February 2023 Market Commentary

March 15, 2023

Market Commentary

After a strong January, in February crypto assets gave up some of the gains they accrued at the start of year. Crypto markets experienced a sharp sell-off in early February, as the market was confronted with an increasingly hostile regulatory landscape. The bullish narrative was temporarily restored mid-month as Hong Kong took major steps towards becoming a crypto hub, evidenced by its plan to let retail investors trade tokens like BTC and ETH and its government’s successful issuance of its first tokenized green bond. While it's important to not conflate Hong Kong with mainland China, Hong Kong may become a proxy for mainland China’s experiments with crypto and serve as a gateway to a $10 trillion asset management market. Over the past few days, crypto markets have moved sharply higher on improved sentiment as it has become clearer than ever that crypto has a vital role to play in the broader financial ecosystem.

Portfolio Considerations

There tends to be elevated negative sentiment going into a token unlock event. Accordingly, we expect increased selling pressure heading into Ethereum's Shanghai upgrade, which, coupled with staked ETH withdrawals at Shanghai, will put pressure on the price of ETH in the near-term. Pending a successful Shanghai fork, the staking component of the upgrade will be bullish for ETH as more users will be comfortable staking the cryptocurrency, providing increased security to the network and receiving rewards for doing so. Additionally, we expect institutional liquid crypto funds, which may not have been able to stake ETH due to withdrawal restrictions, to begin staking ETH following the upgrade. It’s also worth noting that Ethereum developers are already working towards another upgrade, EIP-4844, which aims to reduce gas fees during periods of high activity. While this should benefit the entire Ethereum ecosystem over the long term, the elevated activity expected during Shanghai should fuel greater interest and usage of layer 2 networks in the immediate turn, as gas fees will still be high on Ethereum, driving users to pursue a cheaper alternative to execute their transactions.

Another interesting token narrative to consider is Litecoin’s (“LTC”) upcoming halving. LTC was formed in 2011 as a bitcoin fork and adopts many of the same features as bitcoin, including its proof-of-work consensus mechanism and halving events. LTC’s halving is currently expected to be in August of this year and, historically, cryptocurrencies outperform around their halving events. LTC has been no exception, with the cryptocurrency rallying 109% and 78% in the five months leading up to its 2019 and 2015 halvings, respectively. As more and more investors anticipate LTC’s upcoming halving, we expect strong capital inflows to drive relative token outperformance over the next five months. Importantly, the LTC halving will serve as a preview of both market positioning and investment performance ahead of next year’s Bitcoin halving set to take place April 2024. On the regulatory front, US regulators have been particularly active over the past five weeks:

On 2/9, Kraken agreed to shut its US cryptocurrency-staking operations and pay a $30 million fine to settle charges with the SEC.
On 2/13, the SEC issued a Wells Notice to crypto infrastructure firm Paxos asserting that their Binance USD (“BUSD”) stablecoin is an unregistered security. Shortly after, the New York Department of Financial Services ordered Paxos to stop issuing BUSD. Paxos agreed to cease issuance.
On 2/15, the SEC voted in favor of a proposal that would entrust safekeeping of client assets to qualified custodians. Note: this is not final action. The proposed rule changes are subject to a 60-day comment period after the publication in the Federal Register.
On 3/12, US regulators closed Signature Bank and the Federal Deposit Insurance Corporation (“FDIC”) transferred the bank’s deposits and assets to Signature Bridge Bank, N.A., a full-service bank that will be operated by the FDIC.

From an investment perspective, while the operating environment for crypto firms in the US is becoming more challenging, the recent regional bank turmoil supports the call for decentralized or trust-minimized assets that limit dependence on the traditional financial ecosystem. This is broadly bullish for crypto and specifically for bitcoin, which is resistant to central banks' and other financial institutions' poor stewardship of capital, unpredictable monetary policy, and political censorship from governments—all while providing institutions and individuals an alternative place to store wealth. And while the US has limited some on-ramps to crypto, more and more countries across the world are recognizing its potential, which is driving broader support from international governments, emerging regulatory clarity, and increasing adoption of crypto assets.

With respect to the Kraken regulatory action, we’ve witnessed an increase in demand for liquid staking derivatives (LSDs), a trend we expect to persist well beyond Ethereum's Shanghai upgrade in early April. LSDs offer investors a token to use throughout the Decentralized Finance (“DeFi”) ecosystem—for lending or borrowing, for example—and still earn staking rewards without having to worry about locking up capital for an indeterminate amount of time. LSDs are an important innovation in crypto that will not only benefit Ethereum as the most popular blockchain for DeFi, but also should serve to benefit other layer-1 and layer-2 blockchains with robust DeFi developer activity.

On the SEC crackdown on BUSD, we believe the regulatory action will serve as a catalyst for investors to migrate to decentralized stablecoins, where there are no central entities managing protocols, but rather pieces of code written into blockchains that execute transactions. The continued erosion of trust with centralized finance players in crypto, coupled with the potential regulatory scrutiny they may face (e.g., the Paxos ruling), should support decentralized stablecoins and DeFi protocols broadly.