September 20, 2023

Insights and analysis for the professional investor

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Welcome to Crypto Long & Short!

This week, Todd Groth of CoinDesk Indices explains the golden reason why there's so much enthusiasm about spot bitcoin ETFs.

Then, Michael Nadeau of The DeFi Report delves into the buzz around Ethereum layer 2s.

As always, get the latest crypto news and data from CoinDeskMarkets.com.

– Nick Baker

From the Analyst

A Bitcoin ETF Has Golden Parallels From History

Back to the desk from a late summer break, it's a good time for a quick year-to-date performance scan across the digital asset markets (see Figure 1 below). Overall, bitcoin (BTC) has clearly been setting the mood for 2023, as proxied by the CoinDesk Markets Index (CMI), and it feels like the majority of broad crypto market-moving headlines over the past few months can be placed within the bucket of the ongoing saga towards a bitcoin spot ETF.

Figure 1: Digital asset market performance in 2023. Source: coindeskmarkets.com.

To better understand the context behind the crypto market's focus on a spot ETF, it's useful to draw some useful historical parallels to the creation of gold ETFs and their impact on the gold market.

Like gold ETFs, a bitcoin ETF would make it significantly easier for a broader range of investors to gain exposure to bitcoin. It eliminates the need for investors to directly buy and store bitcoin. While this difficulty did not discourage early adopters, it can be a complex and daunting process for many (i.e., imagine walking a grandparent through the cold storage process). Fun fact: Before the first gold ETF was launched, investors could invest in clunkier closed-end funds, gold companies like miners or lug around the actual shiny metal. With an ETF, investor demand for gold increased. A bitcoin spot ETF could do likewise, leading to a surge in buying by retail investors who aren't currently in the Grayscale Bitcoin Trust (GBTC) or one of the bitcoin futures ETFs like the one from ProShares (BITO).

Related to the increased accessibility would be an increase in liquidity and trading volume in the bitcoin market. Increased liquidity and further diversifying the asset's investor base could help stabilize prices and reduce price volatility caused by illiquid market conditions. This could also shift the investor base from tech-savvy retail investors and crypto enthusiasts to more mainstream, longer-term real asset investors looking for diversification from fiat currencies.

The launch of a bitcoin ETF could catalyze further institutional adoption of bitcoin, as it would delegate the acquisition and storage of the digital asset to qualified custodians. An ETF structure also provides a more familiar and regulated investment vehicle that institutional investors are comfortable using, which could lead to more hedge funds, asset managers and pension funds allocating capital to bitcoin.

Just as the gold ETF made it easier for investors to add additional diversification to their portfolios, a bitcoin ETF could serve a similar purpose. Investors looking to diversify their portfolios may allocate some of their assets to bitcoin through the ETF, viewing it as a store of value or an uncorrelated asset class. This addition of bitcoin to a greater number of investor portfolios would likely be small in percentage terms due to the relatively young and volatile nature of the asset class, but it would still result in a meaningful flow of capital into the cryptocurrency asset class.

In summary, the introduction of a bitcoin ETF could be seen as a sign of the market's maturation. It signals that bitcoin is evolving from a niche asset class to one accepted and regulated within the traditional financial system.

— Todd Groth, CFA, head of research at CoinDesk Indices

A message from Messari

Come build with us and register for Mainnet 2023, the premiere crypto event of the year!

Hosted by Messari, Mainnet returns to Pier 36 NYC from Sept 20-22. Mainnet unites together the leading voices in crypto and will spotlight the true innovations propelling crypto forward, with programming focusing on regulation & policy, real-world finance & DeFi, operators & builders, AI's native currency, and a wide variety of other topics. This year, Mainnet will feature 100+ in-person speakers from across the crypto and TradFi landscapes, including Coinbase's Brian Armstrong, Circle's Jeremy Allaire, Ripple's Brad Garlinghouse, Stellar's Denelle Dixon, EY's Paul Brody, PayPal's Jose Fernandez da Ponte, Onyx by J.P. Morgan's Tyrone Lobban, and many more.

Institutional Outlook

Understanding the Economics of Ethereum Layer 2s

Crypto is on the verge of spawning a new investable asset class globally. And then it will slowly change how just about everything on the internet works.

With the birth of a new asset class will come new business model analysis. New KPIs, metrics, and benchmarks as valuation criteria. New reporting and audit structures. New data providers. And new buy- and sell-side research structures.

Adding to the complexity, crypto investors need to understand concepts such as Metcalf's Law, Moore's Law, Lindy effects, the power of open-source technologies and composability. "Good enough technology" and "The 10-year window."

Furthermore, investors need a framework for how value flows throughout the tech stack to effectively analyze crypto networks, protocols and applications.

This is especially important today. Ethereum is nearing its "broadband moment" – where throughput constraints are solved via a layer-2 blockchain, unleashing scalable infrastructure to support new applications and the onboarding of the next billion users.

In less than two years, we've seen transactions on Ethereum's largest L2 scaling solutions (Arbitrum, Optimism and now Base) grow by 3,438%.

But what does this mean for the Ethereum layer 1?

L2s provide execution services to the application layer of the tech stack by batching transactions, compressing the data and ultimately anchoring proofs of the data to Ethereum as L1 transactions (final settlement).

Therefore, investors need to know the economic relationship between an L2 and L1 to properly assess and forecast value accrual within the tech stack.

Let's take a look at the margins of L2s to date.

In aggregate, L2s are keeping an average of 23.5% of all transaction fees running through applications that leverage their execution engines.

Ethereum validators are receiving the remaining 76.5% of user transaction fees paid on L2.

Therefore, L2s are complementary to Ethereum and to holders of ETH, its related asset.

Every product in a marketplace has substitutes and complements. A substitute is another product you might buy if the first product is too expensive. For example, chicken is a substitute for beef. A complement is a product that you usually buy together with another product. Think gas and cars. Or hot dog buns and hot dogs.

All else being equal, demand for a product increases when the price of its complements decreases. For example, hotels in Miami will go up in price if flights to Miami drop significantly.

If L2s are complements and continuously drive down costs that enable superior user experiences, this should ultimately drive more usage of the Ethereum L1.

Complements tend to get commoditized. Therefore, we expect to see L2 margins compress over time as competitors enter the market and Moore's Law continues to play out.

Of course, this process is still very nascent. And there are additional layers of the tech stack to monitor as well – such as the application layer, Eigen Layer (restaking and "security as a service"), data availability (Celestia), data oracles, etc.

Crypto is on the verge of spawning a new investable asset class globally.

If you're advising clients or investing within the crypto tech stack, you need to understand how value is created and captured at each layer.

– Michael Nadeau, founder of The DeFi Report

Takeaways

From CoinDesk Deputy Editor-in-Chief Nick Baker, here is some news worth reading:

SBF'S PARENTS: It's no secret that Sam Bankman-Fried's personal inner circle overlapped with this business inner circle. CoinDesk very much addressed that theme last year when it reported that SBF lived with some of his top executives, including ex-girlfriend Caroline Ellison, who ran his trading shop Alameda Research. And it's been long-discussed how significant a role his parents played. The folks restructuring FTX just asserted they played a large role and sued them. Within the case is an eye-catching scene involving SBF's dad acting exasperated with his son and saying he's going to pull his mom into the situation. It wasn't a normal family squabble over a curfew or whatever. It was Joe Bankman being angry that SBF was only paying his dad $200,000 a year, not $1 million. He wrote: "Gee, Sam I don't know what to say here … Putting [your mom] on this." Everyone who has parents feels this one. Relatedly, here's CoinDesk's Daniel Kuhn arguing SBF is blaming everyone but himself for FTX's spectacular failure.
MORE TO COME: U.S. officials going after Coinbase and Binance earlier this year was scary enough for everybody in crypto. But CoinDesk's Jesse Hamilton reported this week on foreboding new comments from the head of the Crypto Assets and Cyber Unit at the Securities and Exchange Commission. In Hamilton's words, David Hirsch said the SEC "isn't done chasing down crypto exchanges and decentralized finance (DeFi) projects it sees as violating securities laws in the same vein" as Coinbase and Binance. To state the obvious: This is not the sort of regulatory clarity crypto folks were hoping for.
SHARP DROP: As Binance continues to face scrutiny from regulators and maybe law enforcement officials, its business is shrinking. Its seven-day average trading volume has dwindled by 57% since the beginning of September. And this appears to be specific to Binance, as the data from K33 Research shows volumes on other exchanges have been mostly flat. "The ongoing [U.S. Department of Justice] and SEC cases versus Binance may have dissuaded market makers from trading on Binance, explaining parts of the decline," K33 Research senior analyst Vetle Lunde said.

Want more? For the latest news affecting the crypto markets, listen to CoinDesk's Markets Daily podcast.

State of Crypto: Policy & Regulation

It is now more important than ever to set industry standards and align on practical short-term and long-term objectives through pointed conversations with the best legal minds and Washington D.C.'s most important decision makers.

Join us at State of Crypto: Policy and Regulation on October 24 in Washington D.C. for an unprecedented opportunity to evaluate, dissect and ultimately shape crypto regulatory frameworks that support a vibrant, secure and healthy future for the digital economy.