Insight
October 28, 2022
The spot price of bitcoin jumped 8.2% this week largely driven by a more favorable backdrop for risk assets and short liquidations. Coming into the week, bitcoin had lagged a broader risk rally that saw the S&P 500 and Nasdaq Composite climb 7.9% and 8.5%, respectively, from the recent lows. A well-timed article in the WSJ about the Fed slowing the pace of rate increases led fuel to the rally, which also saw yields on 10y US Treasuries fall from 4.25% to 3.95%. Going into the week, crypto traders had been defensively postured as indicated by the demand for downside hedging via put buying, flat funding rates for offshore perpetual swaps, and a negative basis for CME futures contracts.
While no one news item appears to have touched off the rally, the preconditions existed for the events that followed. Over the 2-day period of October 26th – October 27th bitcoin futures saw $615M worth of short futures and perpetual swap contracts get liquidated on overseas exchanges while the price of bitcoin jumped from $19,300 to $21,000 (+8.8%). Even more spectacular was the rise of ether, which went from $1,350 to $1,590 (+17.5%) amidst $462M of liquidations. Nothing fundamental appeared to account for the difference in returns of the two assets, rather it was likely due to the higher beta ether tends to offer vs. bitcoin in these types of moves.
With the macro backdrop still in flux, it remains to be seen whether this rally will continue. Third quarter US GDP came in better than expected (+2.6% vs +2.4% estimated), breaking the streak of two consecutive quarters of declining GDP. On the flip side, however, a commonly relied upon harbinger for recessions, the 10y-3m US Treasuries yield curve, inverted on Wednesday for the first time since the COVID-19 health care crisis began. Regardless of the macro outcome, we don’t think this meaningfully changes the long-term thesis for the asset. If anything, the events of the recent past, like those in the UK, have laid bare the political and monetary machinations that underpin our monetary systems, making a better case for Bitcoin adoption.
Censorship resistance, the inability for any entity, organization, or nation-state, to control how individuals store or send their wealth; permissionlessness, anyone with access to the internet is free to use; and trustlessness, the lack of intervention of central authority, are the bedrock of the ideals embedded within Bitcoin. Censorship resistance can come in many forms. The censorship of transactions on Ethereum has been a topical item as of late, first with the Office of Foreign Asset Control’s (OFAC) ban of the Tornado Cash mixer and then with the growing percentage of blocks that are OFAC compliant. These events, coupled with forthcoming legislation, have set the stage for an important philosophical and practical discussion about how blockchain and the industry should comply with regulatory requirements.
As a quick refresher, in August, OFAC shut down Tornado Cash, a privacy-preserving software service called a mixer that obscures both the source and destination of funds. While there are plenty of legitimate reasons for the right to financial privacy, OFAC shut down Tornado Cash because it is alleged to have been used to launder over $7B worth of illicit cryptocurrency. There were questions from industry participants from the get-go as to OFAC’s ability to bring this action since it censored access to Tornado Cash’s software called smart contracts, self-executing code that resides on the Ethereum blockchain. At contention was the concept of freedom of speech and code. A landmark Supreme Court decision in 1996 (Bernstein v. Department of Justice) established code as speech and thus protected by the First Amendment. Then, two weeks ago, crypto advocacy group Coin Center sued the US Treasury and OFAC on behalf of aggrieved individuals who had their Ethereum addresses blacklisted by service providers because someone sent them funds through Tornado Cash, an action they are not able to prevent.
While the Tornado Cash case is an example of application layer censorship on Ethereum, a lower-level inspection of the blockchain reveals that today a majority of the Ethereum blocks comply with OFAC sanctions, meaning they will not include transactions to OFAC-sanctioned addresses. Block proposers in Ethereum (akin to miners in Bitcoin) have largely outsourced the construction of blocks to specialized builders using applications such as MEV-Boost. These services optimize revenue by reordering transactions to produce Maximal Extractable Value (MEV) for the proposers. Blocks are sent from builders to proposers using a piece of software called a relay, whose adherence to OFAC sanctions can be found here. The result of all of this is that 64% of all blocks in the past 7 days use MEV-Boost and 58% of all blocks built in the past 7 days are sent by an OFAC-compliant relayer.
These events have shined a light on censorship at the blockchain level and while neither example appears to be desirable, they provoke important questions about how to regulate blockchain technology. Should regulatory compliance requirements occur at the blockchain or smart contract level or should it be the responsibility of service providers who interact with these protocols? Perhaps with coming regulation some of these questions will be answered, but the full journey is likely to be a long and winding road.
Twitter and Block (f.k.a. Square), products of entrepreneur Jack Dorsey, have made important contributions to the Bitcoin ecosystem over the past few years. This week, Block’s Cash App, which is used by over 40M users, enabled payments through Bitcoin’s Lightning Network. This builds on Cash App’s existing functionality of being able to buy, hold, and sell bitcoins as well as send them off app through the Bitcoin network. Now, users can generate or pay Lighting invoices directly within the app. This milestone is an important one for Lightning, which has seen its channel capacity grow by over 50% on a year-to-date basis. And while channel capacity and network usage continue to grow, the Lightning Network is still in its infancy. It has only been a year since Taproot, an important efficiency and privacy upgrade for Lightning, was deployed on Bitcoin and it was only a few weeks ago that Taro, the asset issuance technology on Lightning, got an alpha release. With that in mind, our parent company, Stone Ridge Holdings Group, recently announced a new initiative, In Wolf’s Clothing (Wolf), an accelerator designed to empower entrepreneurs building on the Lightning Network. We are excited to see what comes of this initiative and plan to devote more resources to analyzing the activity and growth of the Lightning Network.
It was a strong week for asset return, with every major asset class track here showing gains. As discussed above, bitcoin had a strong week, up 8.2%. Equity markets also rallied, with the S&P 500 up 3.9% and Nasdaq Composite up 1.7%. Gold was up 1.5% as real rates and inflation expectations fell on the week. Bonds were up across the board, with Investment Grade Corporate bonds up 2.5%, High Yield Corporate Bonds up 3.0%, and Long-Term Treasuries up 2.7%. Oil jumped 3.6% as well.
Investing:
The Only Crypto Story You Need - Bloomberg
Andreessen Horowitz Went All in on Crypto at the Worst Possible Time - WSJ
Companies:
Cash App Enables Bitcoin Lightning Payments For 40 Million Users - Bitcoin Magazine
The AT Protocol - Bluesky
Fireblocks Adds Worldpay as Network Partner for New Crypto Payments Engine - Decrypt
BitMex CEO Alexander Höptner Steps Down with Immediate Effect - The Block
Regulation and Taxation:
Chinese Spies Used Wasabi Wallet to Pay Bitcoin Bribes to FBI Double Agent - Elliptic
Possible Digital Asset Industry Standards - FTX
November 2nd – Next FOMC rate decision
November 4th – United States Non-Farm Payrolls
November 10th – Consumer Price Index
Thanks for joining us again this week. Please reach out with any questions or comments.
Sincerely,
The NYDIG Team
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