Research Round-Up: June 2023

The Research Round-Up On-Demand

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

Market Commentary

In May, digital assets bitcoin and ether found resistance around $30,000 and $2,000, respectively. Bitcoin fell approximately 7.3%, while ether fell just under 1%, closing the year-to-date gains with bitcoin up 8% more than ether. This results in a year-to-date appreciation of 65% for bitcoin and 57% for ether.

The Fed remains steadfast in its fight against inflation. Fed Chair Jerome Powell has signaled the potential for two additional rate hikes in the second half of the year following a recent decision to pause in June. Elsewhere, the largest stablecoin issuer, Tether, announced plans to diversify its reserves into bitcoin, and the Ethereum main net faced issues finalizing transactions.

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.

SEC Sues Binance, CEO Zhao, and Coinbase

The U.S. Securities and Exchange Commission (SEC) filed suit against Binance Holdings Ltd. and their CEO, Changpeng Zhao “CZ,”¹ in what would later be seen as the first of two major enforcement actions against the digital asset industry from the agency in June. The SEC has made several allegations, which amount to 13 separate charges, including operating an unregistered exchange, broker, and clearing agency, selling unregistered securities, including BNB, BUSD, and crypto-lending products, failure to restrict U.S. investors from accessing the international platform, and misleading investors. The SEC also claims that Binance.US redirected billions in customer assets to investment funds, which were controlled by CZ. On Wednesday, June 14, a federal judge rejected the SEC’s request to freeze assets on Binance.US, instead ordering the crypto exchange’s U.S. affiliate and the SEC to begin negotiations² on business operations restrictions as the regulator’s case continues. In a June 5 statement, Binance responded by saying they’re “disappointed” by the SEC complaint, claiming that it “aims to Unilaterally Define Crypto Market Structure,” and that Binance will vigorously defend against “any allegations that user assets on the Binance.US platform have ever been at risk.”³

Just one day after filing a lawsuit against Binance and its founder, the SEC also filed a lawsuit against US-based Coinbase for alleged securities violations.⁴ In its complaint, the SEC said Coinbase acts as a broker, national securities exchange, and clearing agency, which are traditionally segregated functions that require registration. The Commission claimed that Coinbase has never registered with the SEC for these functions and, thus, has evaded the disclosure regime that Congress has established for securities markets. The complaint additionally targets Coinbase’s staking-as-a-service offering, referring to it as an unregistered investment contract. The SEC specifically claims multiple tokens offered on Coinbase are securities, including SOL, ADA, MATIC, FIL, SAND, AXS, CHZ, FLOW, ICP, NEAR, VGX, DASH, and NEXO. In a response, Coinbase’s Chief Legal Officer criticized the SEC’s regulation by enforcement approach, saying it is “hurting America’s economic competitiveness,”⁵ and that the company would continue to operate business as usual despite the complaint. Coinbase CEO Brian Armstrong defended the company’s methodology for listing assets and said the lawsuit against his firm “could really not be more different”⁶ than the lawsuit against Binance, calling it a “technical matter” around which assets fall under the scope of established securities laws. Coinbase’s stock experienced significant volatility following the news with Moody’s downgrading its rating to negative and others cutting their price targets, while Cathy Wood’s Ark Invest continued to add to its position, purchasing an additional $21 million in shares.

Our Two Sats:

While we are not experts in the interpretation of matters of law, the lawsuit against Coinbase appears to more simply be pertaining to questions surrounding securities laws, whereas the Binance suit appears to be another matter entirely.

After the SEC sent Coinbase a Wells Notice this spring, it became clear that, after months of speculation, the exchange was going to be the target of SEC enforcement action. Based on the Notice and other enforcement actions, including against fellow exchange Kraken, we knew Coinbase’s staking offering was going to be at the core of the SEC’s complaint. The Commission’s current interpretation of which crypto assets constitute securities is aligned with recent comments by SEC Chairman Gensler. However, the upcoming litigation battle between Coinbase and the SEC will potentially dictate a precedent for the fate of the industry and the U.S.’ position as a global innovator in the space. We will be closely monitoring how these cases develop.

Lightning Labs Proposes a Protocol to Help BRC-20 Efficiency

Lightning Network infrastructure firm Lightning Labs has been openly displeased with the current implementation of BRC-20 inscriptions. In a public blog post, Lightning Labs shared their admiration for developers building on bitcoin; however, they also note that the current method of writing metadata directly into the blockchain is dreadfully inefficient.⁷ They go on to propose the use of the Taproot Assets Protocol, formerly known as “Taro,” a protocol that was designed to operate maximally off-chain, as a sufficient solution. According to the post, the protocol would enable a limitless number of assets to be minted and/or transferred in a single on-chain transaction. This would then enable developers to integrate these BRC-20 tokens directly into the Lightning Network, allowing for extremely low transaction costs and, more importantly, help users avoid network congestion and high fee markets associated with high block space demand.

Our Two Sats:

This is a welcome development from Lightning Labs as we have written previously about the high fees associated with the new BRC-20 tokens. Whether or not BRC-20 tokens go against the original vision for Bitcoin as peer-to-peer money has been a common discussion within the community recently, especially as the fee market increased along with the craze. However, we don’t think it should be up to one person or a select group to decide who or how the network should be used. By implementing BRC-20 tokens with the Taproot Assets Protocol, both parties can be satisfied. Users would be able to use the Lightning Network to mint new tokens, buy and sell, and transfer these tokens in an extremely efficient manner. All things equal, the layer 1 Bitcoin users would get their low fee market back and the adventurous users would be able to experiment and trade in a new ecosystem in a more cost-effective way. A question worth proposing, though, is how this affects the miners’ fee revenue. Recently, miners have realized their highest fee-to-block-reward ratio in years with a few blocks including more fees from transactions than the current subsidy of 6.25 bitcoin (roughly $169,000 at $27,000 per BTC). If developers continue to move transactions off the base layer, where does the fee market go from there?

Tether Announces Plans to Invest up to 15% of Profits in Bitcoin

Tether, issuer of the world’s largest stablecoin by market cap, announced plans to invest up to 15% of its profits in bitcoin.⁸ The announcement revealed the company would regularly allocate a portion of its profits into bitcoin monthly and self-custody all holdings. The company also said the move would help diversify its reserves beyond cash, cash equivalents, and other short-term deposits, while aligning the company with a “transformative technology that has the potential to reshape the way we conduct business and live our lives.” In a statement, the company said, “Bitcoin has continually proven its resilience and has emerged as a long-term store of value with substantial growth potential. Its limited supply, decentralized nature and widespread adoption have positioned Bitcoin as a favored choice among institutional and retail investors alike."

The firm stated it does not anticipate bitcoin holdings to exceed the value of their Shareholder Capital Cushion or the assets it owns beyond those backing stablecoin supply. At the end of the first quarter, Tether held $1.5 billion or 2% of its reserves in bitcoin. The move comes as other stablecoin issuers, including Circle, made moves to limit exposure to U.S. government debt instruments in fear of a potential U.S. government default before the debt ceiling was raised again.

Our Two Sats:

This isn’t the first time there have been attempts to collateralize a stablecoin with bitcoin. The embattled algorithmic stablecoin ecosystem Terra/Luna held around $2.5 billion worth of bitcoin just before breaking its peg in May of 2022. Those questioning the viability of Tether’s move to invest in bitcoin might point to the ultimate collapse of the Terra/Luna ecosystem as reason not to allocate reserves into bitcoin. However, it is important to note that there are significant structural differences between USDT (Tether) and now-defunct UST (TerraUSD). UST was an algorithmic stablecoin, meaning it artificially maintained its peg to the U.S. dollar through a supply/demand balance between the stablecoin and its governance token, LUNA. Tether, on the other hand, is a fully collateralized stablecoin, meaning there is one unit of fiat currency held at a custodian for every token minted. Fully collateralized, fiat-backed stablecoins are inherently less risky given the relative simplicity of their design.

As stablecoin issuers contend with market factors, such as the banking crisis and uncertain regulatory landscape, Tether has needed to get more creative in how they are managing their reserves. It is not surprising that Tether has made the decision to increase its allocation to bitcoin because many of the asset’s design attributes are intended to address these issues. While the events of 2022 have put pressure on bitcoin’s price, it is important to recognize that the market turmoil never impacted the Bitcoin network’s function and that boring predictability looks more and more attractive in an increasingly uncertain world.

CFTC Chair Says DeFi Exchanges Will Be Regulated

Commodity Futures Trading Commission (CFTC) Chair Rostin Benham said that DeFi exchanges are still subject to regulation, despite operating autonomously.⁹ His comments were made during an interview on Bloomberg’s ”Odd Lots” podcast and, when asked if regulation could be applied to DeFi exchanges, which typically operate with very little human oversight, he said “It’s easy to suggest, ‘Oh there’s no institution, there’s no individual, it’s just code, you can’t regulate that, it’s self-effectuating,’ but that really is the wrong set of questions. It’s really about what are U.S. customers being offered and exposed to? And who is either the individual or group of individuals who set up that entity, that code, to offer those products?” Benham also said that the CFTC would continue to rely on existing regulations and legal precedent to drive their legal assessments around assets considered commodities. While the Chair believes crypto is covered under existing U.S. laws, he said, “there are certainly many characteristics which are unique and, I think, demand a unique set of thoughts and policy ideas about how and whether we should regulate it,” including the question of whether a token launched as a security can evolve into a commodity over time due to decentralization.

Our Two Sats:

The Chair’s comments sound consistent with those of other U.S. regulators, including SEC Chairman Gary Gensler, that many aspects of the digital asset ecosystem are covered under existing U.S. laws. The SEC and CFTC came under pressure following the collapse of many centralized providers, such as BlockFi, Voyager, and FTX and have been focused on bringing more regulation to the space ever since. It is not surprising that they are using the levers at their disposal to try to control the industry.

The U.S.’ approach to regulate the space is not the comprehensive regulatory framework the industry has been asking for and has put increasing pressure on the U.S. to maintain its position as a leader in innovation. In recent weeks, we’ve seen countless examples of companies backing away from the U.S. market, while launching new products and services abroad. It would not be unreasonable to expect that trend to continue as long as this regulatory uncertainty exists, especially with landmark regulatory frameworks being passed, such as the European Union’s MiCA.

Ethereum’s First Inactivity Leak

The Ethereum blockchain failed to finalize for nine consecutive epochs, or about an hour, on May 12, 2023, which caused the network to enter a specialized mode called the “inactivity leak” for the first time ever. This mechanism is designed to restore finality during times of large-scale validator failure.¹⁰ This emergency network state alters validator rewards and penalties to recover finality if over one-third of validators go offline. In general, the inactivity leak gradually reduces the stake of validators who are not participating in consensus until participating nodes control at least two-thirds of the remaining stake.

For an epoch (a set of 32 blocks) to be considered final, it requires two-thirds of all validators to vote on the same set of blocks. Once an epoch is finalized, users can be assured that the economic cost of reverting transactions within the finalized set of blocks is at least one-third of all staked ether.

Finality is important in adversarial systems because it ensures that transactions are immutable and cannot be reverted. In Ethereum’s case, this assurance is provided economically. That is to say, to revert a transaction that has finality, malicious validators would need to destroy at least one-third of all staked ether. Therefore, we say Ethereum has economic finality as opposed to Bitcoin’s probabilistic finality.

Our Two Sats:

Ethereum entering an “emergency state” is certainly good for making headlines. However, the two waves of finality loss that occurred in May lasted less than an hour and users were largely unaffected. Some services chose to extend confirmation periods associated with Ethereum transactions during these times in case blocks were reverted and transactions cancelled. Overall, the network continued to run as designed and it happened to be specific client implementations that were causing some nodes to be overworked, which briefly prevented them from participating in consensus. Once the root cause was identified, Ethereum core developers put in quick fixes to avoid this type of computer overload in the future and, thus, marks the conclusion of Ethereum’s first, relatively uneventful, inactivity leak.

In summary, client diversity, or having multiple implementations of the Ethereum protocol running simultaneously, prevents large network outages and is a significant factor supporting Ethereum’s resiliency as seen in May. However, technical risk is always present and should be factored into user and investor decisions. While software bugs can have immediate implications on network health, we see that regulation could have similar impacts in terms of taking large amounts of the validator set offline. Therefore, geographic dispersion of validators should be considered a high priority for investors and node operators alike. In our view, how certain jurisdictions handle the upcoming digital asset movement will have direct impacts on Ethereum’s network health and is a topic we will be watching closely.

News Quick Hits

• Bitcoiners celebrate 13th anniversary Bitcoin Pizza Day, the first documented purchase of good with BTC¹¹
• Digital payment service Venmo introduces new feature enabling cryptocurrency tranfers¹²
• Crypto-friendly Cross River Bank faces crackdown from FDIC over "unsafe or unsound banking practices"¹³
• BlockFi asks bankruptcy court for permission to begin liquidating lending business after failing to sell platform¹⁴
• Ethereum developers release updates for Prysm and Teku clients after recent beacon chain finality issues¹⁵
• PayPal customers' crypto holdings closing in on $1 billion comprising primarily of bitcoin and ether¹⁶

Data to Watch

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

Address Momentum Down while Transactions Rise

Bitcoin’s address momentum, calculated using a shorter-term moving average of 30-days compared to its yearly moving average, has historically given additional insight into current market sentiment. Expansion of new addresses indicates healthy network vitals as users’ transactions commonly create new addresses, reflected in the short-term moving average. Earlier this month, that short-term average fell below the longer-term average, indicating that users have stopped transacting and, thus, new addresses are not being created.

However, when we look at on-chain data for these transactions, the opposite is true. The 14-day moving average of transactions peaked at just over 570k transactions on May 19. To put that into perspective, the peak was 111% higher than the two-year average.

One of the reasons for this discrepancy between new addresses and transaction count could be that transactions that create new addresses by default are no longer the main type of transaction. In other words, BRC-20 related transactions are currently the main type of transactions. In addition, BRC-20 token transactions have been pushing up fees as users bid for more block space. The competitive fee nature for block space pushes out transactions unwilling to pay higher fees. Another reason could be address re-use. It is common for wallets to use new addresses when transacting; however, that may not be true for the new wallets coming online to support the new BRC-20 tokens built on Bitcoin.

While we are seeing a drop in new addresses, transaction count remains high. In turn, bitcoin miners have seen an increase in revenue, incentivizing and sustaining more hash rate.

S&P 500 Correlation

The correlation between digital assets and traditional equity markets, measured here using the S&P 500, has fallen to its lowest levels in over a year and a half. The increase in correlation during early 2022 that saw bitcoin rise alongside other risk-on assets was largely an outlier compared to much of bitcoin’s history. It remains to be seen whether this “return to norm” will last or if crypto will find itself in the correlated risk-on bucket in its near future again. Over the longer-term, one would expect that bitcoin and digital assets should regularly trade separately from traditional risk assets given their independent nature as an alternative asset class. Additionally, the correlation between bitcoin and ether has reached its lowest level of 2023. While it is likely premature to expect a decoupling in the digital asset markets at this juncture, each network may be forced to survive on its own merit in due time and its fate will be determined by its own unique use case and adoption.

In Case You Missed It

As the first smart contract network, Ethereum introduced groundbreaking blockchain technology that let developers build a growing wave of new user applications. Today, Ethereum must battle against an increasing number of competing smart contract layer 1 ecosystems. Scalability is arguably the primary axis in which Ethereum must fight to maintain its stronghold on crypto users. Alternative blockchains, which can offer lower settlement times and cheaper transaction costs (better scalability), could be seen as a threat to Ethereum’s dominance. In our latest Insights & Education piece, Research Analyst Jack Neureuter breaks down the coming upgrades to Ethereum’s scaling roadmap and the potential these solutions may have for the network’s future.

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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