Introduction
We believe there were several reasons why crypto markets surprised expectations to the upside in the first half of 2023. Developments in this space at the end of last year left market pundits with almost uniformly negative predictions, while outlooks on the macro environment didn’t appear much rosier. This enabled a short covering rally that was sustained by supportive supply dynamics. That is, demand picked up just when many assets were being locked up in the custody of different government authorities or self-hosted wallets.
When the rally was interrupted by a US dollar recovery in mid 1Q23, the US regional banking turmoil positioned bitcoin in particular as an alternative to the failures of the traditional financial system. But then regulatory headlines began to derail performance and some market makers pulled liquidity just as global spigots were tightening. Enter the institutions– relief at the end of 2Q23 came from positive news associated with BlackRock, Fidelity, Charles Schwab and other Wall Street giants announcing new initiatives in the space.
The second half of the year promises to be no less eventful, as the regulatory overhang remains a challenge. But there’s also no shortage of endogenous narratives that should drive this asset class as well. Among these, layer-2s remain an important theme in 2H23, although we expect the market to turn its focus to how value accrues to these scaling solutions. Rollups will also be affected by the Cancun (Dencun) Fork, the next major milestone on Ethereum’s upgrade roadmap. Re-staking may also promise to disrupt the industry. Meanwhile, once the Mt.Gox bitcoin disbursements are complete, we expect more attention on the bitcoin halving in 2024.
Half-time report
The first half of 2023 ended with a potential game changer for the crypto industry as some of the world’s biggest financial firms announced major initiatives in this space. In the wake of these announcements, BTC rallied above US$30,000 for the first time since April.
Developments included the launch of a new crypto exchange by a consortium of major financial players – Fidelity, Charles Schwab and Citadel - mainly targeting Wall Street participants. Separately, asset-management giant BlackRock filed to launch a spot BTC ETF partnering with Nasdaq. Fidelity, WisdomTree, VanEck, ARK Invest and Galaxy/Invesco followed suit, partnering with Cboe. Incidentally, Coinbase supports issuers in a few ways, including as custodian for the underlying BTC. Separately, the Nasdaq and Cboe have also named Coinbase as their surveillance sharing partner in their 19b-4 filings.
Note that the timeline for the US SEC’s decision making process has recently been reset due to refilings. For example, the application for BlackRock’s iShares Bitcoin Trust was recently refiled on July 3 which means that it may only enter the Federal Register for public commentary on July 17. A final decision could take as much as 240 days (putting a potential deadline sometime in mid-March 2024). See table below.
Table 1. Possible iShares Bitcoin Trust application review timeline
Some have argued that even if these ETF proposals are approved in the US, it may not be as transformational for crypto markets as their advocates may think. The argument is that these products already exist in Europe and Canada but haven’t gained significant traction in the years they’ve been around. We think that view is short-sighted, as it focuses on the potential retail demand for these products. In fact, the ETF market in the US is the largest and most developed globally because asset managers and financial advisors tend to use ETFs in portfolios as a means of gaining exposure to a variety of asset classes. Having an available bitcoin spot ETF in the US may facilitate allocations that ultimately translate into significant effects on demand. We may also see institutional investors potentially using an approved bitcoin spot ETF as the underlying for new derivative instruments that could also expand trading volumes.
Chart 1. Risk-adjusted BTC/USD returns based on 65-day rolling window
The second half
Mt. Gox repayments
Looking ahead, we see several crypto specific themes in 2H23 that could be relevant for markets. One of the most well telegraphed sources of pressure in the months ahead may be the 141,686 BTC that’s due to be distributed to creditors as part of the Mt. Gox rehabilitation plan.
Base, intermediate and early lump sum disbursements are supposed to be paid by October 31 (though the deadline may still be extended). But bitcoin selling could take place before then to raise the cash needed for settlements. The general framework is that the first JPY200k (~US$1440) of each creditor’s claim will be paid in cash followed by a mix of around 70%/30% token vs cash for the remaining balance – unless a creditor has explicitly requested a different split (e.g. 100% bitcoin or 100% cash). Incidentally, the two largest creditors representing around 20% of all Mt. Gox claims have also elected to be paid in mostly bitcoin.
Note that we do not know the current number of available creditors as an unspecified number have sold their claims to third parties, but as of end-March 2023, there were 42,394 permitted creditors according to the rehabilitation trust. But in 2019, CoinTelegraph indicated there were 24,000 creditors affected by the Mt. Gox hack, and more recently, they reported 10,000 creditors. Taken together, we estimate the potential upper limit of forced bitcoin selling could be around 35k BTC. Currently, the Mt. Gox trustee is sitting on 137,891 BTC, a balance that has remained constant since May 2018.
Bitcoin halving
Following Mt. Gox, the next most important bitcoin-related event will likely be the “rewards halving” in April or May 2024, which we covered in our last monthly report. In our view, the halving will likely have a material impact on the market, though that’s based less on the historical evidence and more on (1) our macro view and (2) how crypto markets have grown since previous halving events. That is, there is sidelined capital and a much bigger market today than there was 3 years ago. That could make a big difference, particularly if central banks start to cut rates in 4Q23 or early 1Q24. In other words, we don’t think it will be the halving alone that will drive stronger bitcoin performance, but more likely a confluence of factors.
Chart 2. Rolling regression of global liquidity, US 2y rates and DXY vs bitcoin
Ethereum upgrade and blobs
On Ethereum, the upcoming Cancun (Dencun) Fork promises to support scaling on the network via layer-2 (L2) rollups, potentially increasing throughput and making transactions cheaper. Ethereum Improvement Proposal (EIP) 4844 (proto-danksharding) is at the core of this upgrade, which will increase data availability for rollups by creating a new data type called “blobs” (binary large objects).
Why this is significant is that this change will create new temporary space on blocks dedicated solely to the data that rollups submit to the main Ethereum network. That is, at the moment, rollups reduce transaction fees for users by batching multiple transactions into one transaction that gets stored on-chain indefinitely. With EIP-4844, that data will instead be stored as a blob transaction on the consensus layer for only three weeks, during which time the data can be verified. (It’s cheaper if the data doesn’t sit on the network forever.) The initial limit will be up to four blobs per block. The takeaway is that this will lower the floor for transaction fees on rollups and possibly allow rollup operators to post more data per transaction.
Notably, proto-danksharding is only the prerequisite for full danksharding, which is expected to come later and incorporate data availability sampling, so that the verification of blob data will not require a full download each time. We think a more realistic release date for the Cancun Fork is in 1Q24 rather than 4Q23.
Account abstraction
More importantly is what comes next. In our view, this upgrade lays the foundation for account abstraction, which could lead to broader web3 adoption by making the experience more user-friendly. To oversimplify, account abstraction is the means by which the details of user accounts are hidden from the Ethereum protocol by allowing accounts to function like smart contracts. One net benefit of this is that it could allow decentralized applications (dapps) to pay for users’ gas fees or possibly use other non-ETH tokens to pay for gas. When the transaction fees are low enough, we think more dapps may pursue this path, effectively changing the user experience on blockchains and allowing users to focus only on high-level interactions.
L2s and decentralized sequencers
Meanwhile, we think the conversation about L2s themselves will change in 2H23. In the first half of the year, market players were mainly focused on which protocols were dominating market share (as well as speculating over token airdrops to a lesser extent). We think their attention will now turn to figuring out how value will accrue to these scaling solutions and their associated tokens.
Chart 3. Monthly L2 gas usage remained high in 2Q23
Currently, fees on rollups mainly accrue to the sequencers that take transactions in the mempool and order them before submitting them to Ethereum. But most rollups rely on a single, centralized sequencer. An alternative would be to replace this with a network of nodes to order and validate those transactions, such that staking could be employed for validators to earn rewards.
The idea of shared sequencers also seems to be gaining more traction, whereby independent decentralized networks of sequencers could compete and be utilized by any rollup. Such a proposal could also introduce benefits like cross margining across rollups and minimizing liquidity fragmentation, though at the risk of distorting incentives.
Security-as-a-service
Traditionally, we have characterized the business model for layer-1 networks as blockspace-as-a-service. But in our 2023 Crypto Market Outlook, we alluded to the growth of middleware solutions that could introduce a new revenue stream for ETH validators in the form of “security-as-a-service.” Effectively, the concept of “re-staking” by EigenLayer is a way for validators to secure new features in Ethereum – like data availability networks, rollups, bridges, oracles, etc – or even secure other networks, possibly earning additional rewards in the process. EigenLayer recently launched on Ethereum mainnet in mid-June (phase 1) but has not yet started to support actively validated services.
While re-staking allows validators to diversify their revenue sources, providing such security services comes with risk. For example, validators can be slashed by the EigenLayer network for possibly all of their 32 ETH deposits depending on the conditions imposed by a given actively validated service. In the normal course of processing Ethereum transactions, validators are rarely slashed their entire ETH stake. Moreover, the size of the potential earnings is still unknown as it is market-price driven and will depend on the level of demand for these services.
The co-founder of Ethereum, Vitalik Buterin, also offered a critique of re-staking in his blog post, “Don't overload Ethereum's consensus”. He suggests that systemic risks could arise in situations where some calamity on a re-staking-backed service might require arbitration or possibly a fork (or reorg) of the chain to solve the problem. The latter could potentially require the entire validator community (not just those opting into re-staking) to step in, which may also divide interests. Consequently, to ensure the primacy of Ethereum’s base-layer security, it may be incumbent on both (1) validators to not over-extend themselves on their re-staked positions and (2) networks and middleware layers to not expect forking-as-a-solution to rescue them from application layer errors.
