Research Round-Up: December

Watch Now: Fidelity Digital Assets’ Research Director Chris Kuiper and Research Analyst Jack  Neureuter provide additional commentary and market insights in this short on-demand video.

Market Commentary

As we approach the end of the year, we look back on what has been a rough price history for both bitcoin and ether. Over the course of the year, bitcoin and ether fell approximately 66% and 69%, respectively. On the other hand, the S&P 500 was a slightly different story, losing just 16% over the course of the year. In this month’s Data to Watch section, we take a closer look at macroeconomic data and digital asset fundamentals.   

News and Editorial

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

Major Exchange Outflows in the Wake of the FTX News

Charted above is the cumulative exchange balance of bitcoin and ether since January 2020. The yellow circle highlights a 12% decrease in exchange balances from August 2020 to November 2020, which was followed by a steady decline over time through October 2022. This “small” drop in exchange balances is in stark contrast to the recent market reaction. The 12% drop in 2020 took place over four months. The November 2022 drop of 17% occurred in just two short weeks.

Our Two Sats: The exchange balance metric shows that users are increasingly moving to self-custody as trust in central crypto exchanges appears to have wavered. For example, hardware wallet provider Trezor reported a 300% increase in sales in the week following the FTX news, and a 350% increase in website traffic over the same time period.¹ It is important to note that many of the central exchanges that have failed this year offered high yields or large account opening bonuses, and these incentives have to be funded through some source or strategy, which carry more risk. In terms of what outflows could mean for the future market forces, it will be interesting to see if these coins flow back to exchanges or if they remain in self-custody or cold storage solutions. Typically, higher exchange flows have been associated with positive price momentum or bull markets, but as the recent spike in exchange flows was driven by the alleged business and operational failures of some firms in the ecosystem, they are not yet as high as the past year’s average. While the tide continues to go out, there’s no saying how many exchanges and services may find themselves exposed to tumultuous market conditions.

Ethereum Validator Revenue Hits Peak Since The Merge

As noted above, many people around the globe have taken their assets off centralized exchanges and into self-custody. Ethereum on-chain volume spiked 62% month-over-month, spurring higher transaction fees and soaring demand for decentralized exchanges.² This resulted in increased validator revenue as they received more rewards in the form of fees, as well as maximal extracted value (MEV), which are additional rewards above and beyond the standard block reward and gas fees. Rewards associated with Lido Finance, a pooled staking service, sat at over 10% APR for three days of the month, almost double the average rewards since The Merge.³ Solo stakers were able to capitalize on the increased value per block as they don’t share rewards among a large pool of nodes, meaning there is higher potential upside during times of elevated value per block, but this also creates a more volatile accrual of rewards over time compared to their pooled counterparts.

Our Two Sats: The degradation in the trust of centralized exchanges clearly drove demand for more decentralized services. As the demand for on-chain services increases so does the supply of MEV opportunities and the demand for block space, both of which spell greater expected rewards for validators. However, even with demand increasing for decentralized services, validator rewards are not easy to predict. As more validators come online, the rewards per validator naturally decrease, and since The Merge, there has been a steady increase in the total staked ether. This introduces some unpredictability around future rewards since total staked ether impacts the amount of rewards received. Additionally, if layer 2 scaling solutions become the place where future transaction execution takes place, it could drive value accrual to other ecosystems as opposed to the Ethereum Beacon Chain validators. The potential impacts of these events on validator rewards are speculative because there are still many unknowns about the future of validating on Ethereum and the associated rewards. We’re eagerly looking forward to the Shanghai upgrade as it will allow both the full redemption of staked ether and community prioritization of exciting new innovations.

El Salvador Introduces Bill Confirming Plan to Launch “Volcano Bonds”

El Salvador’s Minister of the Economy Maria Luisa Hayem Brevé, recently introduced a long-awaited bill that confirms the government’s plan to raise $1 billion of “Volcano Bonds” and invest them into the construction of a “Bitcoin City."⁴ The bill proposes that lawmakers create a legal framework surrounding the use of digital assets in public issuances by El Salvador. Half of the $1 billion is to be allocated to the construction of a “Bitcoin City” at the base of the Colchagua volcano in El Salvador with the intention of utilizing the hydrothermal energy of the volcano to mine bitcoin, and the other half of the raised funds to be invested into bitcoin directly. The project has been delayed multiple times for various reasons, but it appears the bill could be approved before the end of the year.

Our Two Sats:  The “Volcano Bonds” have been a highly anticipated and hotly discussed development coming out of Bitcoin-friendly El Salvador. After encountering some roadblocks that prevented these from going live, it is a significant milestone to see a bill that would not only put them into practice but also emphasizes the importance of having an adequate framework and procedure in place around how the bonds themselves would be issued and utilized. It is also noteworthy that the government of El Salvador continues to progress along its pursuit of an eventual “Bitcoin City” amidst the current market downturn. While the end goal of having a city built at the base of a volcano for crypto mining purposes may be a bit ambitious, it is emblematic of the entrepreneurial spirit of the bitcoin community and the creative quest to utilize sustainable and renewable energy sources for mining operations at a time where environmental concerns around mining practices remain a large barrier to adoption.

Vitalik Releases Updated Ethereum Roadmap

Vitalik Buterin released an updated Ethereum roadmap via Twitter on November 5.⁵ The update had some big changes, including an entirely new phase called “The Scourge.” The goal of this new phase is to “ensure reliable and fair credibly neutral transaction inclusion and solve MEV issues.” In other words, the Ethereum protocol will look to strengthen its censorship resistance as well as mitigate the negative impacts MEV has on users.

Our Two Sats:  It’s important to note that MEV is impossible to eliminate, but the proposed solution is to minimize the negative effects MEV has on users. Frontrunning is a form of MEV that’s been specifically called out as it degrades the user experience and has no positive side-effects. Issues that arise from MEV don’t all fall into the same bucket, however. MEV in the form of arbitrage is relatively benign in terms of the user experience and can help markets and prices stay consistent. Since MEV comes in all shapes and sizes, there’s no single solution that fixes all associated issues. Starting with addressing its most prominent negative impacts, then working towards addressing the more minimal impacts seems like a reasonable and measured approach. The question now becomes what level of prioritization this new phase will be given within the scope of the larger development roadmap. Is it more, or less, important than scaling? Users, developers, and investors may all have differing opinions on this topic. Keep an eye out for a deeper dive on MEV from the Fidelity Digital Assets team later this month.  

News Quick Hits

• A new bill from Brazilian lawmakers acknowledge bitcoin as a digital form of money that can be used as a medium of exchange and as an investment instrument.⁶
• TP ICAP, one of the world's largest interdealer brokers in the world is registered with the Financial Conduct Authority of the United Kingdom as a provider of digital assets.⁷
• Belgium declares that Bitcoin, Ethereum, and cryptocurrencies that are issued by computer code alone are not securities.⁸
• Binance announces plan to set aside at least $1 billion for proposed crypto industry recovery fund.⁹
• CoinMarketCap launches a proof of reserves tracker for crypto exchanges that gives users the ability to monitor the reserves of exchanges through displays of the balance and value of public wallet addresses.¹⁰
• 10,000 BTC, worth $165 million, moves off crypto wallet linked to Mt. Gox hack.¹¹
• Bitcoin addresses holding at least 1 BTC close in on a million, signaling continued interest and adoption in the asset despite market turmoil.¹²

Data to Watch

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

Bitcoin Hash Rate Decline

After China banned a majority of bitcoin mining in 2021, Bitcoin experienced a 52% drop-in hash rate. However, the hash rate has been in a steady growth trend, hitting a new all-time high on October 31 even as price wavered and fell to levels not seen since 2017. Since then, the upward trend has shifted, with hash rate suffering a 36% pull back as price swings even lower.

When hash rate is high and price is low, miners must choose between keeping their lights on or mining at a loss. The data in the chart below shows that, most recently, miners are selling 100% of their bitcoin revenue as well as dipping into their treasury reserves. Any time the “sell” line moves above the 100% target line, miners are selling more than they mine. Alternatively, the difference between the 100% target line and the “holding” line represents days the miners were able to save. Simply put, the green portion shows a time when miners were able to build their reserves. Today, they’re primarily having to sell 100% of their mining revenue as well as old reserves from their treasury.

Recent Increase in Volatility

Last month, headlines ran with news that bitcoin’s volatility fell below that of the S&P 500. As history has shown, a compression in volatility has ultimately been followed by a burst of volatility with a price move to the downside or upside. In this case, bitcoin’s price jumped to the downside, reaching as low as $15,000. However, this price action is most likely due to the ripple effects of recent crypto firm bankruptcy filings and related news. Another metric to note here is the long-term illiquid supply (bitcoin that hasn’t moved in over a year), which has remained above 66% through these events. This metric may indicate that long-term holders still have conviction at these prices and are unwilling to sell. The all-time high over the past 10 years was set at 66.93% on November 13, 2022.

Ether Issuance Since The Merge

Ethereum’s current fee structure and users’ highly volatile demand for block space have caused waves of extremely high burn which have mostly been balanced out by calmer periods. This has resulted in just 250 net ether issuance from The Merge in September to November 30. To quickly recap how it works, new ether is created and issued to validators on the network that propose new blocks and verify new transactions; this is where the new “issuance” comes from. In order to interact with the protocol, users must effectively “burn” an amount required by the network to complete any computations requested by the user. This is known as a “burn mechanism” or “the burn.” Therefore, if users are continuously using services built on Ethereum or transacting with other users, then the burn rate will trend higher. The chart above shows a period of three days where demand for Ethereum block space was so high that more than 2,000 ether were burned almost three days in a row. To put that into perspective, if 100% of validators perform their duties and receive the reward, the daily issuance of ether is roughly 1,750 as of November 30. This number grows as the number of validators increase and begin staking.¹³ The average daily issuance since The Merge in mid-September is around 1,731.