February 2023 Commentary

News Highlights

1. U.S. SEC targets crypto ‘staking’ with Kraken crackdown
2. Paxos lands on the front lines of new US crackdown on crypto
3. Paxos to Cease Minting New BUSD and End Relationship with Binance
4. SEC and New York regulators push back on Binance.US’s acquisition of Voyager
5. Federal Reserve unanimously rejects application by crypto bank Custodia
6. IMF calls for coordinated action over fears crypto could undermine global monetary system
7. Court approves sale of certain FTX investments, tokens and equity shares
8. Sam Bankman-Fried faces new criminal charges including conspiracy to commit bank fraud
9. FTX co-founder Nishad Singh pleads guilty to fraud charges
10. SEC Charges Terraform and CEO Do Kwon with Defrauding Investors in Crypto Schemes
11. Silvergate Stock Dives 40%. The Bank Faces a Financial Crisis.
12. Coinbase Launches Layer 2 Blockchain Base

Chart of the month:

Figure 1: Time series of implied cross price BUSD/USD (blue) superimposed on the price of BNB (orange) and the price of TRU (green), the governance token for the TUSD stablecoin, around the time Paxos ends its relationships with Binance. TRU spiked on the news that Binance was considering moving to support other stablecoins. Both BNB and the BUSD peg eventually recovered when Paxos announced redemptions will be supported until February 2024. Source: Trading View

Commentary:

The positive streak for crypto markets continued in February, albeit the positive price action was relatively more muted during the month. Considering the headwinds faced over the previous few weeks, a faint positive performance should be taken as a win, and this is reflected in the overall optimistic sentiment, contrary to the end of last year.

Three months after the collapse of FTX the long-awaited hammer of God fell on the crypto industry via various regulatory bodies in the US. A crackdown on retail products started with Kraken being fined for offering staking-as-a-service, followed by Paxos receiving a Well’s notice from the SEC implying that the agency sees BUSD (but not PUSD, the other unbranded Paxos stablecoin) as a security and then being investigated by the NYDFS for irregularities in the administration of BUSD. Other headlines saw the IMF voice its concerns about the crypto industry, the Federal Reserve unanimously rejecting the application of a crypto bank, as well as the SEC blocking the acquisition of defaulted crypto lender Voyager by Binance US. Meanwhile, the agency charged Do Kwan, founder of Terra, for defrauding investors.

Figure 2: Bitcoin price (orange) compared with the NASDAQ index (blue) since the Luna crash in the summer of 2022. The effect of the FTX bankruptcy on the Bitcoin price is noticeable, leading to a deviation from the technology index for approximately two months. Source: Trading View

As discussed, despite the headwinds, the industry has held ground and mildly outperformed the NASDAQ index. The performance of the two is displayed in Figure 2, suggesting how they have moved in lock-step since after the collapse of Luna and the Terra ecosystem. The effect of the FTX bankruptcy can be easily seen on the chart, with Bitcoin temporarily underperforming the technology index, just to quickly recover in the first few weeks of the new year.

We expect the correlation between the industry and more traditional technology indices to remain non-negligible going forward, however, the resilience to the regulatory push on the industry is an encouraging sign of newly found strength. However, as shown in Figure 3, broadening the scope of technology indices considered, we notice how Bitcoin has closely followed the performance of the Goldman Sachs Non-Profitable Tech stocks index ever since the start of 2022.

Figure 3: Bitcoin price (orange) compared with the Goldman Sachs Non-Profitable Tech index (green). Note how Bitcoin has tracked this index closely since the start of 2022. Source: Ikigai

Figure 4: Bitcoin price superimposed on the FED rate implied by the CBOT Futures for September 2023 and 2024 (dark and light blue, respectively). Expectations during February have deteriorated, with higher predicted rates for coming quarters than expected a month ago, partially causing the slowdown observed in February. Source: Trading View

After January was characterised by increasing confidence in a more dovish positioning of the FED on the back of positive CPI print, sentiment changed in February, as demonstrated by the FED fund rate futures contracts for September 2023 and 2024 that have both risen over the last 4/5 weeks.

Figure 5: Time series of the average funding rates on Bitcoin perpetual swaps. Inverse contracts are represented with a red line, while linear contracts are represented with a green line. While rates have generally been higher during January, February has seen considerable volatility in part associated with the BUSD debacle. Source: Trading View

This behaviour indicates that a new scenario is being painted by the market, where inflation might not subside as fast as previously thought, forcing the FED to keep rates higher and for longer. This backdrop could prove an insurmountable hurdle for asset prices over the next few quarters, giving us an overall range-bounded price action in 2023. This is somewhat the consensus among multiple market participants, who do not see a considerable improvement in conditions before Q3.

Admittedly, some positive catalysts have formed over the past few weeks, with the Ethereum L2 ecosystem gaining strength, the upcoming Ethereum Shanghai hard fork, Hong Kong taking a welcoming stance on crypto, and Bitcoin showing some new activity and retail interest via a new protocol that can read and interpret NFTs natively stored on the Bitcoin blockchain. Whether crypto can loosen its ties to the broader tech landscape and macroeconomic backdrop and thrive in riding idiosyncratic tailwinds of adoption remains to be seen.

Thus far, despite the range-bound price action over the last few weeks, derivative markets, as shown in Figure 5, have shown an active market for leverage, with funding rates exhibiting high volatility and overall demand for upside exposure. Open Interest has also grown over the period, with both Inverse and Linear markets growing almost 10% in size, as shown in Figure 6.

Volumes have also remained stable over the month, recovering to levels seen before the FTX collapse and briefly lost during the risk-off period that followed, since the second week of January. We display daily derivative trading volumes across all the major markets, split by exchange, in Figure 7. In Figure 8, on the other hand, we display the monthly volumes on decentralised exchanges, split by protocols. Note how spot trading volumes have recovered since the lows during the risk-off period in December and, more generally, are now on a growth trajectory. In order to validate the narrative that capital is moving towards non-custodial platforms, we would like to observe a consistent increase in activity in decentralised venues over the coming months.

Figure 6: Time series of open interest since late January. In blue we display inverse contracts (left-hand axis), while in red we display linear contracts (right-hand side axis). Despite prices having been overall flat, open interest has grown over the month for both types of contracts. Source: Coinalyse

Figure 7: Daily derivative trading volume on centralised venues across the most liquid tokens over the last twelve months. Note how after the drop in activity post-FTX, volumes have recovered in January and February. Source: Coinglass

While we remain confident about increasing adoption in the long term, the main short-term threats for the industry remain regulatory hurdles, which can be expected to target various corners of the industry, including staking, custody, the designation of securities by the SEC that some tokens could fall under, as well as stablecoins (as witnessed during February). The importance of stablecoins to the industry cannot be overstated and, given their high degree of centralisation, represent one of the most direct attack vectors for the industry. As described before, in mid-February both the SEC and the NYDFS targeted Paxos in a coordinated push to bring down BUSD, the stablecoin issued and managed by Paxos, and marketed by Binance.

Figure 8: Trading volume on decentralised venues over the last two years. Note how volumes have increased since the December lows. Shown are: Uniswap in blue, Pancake in pink, Curve in yellow, Dodo in green, and Sushiswap in purple. Source: DeFi Llama.

As it became clear that both agencies were focusing on the relationship between Binance and its associated entities, Binance’s token BNB began to sell off, following the BUSD peg, that for a short while weakened as Binance hurried to redeem BUSD for cash and mint USDC to satisfy user withdrawal requests. As shown in Figure 1, once withdrawals restarted normally, confidence came back and in just over 24 hours both the BUSD peg and the BNB price recovered the temporary losses. In Figure 9 we show the supply of BUSD and the burn transactions where the token is exchanged with USD dollars. Note the drop in market cap has been sudden, with more than $4bn redeemed in the days following the news. Figure 10, on the other hand, shows a dominance chart for the largest USD stablecoins and indicates how USDC and, in particular, USDT have gained dominance in response to the demise of BUSD.

Figure 9: Supply and burn activity of BUSD stablecoin since late August. Considerable redemption activity can be observed since Paxos ended its relationships with Binance, however, the December activity in response to concerns about Binance’s proof of reserves still considerably stands out. Source: Blockworks.

Figure 10: Stablecoin dominance over the last year with USDT represented in green, USDC in blue, BUSD in yellow, and DAI in violet. Since SEC investigations into Paxos, BUSD has lost 3.6% of its dominance, more than 20% of its supply. Source: Glassnode

Figure 11: Bitcoin transaction mempool (the set of transactions submitted to the network, but not yet processed) since early November. Note the increased activity during the FTX crisis, as well as the recent pick-up in on-chain activity due to Inscriptions, Bitcoin NFTs powered by Ordinals. Source: Glassnode

Turning again towards adoption metrics, we see both Bitcoin and Ethereum thriving in the newly found confidence that has characterised the beginning of the year. In the case of Bitcoin, where the rigidity of the protocol usually does not allow for fast innovation, the community has been shaken by an old idea recently implemented into a protocol that allows the use of Bitcoin’s native transactions to “inscribe” an NFT into the chain, and track it in your wallet using the Ordinals theory. This innovation has driven a lot of criticism having in a few days notably increased Bitcoin blocks and mempool size, as displayed in Figure 11.

The canonical NFT platform, Ethereum, has similarly seen an increase in demand for block space, despite being a more gradual one, and not necessarily driven just by NFTs, but an overall increase DeFi activity. As shown in Figure 12, the median gas price has now reached a consistent reading above 30 gwei, a substantial increase from the average level observed since the collapse of Luna and a clear sign of increasing confidence.

It remains to be seen how long-lived this newly found confidence will last, tested already by repeated regulatory scrutiny, a return to a more hawkish view of the FED’s intentions for the coming quarters, and overall a strong correlation with the most speculative corners of the Tech sector. Over the coming weeks we will gain more clarity on the next steps in the scrutiny regulators are putting on the industry and whether the implications become more severe.

Figure 12: Ethereum gas price since September 2021 superimposed on the price of ETH. Spikes in on-chain activity can be associated with the collapse of FTX and the “bank run” on Binance. Recently a positive trend in demand for block space has been observed, with highs surpassing the previous spikes. Source: Glassnode