Quarterly Blockchain Newsletter - Q2 2022

Section 1: Bitcoin price performance

In the second quarter of 2022, the price of bitcoin fell by 58.6%, resulting in a YTD performance of -58.8%. Coin Metrics’ CMBI 10 Excluding Bitcoin Index, which measures the return of a basket of the next ten largest crypto assets after bitcoin weighted by their free-float market caps, finished the quarter down about 70.5%, resulting in a YTD performance of -72.8%.^[1]

A bit of history

There have been several major drawdowns in crypto market history. In February 2014, Mt. Gox, a bitcoin exchange which at its peak in 2013 handled around 70% of all bitcoin transactions worldwide,^[2] suspended operations and filed for bankruptcy following hacking attacks/thefts that resulted in the loss of hundreds of thousands of bitcoin belonging to customers.^[3] By early April 2014, the price of bitcoin had fallen below $500, down from its then-peak of over $1,000 in November 2013.  

Throughout 2018, there was a general sell-off of cryptocurrencies, following the bursting of the 2017 ICO bubble. The price of bitcoin fell by over 70% in 2018. In the first quarter of 2020, crypto markets experienced a significant drawdown along with most other financial markets following the rise of COVID. The price of bitcoin fell to around $5,000 in mid-March, down from over $10,000 in mid-February 2020. Then in May 2021, headlines around China’s crackdown on bitcoin mining and trading,^[4] as well as tweets from Elon Musk highlighting concerns over the environmental impact of bitcoin mining,^[5] contributed to a sell-off that saw bitcoin’s price fall from over $57,000 at the beginning of May to around $30,000 in July 2021.

In all these cases, the market eventually recovered, and crypto prices rose to new highs.

The current bear market

Which brings us to the current crypto bear market, which started in late 2021 and has extended through the first two quarters of 2022. The current crypto bear market is driven in large part by a general sell-off in risk assets due to macroeconomic factors. Bitcoin’s price hit an all-time high of over $67,000 in early November 2021, however the announcement of the U.S. October CPI of 6.2% on November 10, 2021 increased expectations of central bank intervention. The subsequent rate hikes and quantitative tightening in response to high inflation have spurred recession concerns and signal the end of an unprecedented period of rapid money supply growth which contributed to asset price increases across risk assets over the last two years. Inflation and risk-off sentiment have been exacerbated by the ongoing Russia-Ukraine war as well as supply chain issues resulting from China’s zero-COVID policy. Amidst this backdrop, risk assets have taken a hit since the beginning of the year, with the S&P 500 and NASDAQ indexes returning -20% and -29% on a YTD basis, respectively.

On top of the macro pressures on risk assets, two crypto-specific headlines over the quarter have particularly shaken the crypto market. The first of these events was the collapse of Terra in early May following the de-pegging of its stablecoin, UST. Prior to its collapse, Terra was one of the top blockchains by the market cap of its fundamental token, LUNA. In its (failed) attempt to stabilize UST’s peg, the Luna Foundation Guard, an organization established to support the Terra ecosystem, deployed almost 80,000 bitcoin from its reserves,^[6] contributing to negative price pressure on bitcoin. On May 11, the price of bitcoin fell below $30,000 to its lowest level since July 2021.

On June 12, crypto markets came under further pressure as U.S. cryptocurrency lending company Celsius Network halted withdrawals and transfers on its platform due to “extreme market conditions”, having experienced a rise in redemptions in the wake of the Terra collapse and overall market volatility.^[7] This move left 1.7 million users unable to redeem their assets,^[8] and fuelled rumours that the platform had become insolvent. A crypto lender is analogous to a bank, in that it allows users to deposit their cryptocurrency and earn yield. However, crypto lenders are not subject to the same levels of regulation as traditional banks in terms of transparency, risk management practices, etc., and do not generally have protections such as government deposit insurance. Celsius’ potential insolvency may have repercussions for the broader crypto market, as the firm has deployed significant amounts of assets on multiple DeFi protocols. If it goes into liquidation, the unwinding of its positions could have knock-on effects that result in further price decreases and liquidations for other DeFi users. Bitcoin’s price fell by over 20% in the week following the announcement, falling as low as $17,600 on June 18 after an around $500 million outflow from the Purpose Bitcoin ETF (BTCC) the previous day.^[9]

For more detail on Terra’s collapse and Celsius’ withdrawals freeze, please see Volatility and Crypto ETFs article.

On the heels of Celsius’ announcement came a slew of further negative headlines. Shortly thereafter, insolvency concerns surrounded crypto hedge fund Three Arrows Capital (3AC) after the firm failed to meet margin calls from its lenders,^[10] crypto staking and yield generation platform Finblox imposed a monthly withdrawal limit to “evaluate the effect of 3AC on liquidity”,^[11] crypto lender Babel Finance suspended withdrawals on their platform,^[12] crypto broker Voyager Digital secured credit facilities from trading firm Alameda Research and subsequently lowered withdrawal limits after revealing a more than $600 million exposure to 3AC,^[13],[14] major crypto lender BlockFi secured a $250 million revolving credit facility from FTX to “further bolster [their] balance sheet”,^[15] and crypto futures exchange CoinFlex paused withdrawals citing “extreme market conditions” along with uncertainty around a certain counterparty.^[16] Crypto lender Genesis is reportedly facing “hundreds of millions” of potential losses, related in part to its exposure to 3AC and Babel Finance.^[17] On June 29, a court in the British Virgin Islands ordered the liquidation of 3AC,^[18] which had been invested in a number of troubled crypto projects, including Terra.

Leveraged and high-risk strategies employed by various crypto platforms and within the broader DeFi ecosystem have contributed to liquidation cascades and price drawdowns. A recent report by Chainalysis shows that in H1 2022, lending protocols’ biggest source of funds came from other lending and yield-generating protocols.^[19] This can increase cascading risk in the event of market downturns. Recent events have highlighted the degree of interrelation and potential contagion amongst crypto platforms and will likely incite increased scrutiny on the risk management practices of these platforms. This may be an opportunity for the industry to leverage the transparency of blockchains to analyze systemic risk and build better practices for the future.

Bitcoin performance and correlations

Bitcoin is holding up better compared to many of the other top cryptocurrencies in terms of YTD performance, in line with the idea that although perceived as risky compared to traditional assets, bitcoin is a relative ‘safe haven’ among cryptocurrencies. The recent events concern the DeFi ecosystem more than they do the Bitcoin network, which is still chugging along as designed. However, correlations between major cryptocurrencies tend to be high (the trailing 12-month daily return correlation between bitcoin and ether is over 85%), despite there being important differences across cryptocurrencies. Likely due to the emerging nature of this space, people tend to buy and sell their crypto holdings together. Amidst the volatility, the SEC rejected Grayscale’s application to convert its Grayscale Bitcoin Trust into the first spot bitcoin ETF in the U.S. on June 29, citing concerns including market manipulation.^[20] Grayscale is suing the SEC in response.  

Over the past six months, the correlation between bitcoin and the broader stock market has increased, reflecting the idea that bitcoin and other crypto assets are trading like risk assets as investors reposition their portfolios. The rolling 90-day correlation between bitcoin and the NASDAQ as at quarter end stood at over 65%, up from less than 40% as at year-end 2021. The higher correlation between crypto and equity markets is also being driven by increasingly similar market participants across these markets as institutional and retail adoption of cryptos increase.

Rolling 90-business-day return correlation between bitcoin and stock indexes

Market value to realized value (MVRV) is an indicator of bitcoin market tops and bottoms. MVRV is calculated by dividing bitcoin’s market capitalization by its realized capitalization, which is calculated by valuing each unit of bitcoin at the price that it was last transacted on-chain. Historically, a high ratio of market capitalization to realized capitalization has signaled that bitcoin price was near a local maximum, while a low ratio has indicated that price is near a local minimum. 

Bitcoin MVRV (free float)

Looking ahead

Looking ahead to the second half of the year, there may be positive catalysts for the crypto market such as increased regulatory clarity or Ethereum’s transition to proof-of-stake (PoS) in an anticipated event dubbed the “Merge”. In early June, Ethereum completed a “dress rehearsal” of the Merge when its Ropsten testnet successfully switched to PoS. Over the next few months, similar trial runs will take place on other Ethereum testnets.^[21] If all goes well, the Merge should occur sometime later this year, which may buoy sentiment toward Ethereum and the broader crypto market.

Some remain optimistic amidst the doom and gloom. At this year’s Consensus, an annual blockchain and cryptocurrency conference, the atmosphere remained upbeat and forward-looking despite the bear market. The event attracted around 17,000 attendees and featured a long list of speakers ranging from developers and creators to policymakers, academics, and representatives from institutions such as asset managers, crypto exchanges, and fintech companies. In late June, Michael Saylor, CEO of software analytics company MicroStrategy, announced that the company purchased an additional 480 bitcoin for around $10 million, despite the unrealized losses on its existing bitcoin holdings.^[22]

Adverse crypto-related events such as the ones we’ve seen during the quarter are part of the growing pains and evolution of a still emerging asset class and a nascent financial ecosystem that’s building around it. More broadly, the crypto market is now facing a new macroeconomic paradigm. Up until recently, crypto markets have never really known anything but easy money. Bitcoin was born in the aftermath of the 2008 financial crisis, into an era of low interest rates and quantitative easing. In the short term, crypto prices may continue to be weighed down by the macro environment, as well as volatility-inducing headlines. However, blockchain technology’s core value propositions of decentralization, transparency, and accessibility remain intact, and may drive further adoption of the blockchain ecosystem in the long run.

Section 2: Bitcoin adoption

In April, Strike, a payments company that focuses on facilitating fast, low-cost bitcoin payments by leveraging the Lightning Network, announced its integration with Shopify. Strike claims that the partnership with Shopify will “provide merchants with a cheaper and faster way to accept U.S. dollars using Bitcoin technology”.^[23] According to the press release, the Strike integration aims to offer an alternative to traditional card networks and will be accessible by any consumer in the world with a Lightning Network-enabled wallet, including more than 70 million CashApp users. This announcement highlights the potential of Bitcoin and its associated Lightning Network to be used as a monetary settlement layer that provides an alternative to traditional payment rails, which can be laden with relatively higher fees and processing times to transfer money between parties.

Total value transferred and transfer count on the Bitcoin network

Daily number of active Bitcoin addresses (rolling 30-day average)

Several potential use cases of crypto assets have been illustrated amidst the Russia-Ukraine war. Soon after the invasion in February, Visa and Mastercard suspended operations in Russia, preventing clients from using their Russian cards abroad or for international payments online.^[24] This, in combination with capital controls imposed in Russia,^[25] have prompted some Russians abroad or going abroad to turn to crypto markets for access to funds.^[26] Some Ukrainians are also turning to crypto as an alternative to Ukrainian financial institutions,^[27] likely due to the self-custody and portability benefits of crypto amidst an unstable situation in which reliance on traditional banks seems less compelling. In addition, crypto has been a source of donations to Ukraine, offering the potential benefits of speed and efficiency of transfer. Over $135 million in crypto has been raised by Ukrainian funds as of mid-May, according to analytics firm Crystal Blockchain.^[28]

The Central African Republic (CAR) became the second country (after El Salvador) to adopt bitcoin as legal tender in April. The country also laid out plans to move forward in driving broad-based crypto adoption. Like El Salvador, the CAR does not issue its own independent currency, and instead uses the euro-pegged CFA franc. The adoption of bitcoin may make it easier for businesses in the CAR to conduct international transactions, due to the relative ease of converting bitcoin into other currencies, compared to the CFA franc.^[29]

Section 3: Major headlines over the quarter

General

Fidelity to let companies offer bitcoin in 401(k) accounts: Fidelity Investments, one of the largest 401(k) providers in the U.S., announced in April that it will be launching a new workplace Digital Assets Account.^[30] The product offering will enable employers to offer their employees the option to invest up to 20% of their 401(k) assets in bitcoin.^[31] Bitcoin held within the Digital Assets Account will be custodied by Fidelity Digital Assets. MicroStrategy has already announced that it would leverage this new product, estimated to become widely available in mid-2022, for its employees. Fidelity’s announcement drew criticism from the U.S. Labor Department, which expressed “grave concerns with what Fidelity has done”.^[32] In June however, the Crypto Council for Innovation, a crypto industry group whose supporters include Coinbase and Block,^[33] pushed back regarding the Labor Department’s concern about including crypto in 401(k) plans, saying that the Labor Department “narrowly considers only the risks of cryptocurrencies while disregarding their potential benefits”.^[34]

Vitalik Buterin publishes a white paper proposing “soul-bound tokens”: In May, Vitalik Buterin, co-founder of Ethereum, published a white paper along with two co-authors titled ‘Decentralized Society: Finding Web3’s Soul’, in which “soul-bound tokens” and “Souls” are proposed. Soul-bound tokens (SBTs) are NFTs that cannot be transferred, although they may be revocable by the issuer upon certain conditions, and Souls are wallets that hold SBTs. The idea is that SBTs can be used to build up a person’s digital “resume” in terms of reputation and accomplishments, and can represent various affiliations, memberships, and credentials. For example, a person might have a Soul that stores SBTs representing educational credentials issued by a university. SBTs have many potential applications. For example, they could be used in DeFi to enable reputation-based uncollateralized lending/borrowing, serving as a record of credit-relevant history. SBTs could also be leveraged to enhance the sophistication and security of DAO voting mechanisms. SBTs are currently in development and not yet available.

MetaMask partners with Asset Reality to help victims of scams: In May, MetaMask, a popular self-custody wallet, announced a strategic partnership with Asset Reality, an end-to-end solution for recovering, managing, and accessing seized crypto assets.^[35]  Through this partnership, MetaMask and Asset Reality will aim to help victims of scams recover their digital assets where possible. Asset Reality works with on-chain forensics companies like Chainalysis and crypto specialized law firms. While this service is free for MetaMask users, victims will still have to cover their legal fee if they decide to take that route for recovery. The service will also help victims join forces and pursue collective action as a group if they were hacked or scammed by the same entity. This partnership may improve user experience for people who might be deterred from self-custody due to the risk of getting hacked or scammed.

U.S. Senators introduce new bill to regulate digital assets: In early June, U.S. Senators Cynthia Lummis and Kirsten Gillibrand introduced the Responsible Financial Innovation Act, a bill that aims to create the first comprehensive regulatory framework for digital assets in the U.S. at a federal level. In a statement announcing the proposed bill, Senator Lummis described the bill as framework that would create “regulatory clarity for agencies charged with supervising digital asset markets, provide a strong, tailored regulatory framework for stablecoins, and integrate digital assets into our existing tax and banking laws”.^[36] Points addressed by the proposed bill include the creation of key definitions related to digital assets, the determination of regulatory authority over digital assets as it relates to the CFTC and the SEC, requirements for stablecoin issuers, requirements for the incorporation or organization of DAOs under the laws of a jurisdiction, and tax provisions related to digital asset lending agreements as well as mining and staking activities. The proposal also clarifies the definition of ‘broker’ under the Infrastructure Investment and Jobs Act’s new reporting requirement on digital assets and delays the implementation date to January 1, 2025.^[37]

New York State Senate passes crypto mining moratorium bill: In June, the New York Senate passed a bill that would impose a two-year moratorium on new permits as well as license renewals for carbon-based proof-of-work mining operations in the state.^[38] During the moratorium, the state will conduct a study on the potential environmental impact of proof-of-work mining^[39]. Following the bitcoin mining ban in China, the U.S. has seen an increase in mining activity with states like New York and Texas becoming especially popular among miners seeking cheap power. The bill is awaiting sign-off by the governor of New York before it becomes law.

DeFi

Compound Treasury receives S&P credit rating: Compound Treasury, an institutional offering from DeFi firm Compound Labs, announced that it received a credit rating of B- from S&P Global Ratings in May. Launched in June 2021, Compound Treasury is targeted toward enterprises looking to generate yield on their cash reserves. Accounts offer 4% APR on deposits of USD or the stablecoin USDC, are classified as securities and are only offered to accredited investors.^[40] S&P wrote that "major rating weaknesses include, in our view, the company's very low capital base, regulatory risk associated with cryptocurrencies, considerable operational risk and complexity, convertibility risk between private stablecoins and fiat currency, and the potential hurdles to generate a 4% return".^[41]  According to its website, Compound Treasury is the first DeFi company to receive a credit rating from S&P Global Ratings.

USDC issuer Circle introduces euro-backed stablecoin: In mid-June, Circle Internet Financial, the issuer of the USDC dollar-pegged stablecoin, announced that it was preparing to launch a “fully-reserved, euro-pegged stablecoin” called Euro Coin (EUROC).^[42] The new stablecoin launched on the Ethereum blockchain as an ERC-20 token on June 30, with support for additional blockchains expected later in the year. According to the press release, EUROC is “regulated” and “fully backed by euro-denominated reserves held conservatively in the custody of leading financial institutions within the U.S. regulatory perimeter”. In the EU, the Markets in Crypto Assets (MiCA) legislation aims to harmonize regulation of crypto assets across EU member states, and includes rules pertaining to stablecoin issuers. It remains unclear how a euro-backed stablecoin issued under U.S. standards might be perceived by EU regulators.^[43]

Crypto exchange dYdX to leave Ethereum: In June, cryptocurrency exchange dYdX announced that it will be leaving the Ethereum network and launching a standalone blockchain. The standalone chain will be built as part of the Cosmos ecosystem, a set of interconnected blockchains that can communicate and trade assets with one another. Currently, dYdX uses StarkWare, an Ethereum layer 2 scaling solution that allows for faster and cheaper transactions. In contrast to most decentralized exchanges, dYdX uses a traditional order book model which aims to decrease slippage and be better suited to handle institution-sized transactions. Having a standalone blockchain would provide dYdX with more flexibility to customize fee structures and other features to suit their exchange model.^[44] Although making the move to their own application-specific chain increases customizability, dYdX is leaving behind the vast decentralized network that secures apps built on Ethereum.

NFTs

OpenSea adds support for Solana-based NFTs: In April, OpenSea, the largest NFT marketplace by trading volume, announced that it would start supporting some NFT collections minted on Solana. The company praised Solana’s low gas fees, efficient energy usage, and fast transactions.^[45] Solana’s arrival in the leading NFT marketplace was long anticipated. According to their website, OpenSea currently supports two Solana wallet providers, Phantom and Glow. OpenSea has historically been largely focused on Ethereum-based NFTs. This move marks an expansion that would allow OpenSea to compete directly with Solana-focused NFT platforms like Magic Eden and may serve as a tailwind for further adoption of Solana-based NFTs.  

Thief steals millions worth of Bored Ape NFTs: In April, a hacker stole NFTs worth millions of dollars after compromising the official Instagram account of Bored Ape Yacht Club (BAYC) and using it to post a phishing link that transferred tokens out of users’ crypto wallets.^[46] Users thought they were connecting their wallets in order to participate in an airdrop. It is unclear how the BAYC Instagram account was hacked. BAYC owner Yuga Labs claimed that two-factor authentication was enabled on the Instagram account, a security measure that should have made unauthorized access to the account extremely difficult.^[47] Attacks like this highlight the importance of hyper-vigilance on the part of users when it comes to connecting their wallet to a third party.

Coinbase launches NFT marketplace: In early May, Coinbase opened its Ethereum-based NFT marketplace to the public, after testing the beta version with a select group of users in April. The platform had a rather lacklustre start, with the marketplace seeing just 900 transactions and 73 ether of sales volume in the first week of its beta.^[48] Coinbase’s NFT marketplace is looking to compete with major NFT marketplaces like OpenSea and is debuting with zero-transaction fees for a limited time.^[49] To bring more users to its platform, Coinbase aims to partner with NFT artists globally, who will do collection drops on Coinbase NFT in the future. It also anticipates adding the option to buy NFTs with a Coinbase account or credit card, so the ecosystem is more accessible to mainstream audiences.^[50]

Metaverse

Fidelity launches the Fidelity Stack in Decentraland: In April, Fidelity Investments announced the opening of the “Fidelity Stack”, an experience on the Decentraland platform where visitors can learn about investing essentials. The structure features a multi-level design complete with a lobby, dance floor, and rooftop sky garden for users to explore on foot or through teleport.^[51] The announcement was made on the same day as the launch of the Fidelity Metaverse ETF (FMET) on the Nasdaq on April 21. In May, Fidelity Canada also launched a metaverse-focused ETF product, the Fidelity Total Metaverse Index ETF (FMTV).  

Yuga Labs sells virtual land in forthcoming metaverse space Otherside: In April, Yuga Labs, the company behind the Bored Ape Yacht Club, held a digital land sale for its metaverse project Otherside, which is currently under development. The firm sold NFTs called “Otherdeeds” which represent titles to 55,000 distinct parcels of land in a forthcoming social space, generating around $300 million in sales.^[52] The land sale created some of the highest gas fees in the history of the Ethereum network, with investors spending over $176 million on fees over a 24-hour period.^[53] Holders of Otherdeeds will be able to participate in prototype builds, demos and tests that shape the final design and experience of the Otherside metaverse platform.^[54]

Meta launches marketplace for Horizon Worlds: In April, Meta announced the launch of a marketplace for Horizon Worlds, the company’s social virtual world platform. The marketplace allows creators on the platform to sell virtual items and effects in the worlds they create. This follows in the footsteps of other social platforms like Roblox and Rec Room, both of which let creators sell items that they make. Meta will be taking a cut of what Horizon creators sell, pocketing a 25% cut of the percentage leftover after a platform fee. For platforms such as the Quest Store with a 30% fee, this works out to a 47.5% cut, meaning that 52.5% of the revenue is left to creators.^[55] Economics like this highlight the benefit of using NFTs on public blockchain networks to record asset ownership, which is the approach taken by metaverse platforms like Decentraland. For comparison, the NFT marketplace OpenSea takes 2.5% of each transaction.

Glossary

Airdrop - a distribution of a crypto token, usually for free, to various wallet addresses.

DAO - stands for decentralized autonomous organization, and refers to an organization which aims to have decentralized governance through leveraging the blockchain.

DeFi - stands for decentralized finance, and is an umbrella term for financial services on public blockchains that do not need to rely on centralized intermediaries like banks.

ERC-20 - a standard for fungible tokens issued on Ethereum.

Hashrate - a measure of the computational power that is used to mine cryptocurrencies.

Layer 2 - a term that refers to a set of Ethereum scaling solutions that handle transactions off the main Ethereum network while leveraging the decentralized security of Ethereum.

Lightning Network - a protocol layer above Bitcoin that aims to allow for faster and cheaper bitcoin transactions. 

Metaverse - refers to a potential future state of the internet characterized by a network of augmented reality and virtual worlds that can be experienced persistently and in a shared environment by large numbers of users.

NFT - stands for non-fungible token, and is a type of blockchain token that can represent a specific asset.

Private key - in cryptocurrency, private keys are used to sign cryptocurrency transactions and prove ownership of a blockchain address.

Proof-of-stake - a type of blockchain consensus mechanism in which participants put up cryptocurrency as “stake” into the system.

Proof-of-work - a type of blockchain consensus mechanism in which participants expend computing power to solve mathematical puzzles.

Stablecoins - digital coins that seek to peg their value to that of some external reference, like the US dollar.

Total value locked - the value of crypto assets deposited in a DeFi protocol.

Wallet - refers to a cryptocurrency wallet, a special wallet used to store cryptocurrencies.