December 22 Commentary

1. Sam Bankman-Fried arrested in the Bahamas as criminal charges loom
2. Sam Bankman-Fried Released on $250M Bail
3. Chief executive of FTX sister company pleads guilty to seven offences
4. Sam Bankman-Fried Issues Not-Guilty Plea in FTX Case
5. SBF Claims Robinhood Shares Necessary for Personal Legal Defense
6. FTX Crypto Worth $3.5B Held By Bahamas Regulator
7. US bank Silvergate hit with $8bn in crypto withdrawals
8. Crypto Firm Amber Raises $300 Million to Tackle Damage From FTX
9. Genesis CEO Asks for More Time as Winklevoss Pressures Parent Company DCG
10. New York sues Celsius Network founder Mashinsky, alleges crypto fraud
11. Mango Markets Exploiter Eisenberg Arrested in Puerto Rico
12. Ethereum Devs Opt For Staking Withdrawals in March

Chart of the month:

Figure 1: Yearly price time series for two reference equity indexes: SP500 (red) and Nasdaq (blue), Bitcoin (orange), and Gold (yellow). Three crypto-specific shocks have contributed to the underperformance: the collapse of Luna, the blow-up of Celsius, and the fraud at FTX. source: TradingView

Commentary:

We close the month of December, and the year 2022, one of the worst in history for the ecosystem, with some positive performance for large caps which gain only a tiny fraction of the ground lost in mid-November, during the collapse of FTX. Monthly price action for the top 10 coins by circulating market capitalization is shown in Figure 2.

This year has been so negative for the industry, not so much for the significant price correction and rapid unwind of the liquidity bubble, but mostly for having exposed fraudulent, speculative, and self-interested behaviours deep into the roots of the industry. Large, overfunded players engaged for over a year in reckless activities, seeking an ever-higher return in an increasingly competitive market, in turn creating general distrust in the whole sector. Looking at the yearly price action of Bitcoin against major equity indexes, as shown in Figure 1, it can be observed when and how the impact of such behaviour hit the market: the collapse of Luna and resulting bankruptcies, the blow-up of Celsius and resulting crisis in the credit market, the fraud at FTX where up to 10bn of assets has been stolen from customers.

Figure 2: Monthly price time series for the top 10 coins by circulating market cap (excluding stablecoins). A high level of dispersion can be observed, with monthly returns ranging from -30% to +50%. source: TradingView

Following the collapse of FTX, most market participants have substantially reduced their activity on the market and begun questioning the trustworthiness of counterparties faced for trading or lending purposes. While several exchanges were subject to the beginnings of a run on deposits, most notably Binance — which experienced more than 10bn of net outflows since the collapse of FTX — most have quickly endeavoured to provide cryptographic or traditional audits of their assets to regain trust from market participants. However, it became immediately clear that proof of asset reserves does not provide the whole story on the financial health of the exchange, without providing in turn proof of the liabilities (customer deposits) incurred. But this is an important step towards transparency for the large centralised players in the space. In Figure 3 we provide a table that lists the Assets reported for a set of 11 exchanges for which this figure is available.

Figure 3: Largest exchanges with available estimated assets as provided by Defi Llama. Clean Assets indicate the total Assets excluding tokens issued by the exchange itself. Binance remains much larger than all other exchanges, despite having processed more than 7bn in withdrawals over the last month. source: Defillama

Throughout the year, large exchanges have faced decreasing revenues resulting from a contraction in trading volumes compared with the previous year, which nonetheless remains considerably higher than any year prior (see Figure 4 for details). Even more so than last year, Binance’s dominance has been strongly established this year with many of its competitors losing ground, if not going out of business altogether.

Figure 4: Time series of monthly volumes since 2017. In 2022 volumes have remained stable and, despite being lower than 2021 average, they remain considerably larger than any time previous. source: The Block

Figure 5: Time series of Total Value Locked (TVL) in different DeFi ecosystems since 2020. With a considerable drop in the second half of the year, assets deployed in DeFi have returned to early 2021 levels. source: The Block

Figure 6: Time series of fees earned by various DeFi applications since mid-2019. With most speculative projects losing steam in the second half of the year, fees generated have contracted to late 2020 levels. source: Token Terminal

Decentralised Applications, in conjunction with Centralised venues, have seen their activity and assets under custody shirk over the year. DeFi Total Value Locked (TVL) has decreased from over 200bn in late 2021 to less than 60bn at the end of 2022, as shown in Figure 5. Activity, as proxied by fees generated by on-chain protocols, has also decreased considerably from more than 100m per week in 2021, to less than 20m at the end of 2022, as shown in Figure 6.

A nonnegligible reason for the decrease in activity in DeFi can be attributed to the increase in reference interest rates, near zero during the summer last year, when lending USDC on Aave would have returned >2% per annum, and >4% on Treasuries now, when low demand for leverage has pushed returns for lending USDC on Aave to just over 1%.

Figure 7: Time series of the instantaneous inflation rate of Bitcoin and Ethereum since March 2020. Notice how EIP-1559 (which implements destruction of coins proportional to the fees paid to the network validators) already causes a considerable reduction in the net inflation rate. With the Merge and savings from implementing Proof of Stake, the net inflation rate is reduced to almost 0%. source: Messari

During a year when the world rediscovered inflation, Ethereum finally implemented Proof of Stake resulting in reduced rewards for validators, in turn reducing the inflation on the network, already considerably reduced by the earlier implementation of EIP-1559 where part of the fees paid was burned, instead of paid to validators. Figure 7 shows how the current inflation rate for Ethereum, now close to zero, is much lower than Bitcoin at just below 2%.

DeFi however has also been the subject of numerous exploits which have often impacted its users, with the ten largest totaling over 1.5bn in losses. The largest, the exploit of the Ronin bridge caused over 600m in losses, as indicated in Figure 8.

Figure 8: Summary of the largest DeFi exploits in 2022. source: The Block

Figure 9: Time series over 2022 of the number of members of DAOs with monthly frequency. The increasing trend, with a constant amount of capital available, despite the strong asset depreciation during the period, shows a promising signal for the sector. source: The Block

A segment of the market that has thrived over the past year is the community-driven world of DAOs, with the number of members climbing from just over 2m at the beginning of the year, to over 6m at the beginning of 2023, as displayed in Figure 9.

The NFT market, on the other hand, has experienced a weak second half of the year, with trading volumes and overall prices falling from a cliff around the time of the Terra ecosystem collapse. As displayed in Figure 10, most of the speculative activity on the market lasted one year, since August 2021.

Figure 10: Monthly volumes across different NFT marketplaces since early 2020. Volumes have been dropping consistently since the collapse of Luna, touching lows not observed since the boom in NFT trading in the summer of 2021. source: The Block

Figure 11: Valuation of 7 popular Blockchain-powered metaverses. Together they make up a total market value of available land of 650m USD. source: The Block

Figure 12: Interest over time for Metaverse (red) and OpenAI (blue). source: Google Trend

Closely linked to the world of NFTs, are the Metaverses — most importantly those powered by a Blockchain — that have launched over the previous years. Figure 11 shows 7 of the most popular Metaverses and the total value of NFT land available to buy on them.

These numbers are considerably lower than they have been just a few months ago when they were worth almost one order of magnitude more. As shown by Figure 12 the trend of the moment is artificial intelligence and smart chatbots like OpenAI’s ChatGPT, rather than the Metaverse, which seems to have lost its shine during the year.

Investments in the space over the previous year, and the first two quarters of the year however have been impressive, as shown in Figure 13, thereby providing substantial funding to projects to develop their vision. For comparison, almost 30bn have been raised by VC funds and earmarked to Crypto over H1 2022, while only over 6bn was raised in the second half of the year. Nonetheless, almost half of the rounds have been financed over the period compared to the previous.

While the Crypto industry has suffered from the weaknesses of a few large players, the overall macro environment is what triggered the first difficulties to start with. Despite the cries for a decoupling from the traditional financial system, crypto-assets remain risk assets and as such are subject to the flows of global liquidity that affect any other market.

Figure 13: Monthly VC investments since 2021. Investments over the last two quarters are the lowest over the time period. source: Defillama.

Figure 14: Time series of yearly rolling returns for Bitcoin (Yellow) and Global Money supply (M2 — Green). Like other risky assets, Bitcoin and crypto more generally are subject to changes in available liquidity and prices react accordingly. source: Delphi Digital

As shown in Figure 14, the price of Bitcoin since 2014 has been closely linked with the expansion and contraction of the money supply, now in a steep tightening cycle. According to the long-term averages, the liquidity cycles tend to last approximately 65 months, or just over 5 years, marking 2023/early 2024 as an approximate target to expect liquidity to flow back to the markets.

Despite the setbacks, however, crypto is inevitable. The long-term success is ensured by the impressive flow of talent and capital to the industry, which guarantees continued innovations and development.

Bitcoin continues to establish itself as the independent and supra-national store of value, with emerging economies adopting it as legal tender and populations subject to heavy capital control and inflation using it to escape financial ruin.

Stablecoins are rivaling incumbents in settlement volumes and provide an instantaneous, permissionless, and a near-free way to exchange value all over the world.

DeFi, albeit still small compared with incumbents, offers a new opportunity to create a permissionless and transparent financial system for everyone, from the most sophisticated traders, to the unbanked who cannot otherwise access any form of financing.

NFTs have shown how creators can monetise their work without being subject to predatory take rates of incumbent platforms, while also allowing major brands to create deeper ties with their most loyal customers, improving the overall experience.

Web3 computing protocols are decentralising the digital world and reducing the reliance on giant centralised service providers on the rails of new decentralised computing platforms.