Research Round-Up: March 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

After one of the strongest months on record, digital assets such as bitcoin and ether paused to catch their breath in the month of February, with prices up less than 1% and just over 1%, respectively. Risk appetite has recently been curbed with market participants no longer expecting the Federal Reserve to offer any rate cuts in 2023, according to current futures markets.¹   

The “higher for longer” narrative on interest rates was bolstered by the macroeconomic data on February 24, with the Fed’s preferred gauge of inflation, personal consumption expenditures price index (PCE), coming in at 5.4% year-over-year for the month of January, up from the prior month’s 5.3% print. Personal spending also came in higher than expected at 1.8% (month-over-month compared to the 1.3% expected). Treasury yields continue to rise, putting pressure on the previously rallying risk assets like high growth stocks and digital assets. 

However, correlation between digital assets and equity markets has declined. In this month’s Data to Watch section, we explore this in more detail, along with an analysis continuing from last month on whether we have more confirmation of a new bull market in digital assets. We also come back to ordinals or “NFTs on Bitcoin” and see how it is showing up in on-chain data. 

News and Editorial

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

Crypto Firm Paxos Ceases BUSD Issuance and Faces SEC Charges

Paxos, a blockchain focused infrastructure firm, announced it will cease issuance of Binance USD (BUSD) stablecoins following an order from the New York Department of Financial Services (NYDFS).² The NYDFS cited the order was the result of “several unresolved issues related to Paxos’ oversight of its relationship with Binance in regard to Paxos-issued BUSD.” Issued on Ethereum, Paxos BUSD is different from BUSD directly issued by Binance on other blockchains because Paxos controls both the issuance and redemption of the tokens and the collateral reserves backing them. Paxos said it will support redemptions until at least February 2024 and new and existing customers can redeem for US dollars or the Pax Dollar (USDP) stablecoin.³ Additionally, the SEC notified Paxos of potential charges related to its involvement with and handling of BUSD.⁴ Paxos had issued $16 billion in BUSD, but has burned more than $700 million, or 6% of circulating supply, since the announcement on Monday, February 13. 

Our Two Sats: 
With clearly growing interest in stablecoin regulation from both lawmakers and corresponding regulatory agencies, like the SEC, the Paxos BUSD development is another example of the recent trend of regulation through enforcement. The outcome of these cases will be closely monitored by the industry. The question of whether BUSD and other stablecoins are securities may come down to nuanced arguments around their design and how they are offered to customers. By design, stablecoins are meant to offer price stability through the assets that are backing them and facilitate more efficient transaction interoperability between protocols. It is imperative that stablecoin issuers have standard collateral requirements that disclose what the stablecoins are backed by and ensure that they are fully collateralized 1:1 in addition to having clear reserve asset disclosures and redemption policies. The industry may gain some degree of regulatory clarity from the outcome of these cases; however, further specific regulatory guidance, including documented guidelines, will likely be needed as well to help shape the direction of stablecoins and the role they play in digital asset markets.

Arbitrum Transactions Skyrocket, Overtaking Ethereum in Daily Volume

Daily transactions on Arbitrum, an Ethereum-based layer 2 protocol, hit a new all-time high of 1.1 million on February 21, 2023, eclipsing the daily transaction count occurring on Ethereum’s base layer. According to Defillama, monthly DEX volumes alone increased from $3.56 billion in January, to $8.77 billion in February.⁵ Arbitrum has had an impressive month of February on the development front as well with the introduction of popular new applications and the announcement of Stylus, a general-purpose programming environment that will allow developers to create more efficient dApps using a wider variety of languages. Stylus looks to draw developers to Arbitrum as the new programming paradigm adds scale and efficiency to dApp development. The official launch of Stylus will be introduced later this year.⁶   

Our Two Sats:
In late 2022, the Optimism ecosystem introduced Optimism Quest, which allowed users to voluntarily complete activities for a chance to earn NFTs. In the months following the release, the network experienced a similar exponential boost in activity to Arbitrum. As you can see from the chart below, the goal of incentivizing users to engage in activity on-chain worked well with the highest level of transaction throughput occurring during this event on January 12, 2023, with 800,235 transactions. However, since Optimism Quests have ceased, we’ve seen transaction count quickly drop to more normalized levels. Arbitrum hasn’t released any signals of a potential airdrop or community event, implying this spike in transactions is likely due to a more organic mix of new dApps coming online, such as Factor and Zyberswap, and Arbitrum’s low fee environment.⁷ Average daily Ethereum base layer fees reached an eight-month high in February which could have spurred users to explore new territory. Since layer 2 platforms don’t generate as many fees (in ETH) as the base layer, an important investment narrative for Ethereum over the next year will be whether new users are organically joining rollups or simply fleeing the higher fee environment of the base layer.

Coinbase Launches New Rollup on Ethereum, Base 

Coinbase has launched an Ethereum layer 2 blockchain called Base, which aims to be a “secure, low-cost, developer-friendly” chain that helps builders create dApps on-chain, the company stated.⁸  Base is built on the MIT-licensed OP Stack in collaboration with the layer 2 blockchain Optimism, which is also focused on the Ethereum chain. This is a significant development accomplishment, and it was made possible by the Optimism modular stack, which has already undergone extensive testing. In return, a portion of the transaction fees generated by Base will be allocated to the Optimism Collective, which will fund public goods on Optimism. Furthermore, Coinbase has pledged to establish a Base-native ecosystem fund as well. The official Base testnet launch occurred on February 23, 2023, and Coinbase plans to share mainnet deployment timeframes in the coming weeks.⁹  

Our Two Sats:
Arguably the most intriguing component of this decision from Coinbase is that instead of building their own layer 1 blockchain siloed from the rest of the digital asset ecosystem, they’ve decided to create a layer 2 blockchain with no native token that settles to the Ethereum layer 1. This means that all transactions on Base will use Ethereum as a fee mechanism, driving value to the base layer and natural demand for Ethereum. Additionally, this may set the stage for other notable players to enter the layer 2 ecosystem via chain-creation as the OP Stack enabled quick deployment of Base. It will be interesting to see what apps develop on Base compared to Optimism and other layer 2 platforms as these separate blockchains are free to design themselves in ways that can cater to their specific use cases. Regardless, we are clearly headed toward a world of many increasingly accessible chains settling transactions to the secure, decentralized base layer of Ethereum. To what degree these chains become mainstream depends on developers building meaningful applications and the ability to remove the intricacies of blockchain technology from the user experience.  

State-Backed Russian Crypto Mining Facility to Open in Siberia

Russian media recently reported a new $12 million crypto mining center is set to open in east Siberia.¹⁰ Scheduled to open in the first half of 2023, the facility will own 30,000 crypto mining machines, employ 100 workers, and consume 100 megawatts from the power grid. The facility will be owned and operated by BitRiver, Russia’s largest crypto mining hosting services provider, which has already begun the process of constructing buildings and infrastructure and sourcing the power supply for the center. The mining farm is set to receive a wide range of government incentives including no land or property taxes, a lower income tax rate, and electricity prices cut in half. 

Our Two Sats: 
In the aftermath of the invasion of Ukraine and resulting financial sanctions that followed, Russia has flipped its stance on cryptocurrency adoption and mining. Without offering comment specifically about Russia or the current geopolitical situation, news like this can highlight two core features of Bitcoin and digital assets. The first being that digital assets by their very nature are decentralized and resistant to censorship, meaning any person, government, or entity, good or bad, can adopt them without being blacklisted or prevented from owning or participating. Secondly, digital assets and cryptocurrency mining initiatives are borderless in nature and location agnostic. In other words, any person or government can participate in this ecosystem, regardless of where they are geographically. Mining operations can be set up anywhere there are sources of energy to supply them and internet access and can easily be moved to geographic areas that may be more compatible with renewable energy sources. 

News Quick Hits

• The SEC has cracked down on cryptocurrency staking products and services.¹¹ 
• Banco de Brasil, Brazil’s oldest and largest public bank, announced it now allows residents to pay their taxes in crypto in partnership with Brazilian based startup crypto firm Bitfy.¹² 
• Blockchain gaming made up almost half of decentralized application blockchain activity in the first month of 2023.¹³ 
• El Salvador has announced plans to open a “Bitcoin Embassy” in the United States, in partnership with the government of Texas.¹⁴  
• PayPal disclosed cryptocurrency holdings totaling $604 million at the end of 2022 with bitcoin and ether accounting for $291 million and $250 million respectively.¹⁵ 
• The number of bitcoin addresses with a non-zero balance hit a new all-time high of 44.06 million.¹⁶ 

Data to Watch

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

Last month we noted that it was still too early to tell whether the strong year-to-date gains seen in bitcoin and other digital assets was the sign of a new or sustainable bull market or merely a bear market rally. Unfortunately, even with another month of data the state of the bull market is still in question in our opinion. 

Favoring the bull thesis is a relatively new development of correlations between bitcoin and other risk assets retreating to the zone of the previous regime. We have noted many times that for years bitcoin was valued for its uncorrelated nature to other traditional financial assets, oscillating between slightly positive to slightly negative to the S&P 500, for example. This trend changed starting in April 2022 as equity markets sank along with bitcoin. The question became whether this was the “new normal” and a regime in which digital assets were treated like all other risk assets, or whether it was the exception to the norm and bitcoin would return to its previous regime of low correlation. 

We are now at the high-end of the previous range as bitcoin has rallied harder than equities in the beginning of this year and has held on to those gains…so far. However, if markets continue to come under stress with higher interest rates, we would not be surprised to see digital assets also pare gains and correlations rise as the old adage, “correlations tend to go towards one in times of stress,” once again takes hold.

Moving Average Continue to Be Resistance or Flip to Support?

Another data point that continues to keep markets on the edge of new bull versus continued bear is bitcoin remaining just below the 200-week moving average. Of the moving averages, we tend to favor the 200-week as most significant as it matches bitcoin’s historical four-year cycle driven by its pre-programmed quadrennial issuance adjustments. As you can see, we continue to near the 200-week moving average but have yet to break through it.  

Illiquid Coins Continue to Rise Providing Support

Despite the massive rally in the price of bitcoin year-to-date, we have been impressed that the number of illiquid coins, or tokens that have not moved in a year or more, has continued to rise. In fact, we’re currently witnessing new all-time highs in this very stat, as 67% of bitcoin have been motionless on-chain for over 365 days. While this doesn’t preclude short-term holders from selling and pushing down the marginal price, it does mean that holders with more conviction are not being tempted to take profits with the recent rally and are therefore not adding supply to the market to be sold. 

Percent in Profit Shows Signs of Emerging from Bear Market

Another data tool that can be used to see where investor sentiment and behavior sits in this rally is to examine the percent of circulating coins that are in profit. In other words, it is the percentage of coins whose price at the time they were last moved or spent on-chain is lower than the current price. This metric is coming out of the historically typical bear market level of below 50%. 

Where does this data this leave us?

Building on our market commentary in the beginning of this newsletter and combining with the data points above, there are still signs of constructive bullishness but we’ve not yet broken out of the overall bear market given prices have stalled and failed to break above the 200-week moving average. While the decline in correlations is interesting, with recent macroeconomic data giving support for “higher and longer” rates from the Fed and equities weakening, bitcoin and other digital assets would need to significantly decouple in a new way to create an independent bull market on their own. 

Ordinals (Bitcoin NFTs) Craze Evident in the Data

Last month we touched on the “ordinals” craze that was stirring up the Bitcoin community. These are pieces of data — text, images, and even audio or web files — that are being stored on the blockchain and linked to a specifically numbered sat (the smallest unit of bitcoin). We wondered whether this was going to be a growing trend or fleeting fad, and so far, the data shows its use is increasing with over 150,000 ordinals “minted” and the mean block size rocketing higher. We’ll continue to monitor to see if this fades or if this becomes the new mean block size in the future.