Halving

Shown here is the aggregate bitcoin exchange balance separated by epoch, a four-year timespan between each halving event. The first epoch starts at the inception of bitcoin; however, the exchange balance metric does not start until 2011.

Since the exchange balance peak of 3.2 million bitcoin on March 12, 2020, bitcoin has been steadily leaving exchanges at a rate of roughly 673 bitcoin per day. This peak occurred around the start of the COVID-19 virus concerns. However, with the world starting to return to a relatively “normal” pre-COVID state, exchange balances have continued to fall. Using data from the day of the third halving event, May 11, 2020, until time of writing, exchange balances have fallen roughly 25%.

The most interesting thing surrounding this metric is not that bitcoin is leaving exchanges, it is the combination of bitcoin leaving exchanges and the fourth halving estimated to occur in roughly nine months. The halving event will reduce bitcoin’s issuance rate from 6.25 bitcoin per block to 3.125 and will effectively lower bitcoin’s inflation rate from 1.8% to 0.9%. This combination increases the chances of a supply shock and, in turn, creates an environment ripe for extremely volatile price action. From the 2020 peak to today, exchange balances have fallen roughly 29% from 3.2 million bitcoin to 2.26 million bitcoin. The newly minted issuance of bitcoin will inevitably be reduced by the network at a time where adoption and demand are increasing.

Read more about the halving event and what it entails here.

Ethereum Active Validator Count Continues to Increase

The active validator count has recovered from its previous stall when major institutions, such as Kraken, were unwinding their staking platform. The number of active validators has increased roughly 29% YTD, 15% of that being in Q2 2023. Validators commonly require 32 ether to be staked on the network as proof of goodwill that the validator will not act against the consensus. The metric to watch since the Shanghai upgrade was implemented is the number of active validators. Interestingly, the maximum percentage change in active validators is currently around 0.3% because the entry and exit queue is roughly 1,800 validators per day. This means that if all staking participants decided to unstake at once, they would be required to participate in consensus until the network accepted their request. It is important to note that, as validators leave the network, the individual staking reward increases. This “incentive pendulum” aims to maintain an equilibrium between security and issuance.

In Case You Missed It

Bitcoin’s halving event is now less than a year away. The rate at which new bitcoin is issued to miners will be cut in half for the fourth time in the network’s history, currently estimated to take place in April of 2024. In our latest Education & Insights piece, Research Analyst Daniel Gray covers everything our readers should know heading into this notable event, including a technological overview of the halving, its relevance as a security threat to Bitcoin, its impact on the network’s token supply curve, whether the halving can be priced in or not, and more!

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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℠