It has been a challenging week for the banking sector with crypto-friendly bank Silvergate announcing its intention to wind down operations, the failure of tech-friendly Silicon Valley Bank, and a host of other bank stocks being sold off on more general fears. While some of these issues can be traced to the bank-specific clientele and operations, we think the current interest rate environment and inverted yield curves are broadly impacting the banking sector. For institutions that borrow short term and lend long term, the deeply inverted yield curves are likely crimping net interest margins and therefore profitability. Right now, the 10y-3m US Treasuries curve is the most inverted it has ever been and the 10y-2y US Treasuries curve was only this inverted in the inflation-fighting era of the late 70s and early 80s.
The changing natures of banking relationships with crypto service providers, something we have highlighted previously, are likely having knock-on effects on the crypto industry. Most noticeably, we see a declining share of USD trading of bitcoin compared to stablecoins and widening spreads as order book liquidity declines. Regarding trading volumes, exchange-traded volumes for bitcoin have risen with the rebound in price at the beginning of the year.
However, USD quoted trading volume has been on a secular decline throughout 2022 and 2023. This likely has to do with changing investor adoption and attitudes throughout the drawdown as more trading has shifted overseas.
While exchange volumes have rebounded recently, third-party data provider Kaiko has highlighted that market depth has hit its lowest level since May 2022. Lower market depth will likely result in more intraday volatility and higher execution costs. While neither are ideal outcomes, they are certainly symptoms of the current market and regulatory environment.
With the launch and success of Ordinals over the past 2 months, an important discussion has re-emerged about how Bitcoin’s blockchain should be used. Ordinals, through some technical ingenuity (or “trickery” for those opposed), have shown the ability to embed significantly more data in a Bitcoin transaction than was previously understood to be possible. As a result, the number of inscriptions has crested 340,000, the preeminent NFT creator, Yuga Labs, launched a collection called TwelveFold natively on Bitcoin, and Rollkit has created an Ethereum Virtual Machine (EVM) compatible rollup (an off-chain code execution and data storage environment) for Bitcoin. On one end of the debate spectrum, monetary purists who view Bitcoin only as a financial network to be used for the storage and transmission of value see the growth of Ordinals as a muddying of the network. On the other hand, technological purists see the growth of Ordinals as a new use case for Bitcoin as a data availability layer that can add to network security through increased transaction fees. Where one lands in the debate might depend on how one views Bitcoin; is it a technology layer or a financial layer?
It is important to understand that it has been possible to embed data on Bitcoin’s blockchain for many years using op_return. This function can make a transaction output provably unspendable, but filled with arbitrary information. The data is limited to 80 bytes, 1/50th of the block space that can be allocated to an Ordinal inscription, restricting its functionality, but it is enough to embed small messages or to anchor other blockchains such as Omni, the original home for Tether, Stacks, and Rootstock. The usage of op_return has been controversial throughout Bitcoin’s life, something chronicled in detail by BitMEX research. We think it is important for readers to understand that many of the use cases “unlocked” by Ordinals were previously available but never saw significant adoption because overlaying applications never really took off. The primary difference with Ordinals is the amount of data that can now be stored on-chain. Rather than relying on 80 bytes of storage, Ordinals makes nearly the entirety of Bitcoin’s 4MB block space available for data storage in a single transaction. This naturally unlocks a greater range of features and has led to an escalation of the original op_return debate.
The debate on the purpose of the Bitcoin blockchain, alongside the explosion of the number of digital assets and blockchains more generally, raises an important question: Now that anything can be built on a blockchain, what should be built on a blockchain? Given the tradeoffs inherent within blockchain design and the tension between scalability, security, and decentralization, one guiding principle is that only applications that take advantage of blockchains’ trustless, permissionless, and censor-resistant nature should be built on blockchains. For many, that first and foremost use case is money, a supranational currency natively designed for the internet without government or financial institutions' required administration or intervention. One can envision other financial applications as well, which is why the concept of DeFi is so tantalizing, however, implementation often entails centralization, technology, and regulatory risks. While these risks continue to play out in real time, it is important to understand that not every application needs blockchain or a digital asset.
The price of bitcoin declined significantly this week, down 14.3%, amidst ongoing regulatory activity, and turmoil in the banking sector. Stocks were off as well, with the S&P 500 down 1.5% and Nasdaq Composite down 1.1%. Commodities struggled as well, with gold down 0.3% and oil down 3.1%. Bonds were mixed on the week with investment grade corporate bonds up 0.3%, high yield corporate bonds down 0.7%, and long-term treasuries up 2.6%. Real yields rose while inflation expectations declined.
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Mar 22 - FOMC rate decision
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