by Kyle Waters & Matías Andrade
In this issue of the State of the Network, we explore the theses that we expect to be important in the world of cryptocurrencies in 2023. This year, we will likely be facing challenging macroeconomic conditions again due to the ongoing Russo-Ukrainian conflict and quantitative tightening by the US Federal Reserve. The loan crisis caused by Terra/Luna, 3AC, and FTX-Alameda blowouts will also have significant impacts across companies in the space. Additionally, we can expect to see increasing financial oversight from both the US and EU, including the Digital Commodities Consumer Protection Act (DCCPA) and the Markets in Crypto-Assets (MiCA) regulatory framework.
On the heels of The Merge—a technical upgrade of astounding scale—the Ethereum ecosystem is poised to continue to build on its roadmap, with the Shanghai upgrade expected optimistically in late Q1 or early Q2. As Bitcoin, Ethereum, and other blockchain developers seek the grail of scalability, second layer (L2) scaling technologies are positioned to continue growing in breadth and adoption.
On the decentralized finance (DeFi) front, real world asset (RWA) tokenization is also expected to be a significant topic in the crypto market this year. On a positive note, we anticipate an increasing prevalence and investment in “Game-Fi” gaming projects that integrate with digital assets. These projects offer a new way for gamers to earn and use digital assets, and we expect to see strong growth and new developments in this area.
Overall, 2023 is shaping up to be a year of both challenges and opportunities in the world of cryptocurrencies. We will be closely following these and other important developments as they unfold.
Ethereum Moves Beyond The Merge
As Ethereum moves beyond a year defined by The Merge and its success, developers, users, and ecosystem followers alike are looking ahead to the largest smart contract platform’s next planned upgrades. For all of its implications, The Merge was just one step in the Ethereum roadmap, which developers have laid out to reach mass adoption on the network.
The first planned upgrade in 2023, dubbed Shanghai (Ethereum hard forks have historically been named after cities), will notably incorporate withdrawals of staked ETH from the Consensus Layer. This upgrade is expected in early spring, pending successful testing on Ethereum testnets. Because ETH staking rewards do not compound beyond a validator’s 32 ETH effective staking balance, shrewd validators should have an incentive to withdraw rewards over 32 ETH for more productive uses, such as depositing into a DeFi protocol. There is currently about 1M ETH of staking rewards accumulated and locked up on Ethereum’s Consensus Layer, also known as the Beacon Chain.
Source: Coin Metrics Formula Builder
But all of this ETH will not unlock on the market all at once. Current specifications allow a maximum of 57,600 partial withdrawals per day (256 per epoch). Using today’s data, the average validator holds a total balance of about 34 ETH, which would imply a daily rate of (34-32) * 57,600 = 115,200 ETH entering the liquid market until all validators have had a chance to withdraw their excess balance—which could take roughly 10 days (~500K active validators / ~57.6K withdrawals per day).
However, an important consideration is the effect of liquid staking derivatives, which alleviate the pressure to withdraw excess balances. Additionally, large staking operators, such as exchanges, are likely to pool rewards and spin up additional validators. What is certain is that the activation of staking withdrawals will be a noteworthy event, not just for its technical implications but also its impact on the market dynamics of ETH in the short term.
The Merge was an important milestone and achievement for Ethereum. But in 2023 Ethereum ecosystem participants will also continue to grapple with the complex dynamics of Proof of Stake. Researchers and developers are thinking deeply about how to prevent any centralization and protocol risks posed by Maximal Extractable Value (MEV).
Will L2 Adoption Keep Accelerating?
One of the most pressing problems in crypto is the challenge of scaling blockchains. Although transaction fee levels subsided in the second half of 2022, certain applications and users remain priced out on chains like Ethereum where the number of transactions per second (TPS) maxes out around 15 today. Even as the average transaction fee on Bitcoin floats near $1 (62 cents on January 1st, for example), microtransfers remain impractical. 2023 may develop into a pivotal moment as developers rally to address this issue.
In the Ethereum ecosystem, developers have focused their efforts on the implementation and adoption of a second layer (L2) scaling technique known as a rollup. The key idea of rollups is to move costly computation off-chain while only storing (“rolling up”) the results of bundles of transactions on the base layer, alongside a proof of their correctness. This allows for higher throughput, while inheriting the security of the base layer.
The two largest Ethereum L2s—Optimism and Arbitrum—have experienced incredible growth in the last year. The share of total Ethereum gas used by L2s tripled in 2022. This is encouraging, but the future of rollups on Ethereum is even brighter; the planned Ethereum Improvement Proposal, EIP-4844 will significantly bring down the cost of rollup transactions. The timeline for deployment isn’t certain, but EIP-4844 may well arrive in 2023, helping drive L2 adoption.
On Bitcoin, BTC held on the Lightning Network—a scaling solution for Bitcoin—rose from 3K to 5K in 2022. Increasing the adoption of Lightning-powered applications will be a priority for Bitcoin ecosystem participants in 2023, particularly exchanges which have so far been surprisingly reluctant to adopt Lightning Network for deposits and withdrawals.
Regulation on Capitol Hill
The fallout from FTX’s implosion is set to dominate crypto-regulatory dialogue in the U.S. Sam Bankman-Fried is now in U.S. soil and was indicted on eight counts including money laundering, conspiracy to commit wire fraud, and securities fraud. His trial is set to start in New York federal court on October 2nd.
In the wake of FTX’s collapse, members of U.S. Congress continue to push for safeguards, including the proposed Digital Commodities Consumer Protection Act. Additionally, stablecoins are expected to be a focus of regulatory discussion. With a record $7T settled in 2022, stablecoins have demonstrated product-market fit, and are being used heavily within DeFi applications, for international commerce, and as a convenient medium of exchange. But stablecoin governance remains an important issue for regulatory discussion, especially with the existence of novel risks such as the use of admin keys.
The Senate Banking Committee and House Financial Services Committee, which have differing views on cryptocurrency, oversee the SEC. With new representatives taking control of the House Financial Service Committee, we might see a moderation in the SEC’s attitude towards cryptocurrencies. The Senate Agriculture Committee and House Agriculture Committee, both of which are expected to have a more favorable stance towards digital assets, oversee the CFTC. We can expect further developments on the domestic regulatory front as the SEC and CFTC figure out whose authority will rule over exchanges, stablecoins, and cryptocurrency security status.
EU’s MiCA & RTA
The MiCA regulatory framework is a set of rules governing the crypto industry within the EU, scheduled to pass this year and come into force by 2024. It requires that Crypto Asset Service Providers (CASPs) operating in the EU have management residing and regulated within the EU, and that client assets be segregated. In addition, the MiCA framework sets out specific requirements for infrastructure services such as wallets and exchanges. These requirements are designed to ensure the security and integrity of these services, as well as to prevent money laundering and terrorist financing. The framework also includes ESG requirements, including a requirement to establish “minimum sustainability standards” for consensus mechanisms, which could potentially impact assets secured by Proof-of-Work.
In addition, the MiCA framework regulates the issuance of asset-referenced tokens (ARTs) and non-euro e-money tokens (EMTs), with a cap on daily traded volume on non-euro stablecoins of €200M. It also includes strict TFR (travel rule) regulations for CASPs—with no exemptions or minimum amounts—and strict AML requirements for transfers exceeding €1000. The framework also prohibits algorithmic stablecoins, but the language used may impact decentralized stablecoins such as Maker’s DAI.
The MiCA framework defines two types of crypto assets: “Virtual Financial Assets” (VFAs) and “Stablecoins.” The MiCA framework requires that VFAs and stablecoins be issued and traded in a transparent and fair manner, with proper disclosure of information to investors. It also requires that VFAs and stablecoins be governed by robust risk management and corporate governance frameworks. Stablecoin regulations under the MiCA framework will go into effect 12 months after MiCA and TFR pass, with 18-month periodic reassessments.
Overall, the MiCA EU regulatory framework is an important step forward in the regulation of the crypto industry within the European Union. It provides a clear and consistent set of rules that will help to promote the growth and development of the crypto market, while also protecting investors and consumers.
Real World Assets
Real world asset (RWA) tokenization is the process of representing physical and traditional financial assets in the form of digital tokens on a blockchain. These tokens can then be bought and sold like traditional securities, allowing for more efficient and secure trading of real world assets. According to a report from FortunaFi, the total holdings of RWA tokens have decreased from $1.75B in 2Q22 to $621M. Despite this decline, RWA tokenization remains a promising area of growth in the crypto market.
Recently, a group of 12 banks (including Bank of America and Citi), conducted a pilot program to tokenize various projects in order to reduce the time it takes to settle transactions to T+1. This means that transactions can be completed and settled within a single business day, rather than the typical T+2 or T+3 settlement periods. In early November 2022, JP Morgan, Deutsche Bank, and SBI Digital Asset Holdings traded tokenized currencies and sovereign bonds via Polygon, an Ethereum L2 network. This demonstrates the increasing adoption of RWA tokenization by major financial institutions, and their adoption of L2 for scaling.
MakerDAO, a decentralized finance platform, has recently allocated funds into $400M short-term treasuries and $100M investment-grade corporate bonds. MakerDAO has also recently passed a favorable vote to allow mortgage loans on commercial real estate properties in collaboration with Huntingdon Valley Bank. Société Générale has also set up a vault in collaboration with Maker for its digital asset subsidiary, allowing OFH tokens representing AAA-rated covered bonds to be deposited as collateral to borrow up to $30M DAI. This is significant because it shows the potential for various assets to be used as collateral for crypto-native protocols. RWA-backed loans have also seen a surge, reaching up to $140M. This indicates the growing demand for RWA tokens as a means of financing real world assets.
Source: Coin Metrics Network Data
WisdomTree, a financial services company, has also launched a digital fund called WTSY (Short-Term Treasury Digital Fund). This fund tracks the Solactive 1–3 year Treasury Bond Index and will be tokenized on the Ethereum or Stellar networks. This further demonstrates the potential for RWA tokenization to transform traditional financial markets.
Overall, the adoption of RWA tokenization is increasing in the crypto market, with major financial institutions and platforms exploring the use of these tokens in various transactions. While total holdings of RWA tokens have declined, the potential for growth in this area remains strong.
It is no surprise that gaming is one of the leading adopters of new technologies to empower developers to create new experiences to attract players. Since 2022, there has been a steady increase in gaming companies investing and developing games that go beyond the play-to-earn proof of concept games we had so far seen. Various projects, including MMORPG Big Time, Star Atlas, Yuga’s Otherside, and Ember Sword have attracted significant amounts of investment, and have secured reputable game developers to help bring these to fruition. These developments demonstrate the potential for the gaming industry to embrace blockchain technology and create new opportunities for players to earn and own in-game assets. It will be interesting to see how the gaming industry continues to innovate and adopt new technologies in the future.
In summary, the crypto market in 2023 is expected to face a range of challenges and opportunities. We can expect to see increased financial oversight and the development of new technologies, as well as ongoing macroeconomic instability and other challenges. Despite these challenges, the crypto market remains a dynamic and potentially transformative space, and we will be closely following the key developments as they unfold.