Research Round-Up: November

Watch Now: Fidelity Digital Assets’ Research Director Chris Kuiper and Analyst Jack Neureuter provide additional commentary and market insights in this short on-demand video.

Market Commentary

Source: Coin Metrics, 10/31/2022.

The price of bitcoin increased about 5.4% for the month of October. Ether had a more significant rally of around 18.4%. The S&P 500 also was in the green this month, gaining approximately 7.2%. In this month's update, we'll look at the impact of The Merge on ether issuance and the latest news and data that has been affecting digital asset markets in recent weeks.

News and Editorial

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

Ethereum’s Deflationary Streak Sparked by Speculative XEN Token

Ether’s total supply dropped by 0.005% over the month of October or roughly 6,500 ether (ETH), beginning its deflationary course on the eighth of the month.¹ This sudden change in the trend of issuance was, at first, due to a spike in transaction volumes for minting XEN tokens. XEN token is an ERC-20 token built on Ethereum with an uncapped supply structure. Its utility characteristics are unclear, as currently the only feature of the project is minting new tokens into existence. XEN token minting contracts accounted for roughly 12% of all ETH burned during the month and, at its peak on October 9, was responsible for 46% of all transaction fees burned on that day.^2,3 Shortly after this peak, it became known that a hacker had been able to mint XEN tokens for free due to an exploit of FTX’s hot wallet. The hacker was essentially stealing money from FTX to pay the gas fees required to mint the tokens. Since this exploit became known, the amount of ether being used to mint XEN tokens substantially decreased, and although this may have initially contributed to ETH’s deflationary decline, applications with legitimate use cases, like Uniswap, quickly took the reins.

Our Two Sats:

While XEN tokens may have been the initial catalyst driving Ethereum’s monetary conditions, we’ve seen more mainstream applications continue to push ether towards deflation as shown in the chart below. There are a few factors that make future monetary trends of Ethereum unpredictable, but we believe the most important factor overall since The Merge has been the demand for block space. If adoption of Ethereum and the applications built within its ecosystem continues to rise, this will naturally increase demand for users’ transactions to be included in the next block, which will drive up transaction fees. While elevated transaction fees can be inconvenient for users of the platform, holders of the asset will benefit from additional fees being burnt, therefore acting as a deflationary anchor. As popular applications continue to come online, and scaling solutions potentially being years away, there are some strong cases to be made for a deflationary trend to take hold in the short to medium term.

Source: Coin Metrics, Etherscan, 10/31/2022.

Bitcoin Lightning Network Reaches Milestone Capacity of 5,000 BTC

Bitcoin's layer-2 payment platform, known as Lightning Network, has eclipsed a milestone capacity of 5,000 BTC, equivalent to $96 million in nominal terms.⁴ The layer-2 solution gives users an opportunity to send small denominations of bitcoin, known as satoshis or sats, to other users at faster speeds and with lower transaction fees. This comes just five months after the Lightning Network reached a 4,000 BTC capacity in June, signaling continued interest and adoption growth among users of the network.

Anecdotal evidence of this adoption trend can be found in South Africa, where one of the nation’s largest food and grocery retailers, Pick n Pay, has begun to accept bitcoin payments in its stores.⁵ The experiment began five months prior with 10 locations accepting bitcoin, to now 39 locations with plans to enable the transactions in all its stores in the months ahead. Pick n Pay has almost 2,000 stores located across South Africa, and the potential to bring bitcoin and Lightning Network payments to a large amount of retail stores and under-banked citizens emphasizes the innovative and groundbreaking capabilities of the Bitcoin payment network.⁶

Our Two Sats:

The growth in Lightning Network usage and adoption continues to support the belief and value proposition of the potential of bitcoin as an alternative payment system around the world. Bringing the Lightning Network to underserved and unbanked communities represent both the need and demand for an alternative solution for those that seek cheaper and more convenient options than what is available to them. South Africa is only one such example of a country seeing this potential, as many nations and citizens facing rampant inflation and weak or inaccessible financial systems have also turned to Bitcoin and the Lightning Network as a means of utilizing a cheaper and more reliable payment system.

As this layer-2 scaling solution continues to grow, a positive reflexive loop follows where more bitcoin capacity on the network creates more liquidity for users. This translates into faster payment speeds and larger volumes on the network, ensuring higher payment velocity and lower transaction fees. As more retailers and businesses look to globally incorporate this payment system and more capacity is added to the network, the feedback loop will also continue to grow and will bring about an opportunity to democratize financial services for many around the world.

Bitcoin’s 20-Day Volatility Falls Below Nasdaq and S&P 500’s For First Time Since 2020

The volatility of bitcoin fell below that of the Nasdaq and the S&P500, when measured on a 20-day rolling basis according to Kaiko, a digital assets data provider.⁷ This has occurred once in bitcoin’s lifetime, in 2020, when the asset price was trying to break through the $10,000 resistance. In addition, Kaiko noted that even with bitcoin’s increased sensitivity to macroeconomic data releases, the difference between the 30-day and 90-day volatilities of stocks and bitcoin has been shrinking.

Our Two Sats:

Some journalists and commentators have noted that this is “welcome news to many longtime crypto investors who hope that a mellowing of crypto’s notorious price swings could bring less fear to potential new investors.”⁸ We appreciate the sentiment, as investors have consistently cited price volatility as a barrier to investing in digital assets in our annual survey. However, when examining the long-term historical data, a compression in volatility has been shortly followed by an explosion in volatility with a price move to the down or upside. For example, the low volatility in July 2020 was followed by approximately a 300% increase in price over the next six months, according to price data from Coin Metrics. In other words, bitcoin price volatility has rarely remained subdued for long periods of time in the past and we would be surprised if this current period of low volatility continues. Adding to the conditions for volatility to rise is the fact bitcoin’s illiquid supply has now hit a recent high of 66%, signaling that a majority of the total bitcoin in circulation has not been sold or moved in the past year.

Source: Coin Metrics, 11/01/2022.

News Quick Hits

• McDonald’s has begun to accept bitcoin and tether as an experimental payment method in the Swiss town of Lugano.⁹
• BNY Mellon to offer custody of both digital and traditional assets on the same platform.¹⁰
• Google announces a new deal with Coinbase that will allow select groups of users to pay for cloud services using cryptocurrencies like bitcoin and ether, taking effect early next year.¹¹
• Users can now use the Lightning Network to send and receive bitcoin on Cash App, with a limit of $999 every seven days.¹²
• Mastercard has partnered with Paxos to launch a program offering cryptocurrency trading for banks and their clients.¹³

Data to Watch

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

How Long Can Bitcoin’s Price Stay Below the 200-Week Moving Average?

Source: Coin Metrics, 10/31/2022.

In our June newsletter, we referenced the above chart noting that bitcoin’s 200-week moving average could provide a potential support for the looming bear market. Since then, bitcoin has spent a considerable amount of time trading below this historical support level.

If we define the start of a bear market as more than a 20% drop from the most recent high, this bear market started on December 4, 2021. Since then, bitcoin’s price has closed below the 200-week moving average for 113 days. While statistically the price has rarely traded below the 200-week average, the current bear market accounts for nearly 75% of the total days below the moving average. When we looked further into the data, we counted a total of 150 days below the 200-week average since the start of the metric, May 2014. That means the total number of days prior to the recent drawdown in which the price of bitcoin was below the 200-week moving average was just 37. Currently, the 200-week sits around $23,700. This data helps show how this is among the most significant bear markets bitcoin has ever experienced.

Source: Coin Metrics, 11/01/2022.

Bitcoin Hash Rate at New All-Time High

 Source: Coin Metrics, 10/26/2022.

Looking at Bitcoin’s fundamentals, hash rate represents one of the most important data points for monitoring security of a proof-of-work consensus mechanisms. The higher the hash rate, the harder it would likely be for bad actors to attempt and maintain a 51% attack. At the same time, the higher the hash rate, the harder it is for miners to claim the reward subsidy from the network. Mining bitcoin while receiving less compensation means that profitability is lower and ultimately leads to machines being shut down, bitcoin reserves being sold, or additional financing needed to get miners through a period of low margins. One of the largest publicly traded mining companies has already signaled that they may have to file for bankruptcy, and network data confirms that there has been ongoing sell pressure added to bitcoin because of the rising hash rate alongside a stagnant asset price.¹⁴

Source: Glassnode, 10/27/2022.

Ether Issuance Since The Merge

 Source: Coin Metrics, 10/31/2022.

After reaching a peak in post-Merge issuance with around 13,000 ether added by October 8, the supply of Ethereum’s native token has fallen sharply. This reduction in total circulating supply has been the result of burning tokens (EIP-1559) combined with the recently reduced level of issuance under Ethereum’s new proof-of-stake consensus mechanism. According to some estimates, based on these rates of reduction, the total supply of ether could fall by as much as 11 million (-10% from where it is today) by October 2030.¹⁵ Since The Merge, approximately 2,300 net ether have been added to the token’s circulating supply.¹⁶ If Ethereum had kept its proof-of-work consensus mechanism, the total number of additional ether at this point would have been roughly 558,000.¹⁷

What We Are Reading

The Only Crypto Story You Need by Matt Levine

Bloomberg’s Matt Levine wrote a 40,000 word cover-to-cover crypto issue¹⁸ of Bloomberg Businessweek, which the editor notes is “something a single author has done only one other time in the magazine’s 93-year history” (the other being What Is Code?, by Paul Ford). We think this fact alone makes the article noteworthy and could be looked at as a major milestone for the industry as one of finance’s most well-known writers breaks down nearly all major aspects of digital assets in a widely read mainstream publication. While done in Levine’s signature casual tone, there is no shortage of complex topics that are addressed from hashing algorithms and what a nonce is to things like bridges, wrapped tokens, NFTs, and DeFi. Overall, we thought the magazine’s coverage was a great read and is especially helpful in breaking down highly technical topics. While Levine grasped the importance of network effects to digital assets, we believe some of his misgivings or doubts expressed may be addressed when evaluating bitcoin through the lens of bitcoin as primarily an emerging monetary good (read our Bitcoin First report for our take on this).

In Case You Missed It

• Morning Brew’s Fresh Invest Podcast with Jack Neureuter and Chris Kuiper
• 2022 Institutional Investor Digital Assets Study
• Doubling Down on Crypto with Jack Neureuter and Ramine Bigdeliazari, Director of Product
• New Ethereum resources and insights from Fidelity Digital Assets