Market View
The impressive rally in crypto this week has been supported by a combination of large inflows into US-based spot bitcoin ETFs as well as a short squeeze in leveraged derivative positions. Spot bitcoin ETFs recorded impressive net inflows of almost $1.8B in the first three days of this week, with BlackRock’s iShares Bitcoin ETF (IBIT) alone accounting for 70% of that (see Chart 1). These flows are materializing despite the fact that many wirehouses (large broker-dealers) like Morgan Stanley are still in the midst of carrying out their due diligence on these products, which is a prerequisite for offering them to clients.
The bitcoin price momentum fueled a short squeeze in recent days, with the open interest on BTC perpetual futures at its highest level since January 2022 ($14.2B). The open-interest weighted average funding rate reached 109% annualized on February 28, a level not seen since April 2021, according to Glassnode. This has since moderated to approximately 70%, as we go to publish (see Chart 2). Between February 25 to 28, nearly $750M of shorts were liquidated – each day successively creating a new year-to-date high in the amount of liquidated shorts. Meanwhile, we think we may be approaching the end of short covering based on the long-to-short ratio on futures, but it's not entirely done yet.
Recent performance has been constant with our constructive outlook published in early February, though we are cautious about some of the negative seasonal factors that could still emerge in March. Traditional assets tend to be affected by drivers like tax payments, for example, which could lead to some temporary downward pressures. The large and sustained positive move in funding rates and open interest could also have ramifications if their unwinding causes cascading long liquidations. That said, we are still overall constructive in our outlook over the next several months as spot ETFs continue to be onboarded to wealth management firms and net inflows absorb liquid circulating supply at a faster rate than bitcoin miners produce.
Onchain: Uniswap Fee Switch
On February 23, the Uniswap Foundation (UF) announced a proposal to upgrade Uniswap V3’s protocol governance in order to reward UNI token delegators and stakers with a portion of trading fees. It is important to note, however, that this proposal does not itself turn on the fee switch, but instead sets the technical mechanism for how the fee switch would be implemented. Upon passing, the initial fee parameter would be set to 0, but can be adjusted from 1/10 to 1/4 of trading fees in future proposals.
The largest concern around enabling protocol fees, in our view, is the impact to liquidity providers since any such fees would be deducted from their earnings. This could lead to a reduction in the total value locked (TVL) and MEV-based flows. A detailed analysis by Gauntlet (engaged by the UF) addresses this, and suggests that the impacts to core, non-MEV volumes are likely to be minimal with annual revenue estimates ranging from a conservative $10M to an optimistic $72M based on historical activity. The Gauntlet team will also be responsible for proposing a fee rollout plan should this initial proposal pass.
We think this proposal is likely to be implemented given that it has been set forward by the UF’s governance lead and has generally received broad support in the discussion forums. In fact, the previously rejected proposal to turn on fees in June 2023 saw the majority of voters in favor of a fee switch, but split votes between different fee tiers ultimately gave the “no fee” vote the majority. Given that this proposal does not yet change any revenue structure and won’t suffer from the same vote-splitting problem, we don’t see any significant blockers. Interestingly, this proposal would also tie revenues to governance (via staking and delegating), which we think could incentivize more active community participation by UNI holders. The voting period for this proposal is expected to occur between March 1 and 7.
The widespread attention on this proposal has caused several other projects, such as Frax, to consider following suit. Should this trend continue across other mature DeFi protocols, we think it could begin to bring clarity and grounding to previously speculative token valuations – in particular for tokens and protocols that generate sustainable fees. It also represents a variation in protocol value accrual mechanisms by rewarding delegates and stakers in wrapped ether (the current proposed payout token) in contrast to protocols like MakerDAO which perform buyback-and-burns of its native token.
Onchain: Proliferation of Appchains
Separately, we also want to discuss the widening universe of rollups on Ethereum, which has given rise to a new class of rollups-as-a-service (RaaS) products that simplify the creation and deployment of a rollup down to a few clicks. Modular blockchain development has accelerated with various technologies for deploying layer-2s (L2s) and other application-specific chains. The aforementioned Frax protocol has plans to launch its own L2, Fraxtal, as part of the Optimism superchain. Other major protocols like GMX, a decentralized perpetual futures exchange and the top TVL protocol on Arbitrum, are also flirting with the idea of building their own chain (though the GMX protocol as currently known will remain on Arbitrum and Avalanche C-Chain).
As more L2s are built out, we think there will be increasing scrutiny – and complexity – in the blockchain bridging and interoperability space where different solutions have tradeoffs in security assumptions, confirmation times, development timelines, and costs that can be hard to navigate for non-technical end users. Rollups additionally have fixed costs (for infrastructure and gas costs to the layer-1) that need to be monetized against. In a world of proliferating L2s, profitability could be increasingly more difficult to accomplish and may push applications further down to a layer-3 level and lead to a re-consolidation in profitable L2 chains. This fragmentation of execution environments has led certain critics to believe that the shared state offered by monolithic/integrated blockchains could enable more use cases and better cross-application security.
Arguments for and against both methods of scalability are far-reaching, though we think that discussions on these technical tradeoffs are actually of secondary importance to the technology for creating a smooth user experience. In our view, the widespread adoption of any application will ultimately need to abstract away technological complexities from consumers much like how the underlying technology stacks (and design tradeoffs) for major web2 platforms are largely irrelevant for users today. In light of this, we think that technologies (such as Coinbase’s wallet solutions) that enable users to secure their wallets with passkeys are more critical to growing the crypto pie. Although these sorts of tools are generally overlooked in the scalability debate, we think such innovations could eventually have an outsized impact on user adoption and onboarding – especially if scalability solutions converge to similar performances in the longer term.
