21Shares Monthly Review - February 2023

This Month in Crypto: Executive Summary

Despite a regulatory crackdown on unregistered securities in the US, the total crypto markets remained headwind-resistant throughout February with a slight decline of nearly 2%. The resistance came primarily on the back of “Ordinals,” a Bitcoin-native protocol enabling minting NFTs on the Bitcoin blockchain for the first time, which boosted the network’s assets by 4.61% over the past month. In addition, Ethereum’s testnet that simulated token withdrawals on February 7 increased ETH’s assets under management by ~9% over the past month as shown in Figure 1. The outperformers of last month’s rally were Optimism (21.34%) and Lido (41.56%); factors mainly driving these returns include Coinbase’s own scaling solution dubbed “Base” being built on Optimism and it was also known that Founder of Tron, Justin Sun staked 200K ETH via Lido, among other developments that we’ll delve deeper into later in this monthly review. February’s biggest loser was Avalanche, which declined by 15.10% on the back of a decline in daily activity on the network.

Figure 1: Price and TVL Development of Major Crypto Sectors

Source: 21Shares, Coingecko, DeFi Llama. Data as of February 27 close.

Key takeaways:

The SEC cracks down on unregistered securities, halting the minting of Paxos’ BUSD on Binance among others.
Ethereum executes two testnet upgrades prior to withdrawals.
Coinbase launching Base, its own scaling solution on Ethereum.
Centrifuge suggests backing Aave’s GHO with RWAs, Siemens and Hamilton Lane issue a public bond and direct equity fund on Polygon, and Swarm introduces tokenized exposure to US treasury bills and stocks.
An NFT protocol drives Bitcoin’s assets under management and broadens the use case of the original cryptoasset and Blur flips OpenSea in trading volume on the marketplace.

Spot and Derivatives

Figure 2: BTC Perpetual Swap Open Interest / Market Cap

Source: Glassnode

Figure 2 shows BTC perpetual swap open interest relative to Bitcoin's market cap. We can see that the number of contracts built up relative to the market size increased significantly in 2022 until the FTX collapse. Since then, we have observed a general deleveraging of the system. However, over the month of February, the ratio has increased slightly as BTC's price has consolidated, suggesting that risk appetite may be picking up among investors.

On-chain Indicators

Figure 3: Bitcoin Taproot Adoption

Source: Glassnode

Figure 3 shows that Taproot adoption surpassed 5% for the first time on February 1 and reached 17.68% on February 9. The sudden rise in Taproot adoption is attributed to the launch of a project called Ordinals, which enables Bitcoin-native NFTs. Created by Casey Rodarmor, Ordinals embed image-related data into the Bitcoin blockchain using the input field in Taproot transactions. The Taproot upgrade, activated in November 2021, makes it cheaper to store arbitrary data and allows users to store as much data as they like in a single transaction, as long as they pay for it and the total block size remains under 4MB. Before Taproot, one had to use multiple transactions or inputs to store large amounts of data.

The introduction of NFTs on Bitcoin can expand its use cases beyond a store of value asset. The latter would increase fees, which would be a net positive for the long-term security of the network, especially as the emission of new BTC will end in 2140.

Macro and Regulations

Tension increased between world leaders in February. The month started with the US shooting down a surveillance balloon linked to the Chinese government flying over Alaska. China also accused the US of illegally flying surveillance balloons over its airspace, which the White House denied. On February 21, a day after US President Joe Biden made a visit to Ukraine, Russian President Vladimir Putin announced the suspension of the last standing nuclear arms control pact with the US.

The spread between the 10 and two-year US Treasury yield reached its lowest since September 1981, reflecting increased expectations of a decline in longer-term interest rates, a leading historical indicator of a recession. This may affect investors’ risk appetite for the time being, including cryptoassets, as inflows into gold investment vehicles have been at an all-time high over the past 50+ years.

Layoffs and crypto companies pulling the plug: More consolidation continues in the crypto industry, with Polygon laying off 20% of its workforce, the Australian gaming crypto startup Immutable slashed 11%, and Fireblocks 5%. Local Bitcoins, a Finland-based peer-to-peer company founded in 2012, announced in an e-mail that it would be winding down operations, giving its users 12 months to withdraw their funds.

The crackdown on unregistered securities: Almost a year following the collapse of Terra Luna, the Securities and Exchanges Commission (SEC) charged Terraform Labs – the company behind Terra's UST algorithmic stablecoin – and its CEO, Do Kown, with defrauding investors. That comes hand-in-hand with the agency’s hawkish crackdown on unregistered securities in the crypto industry. In an interview with New York magazine, the SEC’s chairperson Gary Gensler reiterated that pretty much every sort of crypto transaction already falls under the SEC’s jurisdiction, with the exceptions of spot transactions in Bitcoin and the purchase of any goods or services with cryptoassets. The chairperson, who was under fire for the SEC’s sluggish enforcement during the FTX debacle, revealed that his agency has all the legal tools it needs for law enforcement. February was a demonstration of this claim:

February 9: Kraken settled with the SEC for $30M and suspended its staking as a service program
February 13: Paxos announced it would halt issuing BUSD in response to a Well’s notice sent to Paxos by the SEC and an order issued by the New York Department of Financial Services.

Regulations brewing in February: Regulators worldwide continued scurrying to consolidate legislation to regulate the crypto industry further and warn banks from the volatility of this asset class. Namely, the European Central Bank instructed banks within its jurisdiction to self-impose the BTC cap (1.25% of their T1 capital) before the Basel Committee’s proposal goes into effect. EU banks would have to place the maximum possible risk weight on crypto assets under a draft law published by the European Parliament on February 9. On the other side of the globe, Hong Kong has been calculating the repercussions of a U-turn on its adversary policy banning crypto, in contrast with regulators in the US.

Hong Kong’s Securities and Futures Commission proposed granting retail investors access to virtual asset trading platforms that need to apply for licensing before June 2024. The comment period on the 361-page consultation paper published on February 20 ends on March 31.
France: Registration conditions for French crypto firms will be tightened as of January 2024. New crypto companies will have to meet additional rules on internal controls, cybersecurity, and conflicts of interest, according to amendments published on February 10.
SEC tightens grip on custodians: The SEC voted 4-1 to propose a rule requiring registered investment advisers to keep cryptoassets with a qualified custodian, and those custodians would have to abide by certain requirements.
New bill for proof-of-reserves: Sen. Thom Tillis is drafting legislation to require digital asset exchanges and custodians operating in the US to provide an independently verified proof-of-reserves for their assets.
Sen. Elizabeth Warren will reintroduce the AML legislation that would extend anti-money laundering laws to a broad array of the cryptoasset industry; which include digital asset wallet providers, miners, validators and other blockchain network participants.

Crypto Infrastructure

Interoperability (Layer 0s):

Cosmos: Implemented its latest update on the 15th of February. Dubbed RHO, the upgrade introduces the Global Fees Module. A component that would allow the Cosmos governance to set minimum gas prices, in addition to accepting a wider list of Cosmos-based tokens to be used as the currency for the gas fees, via a series of governance proposals. This means that users wouldn’t be limited to paying fees exclusively in ATOM. Most importantly, the upgrade paves the path for the next major technical undertaking known as Replicated Security. Check out our latest State of Crypto for a deeper dive into what this innovation will bring to the Cosmos ecosystem.

Smart Contract Platforms (Layer 1s):

Ethereum: On February 7, the Zhejiang testnet successfully simulated staked ETH withdrawals. Zhejiang is the first of three testnets in the final pre-launch sequence before the Shanghai/Capella upgrade is activated. On February 10, Ethereum core developers named February 28 as the target date for launching the Sepolia testnet. After Seoplia, Goerli – the most critical public Ethereum testnet – will be the final step before staked ETH withdrawals are enabled on the Ethereum mainnet. Although the Shanghai upgrade contains several features, its most anticipated one is allowing withdrawals. Full withdrawals will be available for "exited" validators, whereas partial withdrawals will be available for active validator balances above 32 ETH. As of today, core developers expect Shanghai to occur in mid-March.
Flashbots: The R&D organization responsible for mitigating the negative externalities of front-running and arbitrage on Ethereum revealed its latest tool designed to further democratize accessibility to transaction-shared revenue with the broader community. MEV-share, the newly introduced tool by Flashbots, will now allow users to also receive rewards that were previously allotted only to validators and builders.
BNB published its technical roadmap for 2023, focused on five key areas of growth, including scalability solutions, smarter wallets and increasing the validator size.BNB's roadmap is a significant endeavor as it helps the network adopt some of the vital scalability features shaping the rising growth of L2s, such as the rollup technology with its two subset classes. The developments will be crucial for BNB to protect its market positioning and remain competitive against networks like Optimism, Polygon, zkSync and Arbitrum.
Intain Inc launched intainMarkets, a new marketplace for tokenized asset backed securities. The solution, launching as a subnet on top of Avalanche, will automate the functionalities of many key stakeholders, reduce the costs for debt issuers, and amplify the transparency into the collateral backing. Intain chose Avalanche due to the flexibility in creating a permissioned chain that still leverages the benefits of being anchored to a wider trustless public network, mingled with a far more decentralized validator set.

Scalability Solutions (Layer 2s):

Polygon is ready to implement the production-environment version of its scaling solution. Polygon conducted two public audits in addition to shrinking the time needed to create settlement proofs to two minutes combined with a minimal production cost of 6 cents. We at 21shares anticipate that scaling solutions will remain a dominant narrative this year. We also expect an escalation of an arm’s race between the different scalability protocols toward launching the first fully-functional solution to the market. That is corroborated by zkSync’s move, which shortly followed Polygon’s statement on releasing the mainnet beta version of the protocol on March 27.
The Optimism foundation proposed a major protocol upgrade dubbed collective bedrock for its scalability solution. The upgrade will offer cheaper transaction cost, and reduce deposit times. Most excitingly, the upgrade will implement modularity at the protocol level, separating the main OpStack into three layers: execution, settlement, and consensus. The remodeling should enhance the network’s performance in the process. In addition, the proposal to deploy the upgrade on mainnet was originally being voted on until February 15. However, the foundation team were forced to delay it until cycle 11 ( March 5 to April 7) for a chance to fix critical bugs that were discovered by the community. Thus, the upgrade will be executed two weeks after the community ratifies it, following a vote.
Coinbase announced the launch of its scalable smart-contract network on the Optimism network dubbed Base. By leveraging Optimism's OPstack, Coinbase seeks to build an interoperable, scalable network interconnected with the broader Optimism ecosystem. Namely, Base will be compatible with future OPstack-based networks while sharing security and a communication layer with other protocols to help actualize Optimism's superchain vision. As part of this relationship, Coinbase will forward a portion of the network's gas fees to the OP collective to help it drive the growth of its OP stack, in addition to becoming the second core contributor to the OPstack code base. The news is consequential to the industry as Coinbase has tens of millions of users. The exchange can now onboard them on-chain while abstracting away the complexity of navigating the underdeveloped ecosystem and, most importantly, without leaving the confines of the ecosystem.

Decentralized Finance

Figure 6: Performance of Top 10 DeFi Protocols in February

Source: 21Shares, DeFi Llama

Stablecoins:

GHO is live on testnet: on February 9, Aave’s native stablecoin GHO went live on Ethereum’s Goerli testnet. GHO will be fully decentralized, overcollateralized, and pegged 1:1 with the US dollar. Regarding collateral, GHO will resemble Maker's DAI in that it will be backed by a basket of cryptoassets chosen by users, who will mint GHO tokens against their supplied crypto-denominated collateral. The process will feel familiar to existing Aave users as it's almost identical to the current borrowing mechanics on the platform. When a user mints GHO, the collateral remains locked and accrues interest until the borrower repays the position. Once the borrower repays the principal with the accrued interest, GHO is burned (removed from circulation), and the collateral is returned. One of the most underappreciated aspects of this process is that 100% of the interest fees paid are sent to the Aave Treasury, meaning that GHO will boost Aave's cash reserves and may contribute to the long-term sustainability of the DAO assuming significant adoption of GHO. In contrast, Aave only keeps a small portion of the interest rates on existing loans, while liquidity providers (LPs) take the lion's share.

Stablecoins are arguably the most significant innovation that has come out of DeFi thus far. Ironically, the three top stablecoins by market cap (USDT, USDC, and BUSD) are all centralized. Combined, they represent more than 90% of the stablecoin market, which stands at ~$137 billion. In this regard, GHO is an exciting development not only for Aave but the broader DeFi ecosystem. Beyond boosting the usage of Aave, it will be interesting to see if GHO can gain market share on the centralized incumbents, especially given the stance that US regulators have taken in February. However, given the LUNA-UST debacle from last year, decentralized stablecoins may have to rebuild their vertical brand and continue to be battle-tested in the coming years. Thus far, DAI is the only decentralized stablecoin that has endured several cycles, although it has a tiny market share compared to centralized players.

Centrifuge: The protocol that most recently tokenized BlockTower’s Real World debt — including receivables, loans, and structured products, is now suggesting to back Aave’s new stablecoin GHO with real-world assets (RWAs). As a reminder, RWAs refer to asset classes that exist in the physical world, like real estate and commodities. Tokenizing them would help significantly improve liquidity on-chain as it offers a more sustainable yield that is uncorrelated to the crypto market conditions, and thus supports protocols in continuing to generate revenue during turbulent times. Maker, for instance, leverages trade finance transactions and freight forwarding invoices - tokenized via Centrifuge’s Tinlake platform - as one example of the collateral that backs DAI, so we can expect to see similar activity once Centrifuge officially publishes their formal facilitator proposal.

Ethereum Ecosystem:

Lido V2: the technical contributors of Lido presented the proposal for Lido V2, the most significant upgrade in the protocol's history and a massive step toward its decentralization roadmap. The proposal introduces two important changes 1) withdrawals and the staking router. 1) withdrawals and the staking router.

Regarding the next steps for Lido V2, seven independent audit service providers will conduct a thorough security assessment of all the upgrade-related code during February. At the end of this month, the DAO will undergo a signal snapshot vote on the upgrade.

Real-World-Assets:

Siemens, the industrial German giant, issued its first digital bond on a public blockchain. The bond worth 64M euros is tokenized on top of the polygon network, has a maturity of one year, while Its interest rate remains a mystery. Although this move isn’t the first of its kind, as the European Investment Bank (EIB) and Abn Amro have both recently issued their own respective bonds, it nevertheless highlights the increased awareness of harnessing public blockchain technology to address the shortcomings of the traditional financial system. Comparably, Swarm, a regulated exchange headquartered in Berlin, released new DeFi-compatible tokenized securities on Polygon. The offerings will provide tokenized exposure to US treasury bonds with maturities of 0-1,1-3 Years leveraging the Ishares ETFs, as well as on-chain representation of Apple and Tesla stocks. SwarmX GmbH, wholly-owned subsidiary of the regulated exchange, will be responsible for issuing and fully backing these assets.
Hamilton Lane, the global investment management company with $830B of assets under supervision, is tokenizing three of its private equity funds using the Polygon-based Securitize platform. Asset tokenization will lower the barrier of entry for investors by allowing exposure to the private equity market with a minimum deposit of $20K instead of the previous $5M ask. Equity Opportunities V fund isn’t the first attempt for Securitize as they previously helped launch a $25M diversified art fund, where token holders were able to trade their respective equity on the secondary market after a one-year lockup. To that end, we at 21shares have emphasized over the past months that asset tokenization will be the next catalyst to attract institutional adoption. So it is invigorating to see more bridges being built to extrapolate the benefits of DeFi to the traditional world.

Metaverse and NFTs

Figure 9: Performance of Major NFTs Marketplaces in February

Source: 21Shares, Dune Analytics

Macro headwinds took a direct toll on the NFTs industry, as NFT marketplace Magic Eden announced it is laying off 22 of its staff as part of a company-wide restructuring that would allow them to reach their goals this year, according to the CEO and co-founder Jack Lu. Moreover, the cross-chain NFT marketplace partnered with the Web 3 payments solution MoonPay to introduce credit card payments that would allow users to purchase NFTs across chains using a credit or debit card, Apple Pay, and Google Pay. MoonPay has also partnered with LooksRare in an industry-wide effort to leap towards a cross-chain future to facilitate the onboarding of users into mass adoption.

Blur flips OpenSea: Amid reports of a potential raise for the company at a billion-dollar valuation, NFT marketplace Blur airdropped its token BLUR to reward active NFT traders retroactively. The BLUR token has a total supply of 3 billion tokens, 12% of which were claimable by users on February 14. As of February 20, BLUR was trading at $1.20, valuing the airdropped tokens at more than $430 million. In response, OpenSea announced they will move to a 0% fee scheme temporarily, as well as to a minimum 0.5% creator earnings model for all collections without on-chain enforcement, allowing sellers to pay more. OpenSea will also update the "operator filter" to allow sales using NFT marketplaces with the same policies, which include Blur. Given the volatile nature of this space as it stands, it is a common mistake to make predictions on a lagging indicator such as price. Fundamentals are the only leading indicator, especially in the NFTs industry, and innovation in this space is the strongest indicator of which marketspace will thrive.