It is likely that as long as the Federal Reserve (Fed) continues to raise interest rates, digital asset prices will remain under pressure. At the same time, however, developers are carrying out a tremendous amount of activity, and several major institutions are preparing for the next bull market in digital assets. Although the ecosystem continues to expand beyond Bitcoin and Ethereum, these two assets continue to represent more than 50% of the approximately trillion dollars that the industry encompasses.
In our opinion, we believe that the fact that yields on 10-year Treasury bonds (UST), considered a risk-free rate, have remained around 4% in mid-October, and that interest rates have increased, has hit the Decentralized Finance (DeFi) sector particularly hard. Although DeFi was a popular category in late 2021 and early 2022, it has suffered since then, with its yields in many cases falling below the 10-year UST. It is still possible to increase DeFi returns, but this requires complex strategies and higher risk taking.
Ethereum upgrades, cross-chain bridging solutions and NFT-IPRs in focus
Following the successful move from Proof-of-Work to Proof-of-Stake, the Ethereum network will continue to make headlines in 2023. Future near-term upgrades include releasing Ether placed for staking generating a 4-6% return to the owner who carried it out and the “Sharding” (the fragmentation), which will allow scalability and potentially also the approach of the high gas tariffs (transaction fees).
Ethereum will potentially be a deflationary asset going forward as less new Ether is expected to be issued (miners no longer receive Ether rewards) given that the Ethereum Improvement Proposal (EIP-1559) implemented in August 2021 caused the burning of a proportion of gas fees and permanent removal of token supply. One area we continue to monitor is the potential centralization of the network validator community and the censorship threats this could pose to the ecosystem. Although more than 422 thousand validators protected the network before the merger, four of the largest (Lido Finance, Coinbase, Kraken and Binance) controlled more than 60% of Beacon Chain.
The digital asset industry, being code-based, continues to suffer from hacks and network attacks, many of which have occurred over cross-chain bridges. We expect to see significant innovation and development activity in this area to make the different blockchains interoperable with each other. Two main types of solutions are being developed: cross-chain solutions built directly into the protocol consensus layer, and generalized cross-chain messaging solutions built on top of cross-chain bridges.
We see significant potential in non-fungible tokens (NFTs) within the area of brand and community tokenization. We are already seeing many creative industries adopting NFTs in the hope of unlocking the value of intangible assets, creating digital communities, and potentially designing a shared-ownership business model in which network users can benefit from accumulating value in communities and brands. However, there needs to be clarification with the intellectual property rights (IPR) of NFTs. At the moment, many issuers of NFTs retain full ownership of the commercial rights to NFTs, and this may not be appropriate for all use cases. For the industry to flourish, we believe it is necessary to address the issue of IPR and to be clear about what commercial rights, if any, NFT buyers receive when purchasing the tokens.
Digital asset regulation finally takes shape and paves the way for institutional investors
Digital asset regulation is finally taking shape in both Europe and the US. This will pave the way for institutional investors in need of regulatory clarity to start investing in the ecosystem. In Europe, the regulation of the Crypto Asset Markets (MiCA) is in its final stages of elaboration and will become law throughout the European Union in 2024 overriding all existing national laws that cover crypto markets. In the US, the Lummis-Gillibrand cryptocurrency bill called the “Responsible Financial Innovation Act” is a first attempt to create a regulatory framework for the digital asset industry. It is not yet known when, or if, this bill will become law in the US. Both bills are largely focused on regulating the stablecoin market.
Stablecoins have value tied to government-issued reserve currencies and could become a bit like the mutual funds of today’s money markets, facilitating transactions between the traditional and digital asset industries.
However, there is still some opacity in terms of what kind of assets are actually backing these stablecoins today.
For stablecoins to serve their purpose as a bridge between the traditional and digital worlds, they must be backed by cash, Treasuries or cash-like instruments and not, for example, commercial paper, which is much riskier to hold.