CoinShares 2023 Outlook

Coming Back Down to Earth

2022 was a year of tightening monetary policy which initiated the unwinding of unrealistic valuations in the crypto world after a period of exuberance. Like in most bear markets, this then led to the unravelling of crypto malinvestment and the exposure of bad actors. These events have distracted investors from the key reasons why digital assets were created: to mitigate monetary debasement, decentralise computation and to protect from censorship. 2023 will be a year of coming back down to earth, with many tokens likely being shunned for larger, more viable ones.

As monetary policy reverses in the second half of the year, it is likely that we see much greater support for digital assets by investors. It will also be the point at which the momentary higher correlation between risk assets such as equities and digital assets will degrade.

We expect much tougher regulation, more in-line with existing banking regulations, to begin to be formulated and in-part implemented this year, particularly for the on- and off-ramps for crypto. Although this is likely to be a long-term consultation process for the industry, MiCA from Europe is the most advanced piece of crypto regulation globally and is likely to be used as the blueprint by other regulators.

The bitcoin mining market in 2023 is likely to be a more steady and sustainable year for industry participants. After rapid growth in 2021 and a devastating downturn in 2022, the mining market seems poised for a less dramatic 2023. We note the particular importance of the 2024 supply halving, given that it will have a direct impact on mining revenues across the industry and is only roughly 14 months away.

2023 is shaping up to be the year of Layer-2s, for years Ethereum has been struggling to scale effectively while preserving decentralisation and security and layer-2s have seemingly solved this trilemma. With cheap and fast transactions, and improved economics, the differentiators of competing layer-1s arguably diminish. 

We see further integration between real-world assets and crypto exchanges. This is evidenced by JP Morgan forking AAVE to trade Singapore Dollars, the sale of real estate through NFTs and the lending of stablecoins to SMEs in emerging markets. Smaller, less proven DeFi protocols will have to build both their products and reputation in a more orderly manner as risky behaviours aren’t being rewarded to the same extent anymore. So, for now, while we do expect innovation among newer protocols, we see a clear deviation between the two groups and expect them to further diverge as the year progresses

While the noise may quieten, especially amongst the lower market cap tokens, developer communities are likely to stay thin while adoption struggles, a lingering buzz may continue amongst the larger Layer 1s as innovation will not cease to occur. The signal shows, however, that consolidation and convergence towards the Ethereum ecosystem are the lines of direction for the rest of 2023.

A Year of Reckoning for Central Banks

James Butterfill – Head of Research

We believe Bitcoin and other crypto assets are becoming increasingly connected to the world economy, and therefore those that behave like stores of value, albeit emerging stores of value, are going to be influenced by the monetary policy of central banks. Prior to the FTX collapse, we had seen a period where Bitcoin was increasingly being influenced by economic data releases. This began at the start of 2022 with the US Federal Reserve (FED) announcing a much more hawkish monetary policy than the markets had expected, leading to a plunge in intraday Bitcoin and Gold pricing following the announcement. Throughout the year we saw increasing evidence of this intraday correlation when monetary policy sensitive data was released, such as inflation and employment data.

Most interest rate sensitive assets behaved in the same way, leading to a significant increase in correlation between equities and Bitcoin, despite them being fundamentally very different assets. Continued hawkish monetary policy throughout 2022 led to the worst bear market seen in years for these asset classes. It makes sense that Bitcoin is an interest rate sensitive asset, due to its monetary properties, but this is different to equities, which are interest rate sensitive due to the negative impact that rising rates have on corporate margins.

Thus, a reversal in monetary policy is likely to be supportive for Bitcoin and digital assets in general. Economically, early evidence highlights that a recession is a real possibility in the western world in 2023. The bond market, which has an almost perfect track record in anticipating recessions suggests that there will be one, with the 10Y-2Y yield curve being the most negative since the Volcker years in the early 1980s. 

There are plenty of early signs that this will be the case too, with purchasing manager indices (PMI) are all trending downwards, with the most recent services PMI in the US dropping below 50, matching levels not seen since 2009 (with a brief exception during COVID). Inflation, driven by rents, margin expansion, global food prices and wages are all now falling, although the lack of CAPEX in oil related industries over the last 5 years and the ongoing conflict in the Ukraine may keep it from normalising.

Understanding what will happen economically in 2023 is crucial to understanding what will happen to monetary policy and consequently digital asset prices. We believe the knee-jerk reaction to inflation by western central banks, by waiting too long before raising interest rates and then raising rates very aggressively, will have a lasting economic impact, and one that will push many western countries into a recession.  

History tells us that delays to raising rates is the most common reaction by central banks, it also tells us that they tend to leave it too late before cutting them when the economy becomes weaker, ultimately being reactive rather than proactive. This is what we believe will happen in 2023: western central banks will continue raising interest rates in the first half of 2023, but then will be forced to reverse course and cut rates in the face of an economic recession in the second half of 2023.

Our outlook for interest rates suggests that the first half of 2023 will continue to be challenging for digital assets prices, particularly while some key players in the industry resolve some of their ongoing solvency challenges prompted by the collapse of FTX - rallies are likely but it is difficult to see them being sustained until we see a dramatic reversal in monetary policy. 

As monetary policy reverses in the second half of the year, it is likely that we see much greater support for digital assets by investors. It will also be the point at which the momentary higher correlation between risk assets such as equities and digital assets will degrade. Equities are likely to suffer from the poor economic outlook, while assets such as Bitcoin will outperform off the back of poor central bank monetary policy and the prospect of lower interest rates. 

Another Crisis of Confidence in Crypto

Chris Bendiksen – Bitcoin Research Lead

As we wallow in the depths of the third major crypto winter it’s a good time to look at where we are and what got us here. Interestingly, this time around feels a lot more similar to the first crypto winter than the second. 2018 was more of a textbook market over-extension with a corresponding loss of faith in crypto promises (that is, the ICO boom fuelled by the Ethereum ERC20 token standard and the ‘tokenise everything’ narrative), this time things are more similar to 2014.

Just like in 2014, a major exchange has gone bust. Money has disappeared. Fraud, hacking, incompetence—it’s all there. And just like then, confidence in crypto has been rocked. The thing is, though, that the collapses of MtGox or FTX are not anymore the fault of ‘crypto’ than the US Dollar is at fault for Madoff, or energy for Enron. And herein lies a problem that, while somewhat improved since 2014, still confidence plagues the industry.

The problem is that almost no one understands what ‘crypto’ is. There’s no agreement within the industry, and the general public, although they will at this point at least have heard of Bitcoin, or crypto, still mostly have no idea what either term actually means. 

It is probably true that the broader public view crypto in general as an all-encompassing term containing absolutely everything that is in any way related to cryptocurrency protocols. There is little appreciation that a crypto exchange generally has no more of a connection to any specific cryptocurrency than an FX broker has to the US Dollar. Furthermore, there is little appreciation for the equally important difference between Bitcoin and ‘crypto’.

When a fraudulent exchange falters or an irresponsibly levered hedge fund fails and these companies are in the ‘crypto industry’, the confidence, even in entirely unrelated systems such as Bitcoin (upon which one cannot even lay any blame for enabling DeFi fraud, hacks, rug-pulls etc.) will suffer.

No matter how nonsensical this entanglement is, however, the fact remains that the end result is the same. And so, in order to re-emerge out of winter, we’ll need to retrace those same steps as we’ve done before:

As leverage and speculation both tone down, market volatility reduces and the sensationalist headlines lose their lustre, the crypto winter will fall out of the news cycle and out of the public consciousness. Meanwhile, protocol development keeps moving forward. Blocks are found, transactions are settled, new products are built—utility and non-speculative usage grows.

The next Bitcoin halving is right around the corner. When that yet again fails to fulfil the cicadian prophecy of a mining death spiral, where the lower rewards regime tightens miners margins, investors will again question why these protocols refuse to go away.

And with that, the cycle repeats. Investors who may have only heard about crypto in passing a few years back will start looking at it more deeply. As they do, many get excited and start talking about it to their friends and acquaintances, the meme spreads, and demand starts to pick up once more—right as new supply has yet again been cut in half. The media starts noticing that crypto didn’t go away this time either and crypto re-enters the public consciousness.

Confidence is rekindled. Speculators return. With each successive cycle, more and more investors realise that what we have in front us is technology. And useful technology does not merely go away—it grows. The growth might be irregular, sure, but if it is consistent over time that should tell us something. It should tell us that people all around the world find it useful. Utility sparks demand, and if supply is limited, any economics textbook will tell you what happens next.

2023 Regulations outlook

Townsend Lansing – Head of Product and Nick du Cros – Head of Compliance & Regulatory Affairs – UK

 2022 was the veritable annus horribilis for the digital asset industry: a single-point failure in an ill-conceived “stablecoin” led to a contagion that put numerous digital asset intermediaries into bankruptcy, causing client losses in the tens of billions of dollars. In addition, in the United States, both the SEC and the CFTC took fairly aggressive action against some of the digital asset industry levying some fairly serious fines. And finally, (although one might see this as the silver lining), the EU has almost approved the Markets in Crypto Assets Directive (MiCA), which promises to introduce a comprehensive digital asset regulatory regime across one of the largest trading blocs in the world.

 2023 will very likely bring the backlash, at least from a regulatory perspective. We expect heightened scrutiny for the entire industry, driven by increasingly emboldened regulators keen to ensure governance over an industry that has largely escaped regulatory scrutiny for over a decade.

 MiCA and the European March Towards Regulatory Transparency 

The EU is expected to formally adopt MiCA sometime in early 2023 with an eye towards establishing a comprehensive and transparent regulatory regime for digital assets throughout the European Union. Once finalised expect steady implementation from both Member States as they pass MiCA into their domestic law and for firms that will find themselves subject to a wide range of regulatory obligations.

We also expect the EU to monitor market developments with an eye to ensuring that MiCA addresses any possible eventualities (i.e., loopholes). We think Member States will focus on retail intermediaries, especially those who may try to access the market from unregulated third countries via reverse solicitation. Retail marketing efforts are likely to be heavily scrutinised and held to a standard similar to the marketing of financial instruments.

As the implementation period progresses, it is very likely that innovation will overtake some of the regulations, so we would expect continued engagement from the EU and Member State regulators on the market. Furthermore, the EU has promised to look more closely at decentralised finance (DeFi), which was initially excluded from MiCA, which in turn is likely to lead to further amendments to MiCA.

United States

With the recent elections and the assertion of power by the right-wing of an already right of centre Republican party in the House of Representatives, bipartisan support for a new legislative regime governing digital assets looks unlikely in the near future. 

Absent that legislation, responsibility will continue to sit with the SEC, the CFTC (and, if necessary) the DOJ or the states’ attorney generals. Those organisations will use the enforcement tools available, which means more aggressive actions against unregistered security offerings by the SEC and market manipulation suits by the CFTC. Firms offering digital asset services in the United States will likely need to review their offerings with lawyers to identify areas where increased regulatory enforcement could impact them. United Kingdom

In April 2022 the Treasury announced a plan to make the UK a global cryptoasset technology hub.  The lack of substantial progress on the stated objectives has been a disappointment to many in the industry.

However, on the regulatory front there are a number of measures which we do see as being finalised in 2023 which will have a direct impact on UK cryptoasset firms, and those international firms targeting the UK. These include:

•             the regulation of stablecoin by the Bank of England once the Financial Services & Markets Bill is passed by both Houses of Parliament; and

•             tighter rules on the marketing of cryptoassets in the UK. Including which firms can approve cryptoasset advertisements; and that cryptoassets will be classified as high-risk investments requiring certain mandatory disclosures over and above traditional financial instruments.

And then there is the biggest question, given its stated cryptoasset technology hub objectives, of how the UK will respond to MiCA?

The Bitcoin Mining Market Will Rebalance in 2023

Matthew Kimmell – Digital Asset Analyst

The growth of the Bitcoin mining industry is expected to continue over the next several years as entrepreneurs take increasing advantage of the abundance of opportunities to monetise stranded and waste energy sources. However, there are several factors that will likely lead to a rebalancing of the mining market in 2023. This rebalance will likely be driven by the exit of unprofitable companies, a potential decrease in bitcoin price volatility, and the delivery of new, more efficient mining machines.

First, general mining competition is expected to decrease as uncompetitive miners are forced to exit the market. A typical ‘Inventory Flush’ subcycle, 2022 was characterised by a double-whammy of increasing bitcoin production costs and decreasing market rates. The result has already been and is likely to continue being bankruptcies, insolvencies, and subsequent consolidation of mining power among the best capitalised and lowest cost players, who are better equipped to handle the challenging conditions of the current mining market.

Second, bitcoin price volatility is expected to decrease compared to 2022, as the unwind of leverage, short term speculation and industry failures takes its toll. If the price of bitcoin steadies, miners will be able to plan their operations more effectively and make more informed decisions about their investments. This, in turn, will help to stabilise the mining market and reduce the pain of sudden (especially downwards) shifts in miner profitability.

Finally, the better capitalised miners will have access to more efficient mining machines in 2023, and at a lower cost per hash than the 2022 average, which will allow them to reduce their capex cost per hash and increase output without incurring additional ongoing cash-costs. As these machines become more widespread, they will allow for more cost-effective mining operations. The result is greater separation between the struggling miners and the most well-capitalised miners, who can now power through the bear market, upgrade their mining fleet, and increase their share of the pie ahead of the looming supply halving in early 2024. 

Overall, we find that the bitcoin mining market in 2023 is likely to be a more steady and sustainable year for industry participants. After rapid growth in 2021 and a devastating downturn in 2022, the mining market seems poised for a less dramatic 2023. This would be positive news for both miners and investors alike, as it will create a more predictable market for all involved.

In closing, we note the particular importance of the 2024 supply halving, given that it will have a direct impact on mining revenues across the industry and is only roughly 14 months away. In anticipation, a potential strategy by mining companies may be to focus on reducing operating expenses above their cash-costs (including overhead, debt, hosting, etc.). This would strengthen miner balance sheets and in turn extend their cash runway.

For those forced into negative margins after the halving event, it could also possibly allow them to continue mining long enough to see another cyclical period of increasing profitability: a “Gold Rush”. And while we don’t expect all miners to adopt this strategy, focusing on cost reduction and balance sheet strengthening rather than expansion ahead of the halving, should also lower the likelihood of abrupt market changes—in this case caused by difficulty adjustments—for the industry overall throughout 2023.

The Shift from Layer-1s to Layer-2s

Marc-Thomas Arjoon, CFA – Ethereum Research Associate

2022 marked the 5th year in a row that blockchains dubbed “Ethereum Killers” failed to kill Ethereum. Yet, despite its innovation and reliability, during periods of high demand, Ethereum is slow and expensive and as a result, has seen its market share eaten away by its competitors. However, in response to its deficiencies, the Ethereum vision has shifted from being the blockchain that does it all to one that lets the free markets handle the load for it. This is where Layer-2s enter the picture, for a quick primer on Layer-2s check out our report but essentially think of them as data compression solutions. Users interact with a Layer-2 blockchain, and their transactions are bundled into one transaction, then posted on the Ethereum Layer-1 for verification.

The advantages of Layer-2s are why we see an upcoming shift towards them in 2023. The design space for Layer-2s is large and growing with some offering fast transactions, some that offer free transactions, and others that use the entire chain just for one app. Currently, Layer-2s have caught up to Ethereum and handle around 1 million transactions per day, however, we expect Layer-2s to continue their climb and handle more than double Ethereum’s transactions by the end of the year.

Layer-2s are also faster and cheaper than Ethereum and many other Layer-1s and don’t require an extensive network of miners/stakers for consensus. Since a Layer-2 doesn’t need to pay out hundreds of millions of dollars incentivising validators, this makes the economics of launching a Layer-2 more appealing than a new Layer-1. Launching a Layer-2 on Ethereum allows the chain to benefit from the decentralisation and security of Ethereum out of the box. And although still nascent, as the developer tools continue to improve, we foresee the ability to spin up a Layer-2 eventually being only slightly more effort than spinning up a dApp. Given the incentives, we expect to see more Layer-2s than Layer-1s launch their mainnets in 2023.

Layer-2s like Arbitrum and Optimism only fully launched in 2022 and most Layer-2s are still in their testing phase yet Layer-2s already handle more transactions per second (TPS) than Ethereum does. On average Ethereum handles ~11 TPS, as of January 2023, Layer-2s in aggregate handle ~13 TPS, we expect this number to be at least 3x by the end of 2023. Furthermore, from a Decentralised Finance (DeFi) view, Layer-2s already make up 2 of the top 10 chains when measured by Total Value Locked (TVL). Arbitrum sits in 4th at $1bn with Optimism in 7th at $500m. We foresee at least one other Layer-2 joining the top 10 at some point during the year (TVL >$200m).

Moving on to costs, Layer-2s are already cheaper than Ethereum, with the average transfer fee on Layer-2 costing ~$0.04 vs Ethereum’s ~$0.45. However, an upcoming upgrade, EIP4844, is expected to be included this year and will introduce a new data space specifically for Layer-2s to post their transactions. We expect the upgrade to happen closer to the end of the year and make transaction fees on Layer-2s an order of magnitude cheaper.

2023 is shaping up to be the year of Layer-2s, for years Ethereum has been struggling to scale effectively while preserving decentralisation and security and Layer-2s have seemingly solved this trilemma. With cheap and fast transactions, and improved economics, the differentiators of competing Layer-1s arguably diminish. There are still innovations in layer-1s such as app-chains and zero-knowledge Layer-1s but keep an eye out for the releases of StarkNet, zkSync, Fuel labs, and Aztec as these Layer-2s have been in the works for years and are nearing their mainnet launches. Expect leaders like Optimism and Arbitrum also to continue their growth and for competition among these Layer-2s to really heat up. Unsurprisingly, there are “Layer-2s” being built on other networks as well, such as Bitcoin’s Lightning network, Nitro on Solana, as well as other efforts on the Tezos, Cardano and Near blockchains. However, with a first-mover advantage and the most social capital, these advancements in scaling should help the Ethereum ecosystem prepare for the next wave of adoption and regain some of its lost market share. 

DeFi Divergence

Marc-Thomas Arjoon, CFA – Ethereum Research Associate

2022 was a year of reckoning for many DeFi protocols, as interest rates rose, assets on the further end of the risk curve contracted. The liquidity that helped prop up markets was quickly removed while the strategies used in prior periods no longer sufficed. At the beginning of 2022, decentralised applications (dApps), Anchor and Abracadabra were both in the top 10 DeFi protocols measured by Total Value Locked (TVL). Since then, they have lost 100% and 95% of their TVL respectively as these dApps utilised riskier business practices to acquire new customers. 

So how will the DeFi markets progress in 2023? We see a divergence within the industry as the tried and tested protocols continue to amass greater market share. We’ve already seen evidence of this - the largest 5 DeFi protocols constitute 59% of all TVL vs 35% this time last year. We believe that the larger DeFi protocols will continue to build trust, grow revenues and develop Lindy among their peers. 

One of the largest DeFi protocols, MakerDAO already generates revenue through loans to Tesla and investments in US Treasuries and corporate bonds. We see further integration between crypto and real-world assets with the largest DeFi players best positioned to take advantage of this upcoming trend. 

Many of the large “old-school” DeFi protocols have also tapered down or completely eliminated their token incentive programs. Thanks to their 100% uptime, strong risk management and strong branding, we see their continued success throughout 2023. Below we show how Aave successfully onboarded thousands of users through incentives and retained them through product market fit. Reduced marketing costs also increase the profitability of these protocols, allowing them to spend more on talent, engineering and acquisitions. 

Furthermore, the FTX debacle has caused many crypto participants to lose trust in centralised exchanges and will lead more individuals and entities toward DeFi. Billions of dollars have left centralised crypto exchanges since the FTX fallout and have moved mostly on-chain - below we show that the amount of ETH held on exchanges fell by 27% in just one month after FTX. As the larger protocols tend to be more decentralised and hence more trustworthy, we see further gains (albeit not massive) to be made from the CeFi to DeFi transition. 

Looking among the 5 largest DeFi protocols, three of them, MakerDAO, AAVE and Curve are lenders. Similar to MakerDAO’s DAI product, we anticipate both Curve and AAVE to release their own stablecoins later this year. Following Uniswap Lab’s acquisition of Genie, we also expect NFT trading to be fully launched in 2023 on Uniswap’s front end. These moves highlight increased vertical integration among the larger DeFi protocols and will further increase their total addressable market.

We have a few reasons to believe in the consolidation among the large DeFi dApps. Firstly, they worked as intended despite the volatile environment and cascading liquidations throughout 2022. Also, despite the fall in prices and reduction in token incentives, their user bases have actually grown with weekly active users in an upward trend. Hacks and scams from smaller DeFi protocols have eroded trust in newer applications while leverage and lies have eroded trust in centralised exchanges. Venture funding for DeFi start-ups has become more difficult in a more competitive environment.

 Lastly, we see further integration between real-world assets and crypto exchanges. This is evidenced by JP Morgan forking AAVE to trade Singapore Dollars, the sale of real estate through NFTs and the lending of stablecoins to SMEs in emerging markets. Smaller, less proven DeFi protocols will have to build both their products and reputation in a more orderly manner as risky behaviours aren’t being rewarded to the same extent anymore. So, for now, while we do expect innovation among newer protocols, we see a clear deviation between the two groups and expect them to further diverge as the year progresses.

Ethereum’s Multi-chain world threatens altcoins

Max Shannon – Digital Asset Analyst

Macro and industry factors have caused a substantial decline in prices and trading volume leading to disillusionment and disinterest in the broader crypto ecosystem, marking the end of meme season. 947 coins died in 2022, as defined by CoinGecko, based on zero trade activity within the last two months and tokens deactivated or revealed as a scam. Aggregating adoption and developer community metrics provides a detailed and holistic view of the top 40 tokens by market cap to decipher the outlooks of blockchains throughout 2023. 

Divergence from a cross-chain world (e.g., Ethereum to Avalanche) to a multi-chain world (e.g., Ethereum to Polygon) within Ethereum’s zone of sovereignty is a likely theme for 2023. Ethereum’s Zone of Sovereignty includes all blockchains that attach to Ethereum’s consensus - those that settle transactions on Ethereum’s base layer.

Convergence towards Ethereum’s multi-chain world

·        Ethereum and Layer 2s transaction share increased from 30% to 60% by year end.

·        Ethereum developers are 5%, 10% and 14% more productive than Solana, Avalanche and Cosmos.

·        Ethereum developers number 2x, 3x and over 8x as many as Cosmos, Solana, Avalanche.

·        Arbitrum and Optimism number of addresses grew the fastest out of all top 40 by market cap, and daily transaction counts increased by 675% and 1314%, respectively.

A smaller decline in Ethereum’s transactions and addresses shows genuine utility

The limited decline from All-Time-Highs (ATHs) regarding the number of transactions and active addresses shows Ethereum’s resiliency and utility amongst other blue-chip blockchains. Ethereum, Solana and Avalanche transactions decreased 22%, 53%, and 86% from their respective ATHs to 1m, 130k and 2.9m per day on a 30-day moving average. 

Active addresses show a similar story. Ethereum, Avalanche and Solana declined 9%, 62% and 79% from their respective ATHs to 583k, 34k and 376k on a 30-day moving average. As a result, only Ethereum and Solana fall within the top 25% of transactions and addresses out of the top 40 by market cap, as Avalanche had one of the steepest declines amongst the top 40 in both adoption measures. Hence, from around May 2022 onwards, Ethereum’s weighted average of transactions and addresses almost quadrupled from 10% to 40% by year-end. We suspect this trend to continue against its two largest competitors mainly due to its increasing dominance in DeFi and NFTs.

Adoption stems from applications. Ethereum and its Layer-2s have notable DeFi accomplishments, such as Uniswap, Lido and MakerDAO, yet these are mostly not present on Avalanche or Solana. Ethereum’s multi-chain world increased their respective share of DeFi TVL from ~64% to ~69% (albeit, over 90% of Ethereum’s TVL) last year, whereas Avalanche and Solana halved to ~3% and ~2%, respectively. Given Solana’s bad year for price action, protocol outages and TVL-blow ups, ‘trust’ in a trustless system has been severely damaged, and negative sentiment will likely weigh on users and investors throughout 2023. And, despite some traction from 1Inch and GMX launching on Avalanche, we’ll continue to see the flow of capital into and around the largest, most liquid and ‘safer’ applications in the Ethereum ecosystem.

Ethereum hosts 80% of the top 25 NFT projects by volume, but Layer-2s have already shown signs of adoption. Polygon’s partnerships with Starbucks, Disney, Adidas and Reddit, are incomparable to Avalanche’s Chikn NFT, Smol Joes, and Rich Peon Poor projects. Solana’s top two performing NFT projects, DeGods and y00ts, also migrated to Ethereum and Polygon at the end of 2022. Corporate network effects will likely develop on Layer-2s throughout 2023 as many firms are entering the experimental stages or continue to explore customer and community engagement using token incentives and blockchain technology.

An extensive and productive developer community

Avalanche has the smallest number of transactions, addresses, developers and pull requests (active changes pushed to the code hub for review by peers) out of the three. Solana had the most significant decline in both developer community metrics. To support our multi-chain thesis, Ethereum’s developer community is larger and more productive than Solana’s and Avalanche’s, and other interoperability networks such as Cosmos. Ethereum developers made 0.91 pull requests each per day, higher than Solana, Avalanche and Cosmos by 5%, 10% and 14% respectively. This ratio translates to approximately 125 pull requests per day on Ethereum, almost 2.5x Cosmos’, 3x Solana’s and over 8x Avalanche’s figures. Ethereum’s global community of developers is also more extensive, standing at 132 active developers per day, which is almost 2x, 3x and over 8x, respectively. Simply put, Ethereum developers are larger in number and more committed to creating a working product, continuously polishing and upgrading its features. 2022 saw a successful Merge and upgrades throughout 2023 include Shanghai and maybe Sharding, all very important for core protocol ossification and future scaling. 

Continued Layer-2 dominance will drive Ethereum’s multi-chain world

Polygon and Ethereum Layer-2s, Optimism and Arbitrum performed well across all metrics. All three blockchains stand in the top 50% of active addresses across the top 40 by market cap. Polygon’s active addresses declined 2% throughout 2022 and is still the fourth largest behind Bitcoin, Ethereum and Solana. Arbitrum (~55k) and Optimism (~55k) grew the fastest (excluding blockchains from a base below 1000), around ~12x and ~23x, respectively, amongst all top 40 blockchains. 

Over the last 30 days, Polygon has recorded the fourth largest number of transactions (~3m/day) behind Tron, Algorand and Stellar (albeit the largest of all legitimate blockchains beating Ethereum, Binance Chain and Solana). Arbitrum’s and Optimism’s daily transaction counts increased by 675% and 1314%, respectively.

Approximately 54 applications joined Optimism every day throughout 2022. This year, Optimism will launch Bedrock on the mainnet, an upgrade which will decrease fees further and improve bridging security thereby attracting more users, applications and capital. Expect Arbitrum to relaunch their Odyssey program in 2023 and possibly release their token alongside it. Polygon’s suite of nine teams, products and roadmaps are all being developed simultaneously to fit different users’ needs including enterprise-specific blockchains, self-identity and pure Ethereum scaling. We expect at least two of Polygon’s products to hit mainnet in 2023, likely in a beta environment. 

In closing, while the noise may quieten, especially amongst the lower market cap tokens, developer communities are likely to stay thin while adoption struggles, a lingering buzz may continue amongst the larger Layer-1s as innovation will not cease to occur. The signal shows, however, that consolidation and convergence towards the Ethereum ecosystem are the lines of direction for the rest of 2023.

Blockchain equities: Soft landing vs hard landing

Alexander Schmidt, CFA – Index Fund Manager & Satish Patel, CFA – Equity Analyst

We see 2023 as a year of digesting the record interest rate hikes from 2022 and whether the global economy, in particular the US, can remain resilient in the face of deteriorating leading economic indicators. As the rate of US inflation is appearing to decelerate rapidly based on the past three months (October 2022 – December 2022), the question remains: Will we have a soft or hard landing in 2023?

In our view, a soft- landing scenario in the US would constitute moderately lower inflation and tepid rises in unemployment, possibly in the ranges of 3-4% and 4-5% respectively. Fed fund rates are likely to remain higher for longer in a soft landing, near the terminal rate of 5%, with the economy extending GDP growth for longer. This is likely to have a diverging impact on blockchain equities with the more value-oriented and growth-at-a-reasonable price companies outperforming the higher beta, growth sector. In this environment, we would expect cryptocurrency prices to remain stable (assuming no exogenous risk) and therefore, pure-play companies might be better positioned to predict the path of their revenue generation going forward. In retrospect, companies with weaker balance sheets are unlikely to be able to access debt markets for financing or capex spending and may underperform businesses that are capital light, have earnings predictability and benefit from higher interest rates. 

On the other hand, a hard landing scenario would result from a continuation of declining business activity, deflation, rising unemployment and deteriorating consumer balance sheets. Interest rate cuts are likely to follow in response, which could spark a narrowing of bond yields and lead to a bull-steepening yield curve. In this situation, the narrative for equities depends on whether the recession is mild or harsh. A mild recession could be supportive of cryptocurrency prices as the Fed would remove a restrictive policy stance. On the other hand, a deep recession could lead to a liquidity crunch with a risk-off type of environment despite the FED moving to a more accommodative monetary policy regime. In this scenario, corporate profitability is likely to decline, however, once this phase passes, the outlook could be brighter for growth equities with gradually improving liquidity and looser monetary conditions.

Below we have highlighted the potential impact of a soft versus a hard landing on the sectors concerning blockchain equities:

Summary Table

Japan outlook: stabilising financial conditions and compelling valuations

In Japan, the economic conditions are more nuanced than the US. Inflation is at 3.8%, a level not seen since 2014 which is, in part, due to the weaker yen and accommodative fiscal and monetary policy throughout 2022. However, in December 2022, the Bank of Japan (BoJ) announced a relaxation of their yield curve control to raise the cap of their 10-year government bond yields to 0.5% from 0.25%. Although this represents a slight change in narrative, we do not expect a material shift from accommodative to restrictive policy in 2023 despite the upcoming change in leadership at the BoJ in April 2023.

The full removal of COVID restrictions in the country, paired with a stabilised yen and economic growth have promising implications for Japan in 2023. For equities, valuations remain low compared to the US, especially with large cap value companies. A range of these companies have resilient balance sheets coupled with operating leverage that could be utilised to increase share buybacks and dividends to boost shareholder returns – a growing trend in Japan. The risks are that inflation climbs higher than expected and starts to become entrenched, in which case we could see higher caps on the yield curve and a gradual shift to monetary tightening.

China outlook: re-opening takes the spotlight

China, unlike the rest of the world, is loosening monetary and fiscal conditions to stimulate economic growth. Persistent lockdowns in the past couple of years have hurt corporate profitability in China, but as these measures start to ease, company earnings are poised to increase, helped by the weakening of the US Dollar from an exporting perspective. For the global economy, this could be a positive, as historically, China has been a net exporter of deflation. In the short term, however, an increase in economic activity in China could be supportive of appreciating commodity prices.

Valuations remain compelling in Chinese equities, with the re-opening favouring the energy, financial services and hospitality sectors, while investment in consumer electronics and semiconductors may have peaked during lockdown. As a result, there is likely to be a mixed picture for blockchain equities from a China perspective, with some sectors doing better than others and an unclear overall net impact. 

2023: building up to a hard landing in 2024

Finally, we believe that it is increasingly likely that a delayed deterioration in lagging indicators, such as the unemployment rate, may disguise a hard landing scenario that is postponed to 2024. Therefore, we consider that 2023 could spell more absorption of restrictive monetary policy in the US, with corporate profitability starting to decline in the latter half of the year. Value-oriented equities may outperform growth, with cyclical industries such as semiconductors and high growth technology not faring as well due to persistently high interest rates and declining consumer and business fundamentals. 

Dramatic Changes in the Exchange World

James Butterfill – Head of Research

Spot and futures volumes are notoriously difficult to get right in the cryptocurrency world for several reasons. The data is very fragmented, with few providers providing a full picture of what's being traded, and there is often an element of wash trading, which we estimate could be up to 60% of total volumes. Quantifying volume is essential though, as it highlights to some extent how much a cryptocurrency is being used on exchange, being relatively agnostic as to what its use is. Cryptocurrencies can also be traded OTC, but this is difficult to reconcile accurately, and it can also be traded in marketplaces that are hosted directly within a cryptocurrency platform itself, often called decentralised exchanges.

Our analysis is focussed on the spot markets using a select group of trusted exchanges on both the centralised and decentralised markets. We are also focussing on just Bitcoin and Ethereum, which we estimate to comprise ~65% of total spot volumes on trusted exchanges, excluding stablecoins.

We have followed similar criteria to Coinmetrics in selecting trusted exchanges which are based on a combination of volume correlation, web traffic analytics and qualitative factors. The list comprises ~45% of total market spot volumes while it adopts a conservative approach, so it is probable that we are understating volumes to some extent.

The results highlight that spot Bitcoin averaged a daily US$11bn and spot Ethereum US$6bn in 2022, having fallen 23% and 34% respectively relative to 2021. Regardless, these trading volumes are substantial when compared to the FTSE 100 and the Nasdaq 100, which both traded a daily US$4.4bn and US$38bn respectively in 2022.

2022 was a year of seismic shifts in trading patterns, with stablecoins usage growing by 3.5% relative to 2021, averaging US$7.8bn per day. Meanwhile, FIAT and Cryptocurrency Bitcoin trading pairs fell 40% and 73% respectively over the same period, leading to a dramatic rise in stablecoin market share to 70% of all bitcoin trades. The same phenomenon was not seen in Ethereum, with market share remaining relatively stable over the course of 2022.

We believe the shift to stablecoins is due to investors favouring the ease and accessibility of stablecoins, particularly in frontier markets (which we have written about here) but also the rise in popularity of BUSD, Binance’s stablecoin (approved by the New York State Department of Financial Services), which has favourable trading fees. It is rapidly gaining market share against Tether, having started 2022 with 9% market share of Bitcoin volumes to its now 30%.

Looking at the combined volumes of Ethereum and Bitcoin for exchanges highlights the dramatic rise in market share of Binance, with its stablecoin and other trading pairs rapidly rising in popularity, due to very competitive fees, high liquidity, a long list of tradable assets and perhaps not being subject to US regulations. Binance looks to have primarily gained market share from smaller exchanges rather than some of the other key exchanges such as Coinbase and HitBTC, while the substantial gains towards the end of 2022 were due the collapse of FTX.

A word of caution is necessary, however. While Binance is dominating the spot centralised exchange market, it is being threatened by the rise of decentralised exchanges (DEXs), which are free of a lot of the custody and due diligence problems that were made so evident by collapse of FTX. DEXs had been losing to centralised exchanges earlier in 2022, but the FTX incident was a reminder to investors as to how important safe custody of assets is, and we have since seen a recovery in their market share that has been trending upwards over the last of the last two years towards 15%. 

Despite the recent crisis, crypto trading volumes remain deeply liquid, and continue to trade in greater volumes than most equity exchanges around the world. Measuring trading volumes, while use-agnostic, is a good measure of the use of crypto assets, particularly when we have seen much of the speculative froth leave the market.

As the exchange market continues to mature in 2023, we are likely to see a continued move away from centralised exchanges due to their inherent vulnerability to human error. Decentralised exchanges and sophisticated OTC solutions are likely to be the main beneficiaries of this change in user behaviou

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