Research Round-Up: May 2023

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

Digital asset price activity in April may appear understated when simply looking at the month-over-month changes. Bitcoin gained just over 3% while ether increased around 3.5%. However, throughout April, bitcoin moved as much as 10% in both directions as did ether as much as 18%. This leads to about a 77% year-to-date bitcoin price appreciation and 57% year-to-date ether appreciation.

The most prominent catalysts for these price movements could be attributed to the continued banking system fragility that underscores many potential benefits of alternative decentralized financial networks. The Federal Reserve raised interest rates another 25 basis points on May 3 in its attempt to fight inflation and only time will reveal the stress this rapid financial tightening may afflict across financial markets. Elsewhere, Ethereum’s Shapella upgrade took place on April 12, allowing validators to unlock their staked ether and any accrued rewards, permitting their staked ether to become liquid.

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.

Source: Coin Metrics, 04/30/2023.

Notes from the Field

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

Consensus 2023, Austin TX

Consensus is an annual event hosted by CoinDesk that brings together digital asset community members from across the globe including developers, investors, founders, institutions, policymakers, innovators, and influencers. For the second year in a row, the event was held in Austin, Texas and brought together all sides of DeFi, blockchain, digital assets, Web3, AI, and the metaverse. Occurring between April 26-28 after a tumultuous year for digital assets, it was promising to see so many enthusiastic minds remain optimistic for the industry’s future and the incredibly transformative potential of the underlying technology that powers it. The following are some of our key takeaways from the three-day conference.

The Graph

The panel provided by The Graph required some basic developer and systems understanding to follow along. Regardless, the general understanding was that The Graph, and many others, are providing permissionless public goods for developers, users, and hobbyists with which to interact. Whether that be to exchange value, protect the overall network, or in The Graph’s case, query smart contract data, the digital assets ethos continuously supports the community with public goods. The next most important topic then becomes that of public goods funding. For many projects, it can be difficult to continue to support public goods in a way where they are sustainable. It is a topic we will not dive into in this piece, but Vitalik Buterin in October 2022 shared an interesting way of analyzing how to prioritize public goods funding.

Pooja Ranjan: Protocol Governance in Ethereum

In this panel, Pooja Ranjan (Herder in Chief of Ethereum Cat Herders) addressed the common critique that claims "All Core Devs decide the upgrade proposals.” Her talk provided insight into the structure in which Ethereum governance has evolved over time to encourage participation in a permissionless fashion. In 2019, the Ethereum Cat Herders group was created to support developers with project management and process improvements. They gradually formalized and improved the mechanisms in which decisions were made, and in the current state, anyone can join every single part of the proposal process, which includes:

1. The formal Ethereum Improvement Proposal submission (EIP)
2. Official discussion forum – Ethereum Magicians
3. Developer Meetings

Steps one and two funnel into developer meetings where EIPs’ original authors can join and discuss prioritization, specifications, and gather feedback for future implementation. Since the core developers are the ones pushing the upgrades, it may seem from the outside that all the decisions on the roadmap and design come from them. However, every step in the proposal process before final delivery is open for community collaboration. In our opinion, the most centralizing force in this process may be the complexity of Ethereum itself. It is not an easy task developing a world computer with aspirations of providing decentralized, secure code execution on a large scale and this may be the largest reason why everyone is unable to contribute; but nonetheless, the door is open to all.

Overall, Consensus 2023 saw a strong turnout despite the industry downturn exacerbated by the events of 2022. Despite industry headwinds, such as lower asset prices, contentious regulatory actions, and high interest rates, the long-term thesis and core principles underlying digital assets remain unchanged. Digital assets were founded upon principles of transparency, resiliency, reliability, decentralization, censorship resistance, and, above all, hope. With these principles at the forefront, we look forward to following the developments of this nascent industry in 2023.

Bitcoin Policy Institute

Fidelity Digital Assets Director of Research, Chris Kuiper, had the privilege of attending the inaugural Bitcoin Policy Institute Summit¹ in Washington, D.C. on April 26, where he also moderated the first panel of the day, “What Makes Bitcoin Unique Among Cryptocurrencies.” The panel featured four different academics who have been writing on this subject and emphasized how Bitcoin is the most neutral among all digital assets due to its founding and history, network effects, governance, mining process, and even distribution. The event, described as a “policy conference exploring Bitcoin as a strategic opportunity for the United States,” also featured topics, such as how Bitcoin can be used to promote human rights, how the U.S. could view Bitcoin through the lens of geopolitics and to achieve strategic goals, and how Bitcoin mining can be used to strengthen the U.S. energy grid and fund upgrades. We particularly enjoyed the keynote speech by Strike’s Jack Mallers, who repeatedly emphasized that the Bitcoin network should be viewed as a public infrastructure that can move value globally, just as the Internet does for information. 

News and Editorial

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

JPMorgan Acquires First Republic Bank as Regional Banking Woes Continue

Struggling regional bank First Republic Bank (FRB) has been seized by regulators and sold to global banking powerhouse, JPMorgan Chase, after initial rescue efforts failed. Additional signs of trouble for FRB became apparent on April 26 when news initially broke about a government receivership, after which shares of FRB plummeted around 20% following the announcement. The ensuing days only displayed more stock price volatility before regulators stepped in to close the bank. The bank was placed under the FDIC’s receivership after the California Department of Financial Protection and Innovation closed it on May 1.² 
Consequently, the FDIC entered into a purchase and assumption agreement with JPMorgan to protect depositors. Under this agreement, JPMorgan will assume all assets and deposits of First Republic Bank, including all uninsured deposits, which respectively stood at $229.1 billion in assets and $103.9 billion in deposits as of April 13. A loss-sharing agreement was arranged between the FDIC and JPMorgan for residential and commercial loans acquired by FRB, meaning any losses and recoveries on the loans covered by the loss-share agreement will be split between the FDIC and JPMorgan. Additionally, 84 FRB locations in eight states will reopen as JPMorgan Chase as part of the transfer agreement and all depositors of FRB will also become part of JPMorgan and have access to their total deposits, which are insured by the FDIC.

Our Two Sats:

Another domino has fallen in the wake of the regional bank fallout as First Republic has joined Silvergate Bank, Silicon Valley Bank, and Signature Bank on the list of 2023 U.S. bank failures. As the second-largest bank failure in U.S. history and the fourth major collapse of 2023, we will be watching closely to see how systemic this trend becomes. In relation to digital assets, this news underscores two major proponents of Bitcoin’s value proposition. The first: bitcoin has the potential to be a monetary policy hedge, as only 21 million bitcoin will ever be mined into existence. This, coupled with the exacerbated second order effects of insuring the bank deposits, likely points towards more monetary expansion in the future to service these debts, and thus, monetary debasement. Bitcoin’s supply is pre-programmed and fixed, compared to fiat money, which is not—supporting bitcoin’s value proposition as a scarce asset. Additionally, this news highlights bitcoin’s potential use case as a store of value. It remains to be seen whether Bitcoin will receive increased interest from this most recent failure, but Bitcoin’s underlying value proposition was founded upon ideals that seek to provide an alternative to these very challenges of the legacy financial system.

US House of Representatives Introduces New Stablecoin Bill Draft

The House Financial Services Committee has released a new bill draft to provide a regulatory framework for stablecoin issuers in the U.S.³ Discussions were initially stalled before the midterm elections due to bipartisan congressional differences, but restarted after a new Congress convened in January. The bill draft was reintroduced in April and another new draft, which was about half the length of the original, was released on April 24.

The most recent draft aims to focus on rules overseeing the registration and approval process for forthcoming stablecoin issuers. The draft builds upon many of the stipulations discussed in prior proposals of the bill, including requirements that payment stablecoin issuers are to be approved and regulated by either a federal payment stablecoin regulator or a registered state qualified payment stablecoin issuer. To gain approval as an issuer, a stablecoin provider would need to meet reserve capital requirements and provide monthly disclosures of their reserve portfolios. Additionally, the draft specifies and updates U.S. law to confirm that stablecoins are not securities and therefore should not be regulated by the SEC. Despite the majority of states not yet having a stablecoin regulatory framework in place, the new draft proposes a larger market oversight from state regulators. Additionally, the new version seeks to give state regulatory agencies more leeway around the specific requirements for approval of prospective stablecoin issuers on the condition that these requirements meet a basic standard defined in the federal legislation and allows states more time to investigate and settle any potential noncompliance issues that emerge from those states’ approved stablecoin issuers.

The latest draft would require an issuer of a payment stablecoin to be a subsidiary of an insured depository institution (IDI), a federal qualified non-bank payment stablecoin issuer, or a state qualified payment stablecoin issuer. The appropriate federal regulator for the insured depository institution would have supervisory and regulatory authority over any IDI subsidiary authorized to issue payment stablecoins. The Federal Reserve Board or Office of the Comptroller of the Currency would have sole supervisory, examination, and regulatory authority over non-bank stablecoin issuers. The appropriate state regulator would have primary supervisory, examination, and regulatory authority over state qualified payment stablecoin issuers, and the Federal Reserve Board would have certain backstopping powers. Additionally, certain requirements, such as those related to reserves and redemptions, would apply to all three categories of issuers as a matter of law. Other requirements related to capital, liquidity, and risk management would only apply to the first two categories of issuers and would be implemented through rulemaking.

The most recent version was led by committee Republicans and was described as a starting point for conversations about stablecoin regulation with House Democrats, the Senate, and the White House in the coming months. It is not yet apparent what the next step for the legislation would be, or when it might be formally introduced in the House, but the draft has yet to receive any Democratic support.

Our Two Sats:

For much of the digital asset industry, regulatory ambiguity has remained a constant source of struggle. It is encouraging to see progress being made on this front to provide a relative stablecoin framework off of which industry participants may build. It is not surprising to see some of the specific guidelines presented in this bill given the events that occurred during and after the Terra/Luna algorithmic stablecoin fiasco in May of 2022 where the TerraUSD (UST) stablecoin broke its 1:1 peg to the U.S. dollar.

Since the draft proposes to give the Federal Reserve or Office of the Comptroller of the Currency (where applicable) oversight of non-bank issuers, it would not be surprising to see difficulty for these issuers obtaining approvals. Regulators have historically been unaccommodating towards non-traditional institutions, such as Custodia Bank, when it comes to gaining appropriate regulatory approval. While historical actions are no indicator of future ones, it would be unreasonable to expect a different treatment for stablecoin issuers.

The desire to regulate digital assets and, more specifically, stablecoins has received bipartisan support. However, the role of federal regulators and how to appropriately protect investors remain points of contention. It would not be unreasonable to expect members to introduce additional bills building off this one, however, few are likely to imminently become law given Congress’s bipartisan divide. This latest bill draft relies on consensus opinion over the role of state regulators having oversight over stablecoin issuers and it remains to be seen what kind of support or opposition it will get. While the future direction of stablecoin legislation remains ambiguous, we hope that the framework surrounding potential future stablecoin issuance will be built around core digital asset foundations of privacy, trust, and transparency.

Shanghai/Capella Upgrade Caps The Merge

A hard fork of Ethereum occurred at block number 17,034,870 at 6:27 p.m. ET on April 12.⁴ The code upgrades included changes to both Ethereum clients, which is the reason for the dual-naming convention. The upgrade to the execution client was named Shanghai, while the upgrade to the consensus client was dubbed Capella. The major code changes to these clients were to allow withdrawals to be processed, which effectively completed the last missing piece of the validator life cycle.

Fun Fact: Historically, upgrades to the execution client have been based on Devcon city locations, while the consensus client upgrades have been named after astrological stars.

Shortly after the hard fork, the network saw a drop in overall performance with many nodes experiencing high latency and missed block proposals. These issues turned out to be short-lived with network performance jumping back to normal levels within 24 hours. Overall, the code change was a success as the network immediately started correctly processing withdrawals and address changes, new operations that were just introduced in this hard fork.

As of May 7, some notable observations include:

1. The top-three entities executing full withdrawals are centralized exchanges: Kraken, Binance, and Coinbase.⁵
2. Active validator count has remained at 561,655 since April 14 as validator entries and exits have been at their maximum churn with 1,800 exits and 1,800 entries occurring per day.⁶
3. Currently, the activation queue, or those wishing to become a validator, is at 29,000, while the exit queue is just about exhausted at 113 validators.⁷

Our Two Sats:

The above observations support the narrative presented in our previous Shanghai/Capella piece in which we proposed that validator exits and selling pressure would be limited due to a large portion of the market already having liquidity through liquid staking tokens as well as many validators having unrealized losses compared to the time they began staking. Additionally, the increase in capital efficiency that this upgrade provides (allowing nodes to access accrued rewards) would spur many successful validators to re-stake their previously dormant earnings. Look out for an upcoming research piece where we will take a closer look into the upgrade and what we’ve seen from on-chain data one month post-Shanghai/Capella.

Memecoin Mania Exposes MEV

A surprising highlight in April was the elevated level of meme-tokens popping up on Ethereum. The exchange-listings of several ERC-20 tokens on Ethereum seemingly spurred notable social interest and price action. The meme coins on Ethereum that have seen large price increases include Pepecoin and Wojak, increasing 1,329% ⁸ and 111%⁹ respectively in April. More interestingly, the popularity of these tokens among retail traders allowed entities (searchers) to extract millions of dollars using controversial MEV (maximal extractable value) strategies, such as sandwich attacks, where these searchers profit at the expense of uninstructed traders.

Our Two Sats:

In the Ethereum world, all eyes were on searchers as they extracted immense value from traders playing into the meme-token hype. While it’s an industry standard in traditional finance to ensure best pricing for user trades, the digital assets ecosystem hasn’t yet matured enough to this point. In fact, the business model of many of these searchers, often called MEV bots, is to look for transactions in the mempool that carry some profitable opportunity and execute transactions around them to capture value. Exchange-to-exchange arbitrage is the most common form of value extraction and is typically thought of as a benign form of MEV that results in narrow price spreads across platforms. On the other hand, sandwich attacks and frontrunning in digital asset is widely viewed as destructive. These harmful types of value extraction methods reward well-capitalized, sophisticated actors at the expense of normal users, preventing them from getting fair pricing.

There are simple solutions for users to avoid these harmful types of value extraction on-chain, two of which launched in April 2023. Flashbots released a beta program called MEV-Share¹⁰ on April 21 and a group of 27 entities across the digital asset ecosystem launched MEV Blocker¹¹ on April 5. Both programs are designed in a way such that they provide protection against harmful forms of value extraction and use auction mechanisms that incentivize searchers to reimburse any extracted value back to the user. These efforts are a huge step for the industry as they more closely align with the ethos of providing best execution to traders that we’re accustomed to in traditional finance. Additionally, these services allow users to transact on-chain more safely without needing to understand the intricacies of MEV, providing a huge improvement to the user experience. 

News Quick Hits

• Block has completed the design of its new prototype ASIC chip that the company claims will democratize an open-source Bitcoin mining rig design.¹²
• Cathie Wood-led ARK Invest and European crypto investment firm 21Shares together file with SEC for U.S. spot Bitcoin ETF for third time after two prior rejections.¹³
• Argentina securities regulator has approved a Bitcoin-based futures index, which aims to start trading in May.¹⁴
• The U.S. Treasury Department published an illicit finance risk assessment report focused on DeFi.¹⁵
• Marathon Digital reported a quarterly record of 2,195 bitcoin mined over the first quarter of 2023 worth roughly $62 million.¹⁶
• Glassnode data shows the Bitcoin Lightning Network is 1,000x cheaper than Visa and Mastercard.^17z

Data to Watch

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

Ordinal Text Inscriptions (BRC-20) See Explosion in Demand

The once-ossified Bitcoin fee market has been anything but that in recent months with the advent of ordinals. Now that users can attach arbitrary data to specific satoshis, users and developers have found interesting new ways to interact with the protocol and exchange value. Memes seem to be as alive as ever with some of the top text-based inscriptions being “pepe,” and of course, “meme.”¹⁸ This has caused bitcoin transaction volumes and network fees to skyrocket. Bitcoin’s transaction count waiting in the mempool has risen to roughly 170,000. To put that in perspective, today’s transaction count is 2,000% higher than the beginning of the year. Whatever the ethos of Bitcoin, the market ultimately decides what transactions are most valuable and the month of April was full of inscriptions. Whether this interesting technology development grows legs or dies out over the next few months will be something to watch. New innovations may continue to arise from past upgrades, such as Taproot. Will developers be looking at Bitcoin through a new lens as the protocol looks to be more fertile for development than previously thought?

It is also worth noting that ordinal transactions have not been a high percentage of block space until recently. The first week of May brought total block space bought by ordinal transactions to above 50%.

Ethereum Now Has More Validators Wishing to Stake than Unstake

Source: Glassnode, 05/07/2023.

Looking at validator entries and exits can help us gauge short-term sentiment around staking ether. An entry queue forms if there are more than 1,800 nodes per day looking to begin validating, while an exit queue forms if there are more than 1,800 nodes per day attempting to stop validating. Highlighting the chart above, we can see the network has been at maximum validator churn for both entries and exits since roughly April 13. However, the number of Ethereum validators waiting to unstake and withdraw their ether and accrued rewards (exit queue) is now less than the number of those waiting to stake ether (entry queue). After a successful Shapella upgrade, this may signal that validators are comfortable enough with the upgrade and unstaking process that they instead wish to stake their ether and use it as a productive asset. Heading into May, the exit queue has nearly depleted with the latest data showing only 113 validators over the churn limit.

Trend Reversal for Long-Term Investors

At the end of Q1 2023, we noticed that longer-term investors were slowly letting off the gas and the metric tracking their net purchases was trending lower. However, the last day of April showed a strong reversal in this trend. Recent data shows a substantial increase in purchases on April 30. This could mean that long-term investors took profits around the $30,000 level and are starting to accumulate again. The last time the net position was negative was when bitcoin’s price dropped below $16,000 and stayed negative until December 18, 2022. It may be meaningful to note that the last day of April included a net change of 38,925 bitcoin, 121% higher than the month’s average of roughly 17,606 bitcoin per day. May 1 closed with a net change of 41,795 bitcoin, possibly signaling the start of long-term investors' accumulation.

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 Q1 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