1. Market movements
In the third quarter, the crypto asset markets outperformed and showed remarkable resilience. Despite crypto running a demanding regulatory gauntlet in markets like China and the US, Bitcoin (BTC) and Ethereum (ETH) gained 25% and 33%, respectively, in the third quarter (Table 1).
Table 1: Price development: Bitcoin, Ethereum, Gold, US stocks, USD, US government bonds with long maturities
Sources: Blockchain.com, Google Finance
However, in September, crypto prices fell along with declines in stocks and many other traditional asset classes.
As we discuss in our Market Framework below, the ongoing uncertainty surrounding regulation, the impact of the Fed’s tightening, and when new catalysts will arrive for adoption could tarnish the picture for crypto in the fourth quarter.
2. Our market framework
We are observing a variety of factors that are likely to affect prices in the crypto market in the coming months.
At a high level, the most important issue we see is the interplay between the growing institutional interest in crypto space and the increasing regulatory headwinds the market is facing.
While it may seem contradictory and unwise for The Street to provide capital to the industry in the face of the increasingly aggressive opposition from the official sector, we believe that both trends stem from the same cause, namely the disruptive potential of technology is becoming obvious and too important to than to be ignored.
While we expect higher volatility as crypto participants and the authorities work out new regulatory frameworks, we see these tensions as part of a necessary maturation process that will ultimately create long-term integrity for the asset class.
The level of activity in our customer franchise indicates that there is still a lot of catching up to do in this area, with significant additional inquiries and new allocation streams to come.
In line with this theme, the recent upward trend in alternative Layer 1 (L1) networks (i.e. blockchain networks beyond Bitcoin (BTC) and Ethereum (ETH) like Algorand (ALGO), Solana (SOL) etc.) seems to us as a further validating data point on institutional inflows. Given that crypto is still in its infancy, the “old L1 trading” appears to be a case of allocators trying to support a broad basket of all the credible horses in the race. This is a solid strategy for crossover investors who lack the bandwidth to choose preferred individual investments.
Against this core dynamic, technological developments within the ecosystem accelerate. Given the recent easy availability of venture and growth capital for crypto projects and infrastructure (e.g. Bitcoin mining), we do not see any reduction in this trend for the foreseeable future. In particular, we are watching the growth of Layer 2 scaling solutions for BTC (e.g. Stacks (STX)) and ETH (e.g. Polygon (MATIC)) as a potential topic to grab the market’s attention in the coming months. As a product manager here at Blockchain.com recently told us, “Things are actually working now. We can develop functions and apps that we couldn’t do three months ago … It’s great to feel young again in crypto! “
In other words, new technical skills should provide a powerful tailwind for activity and innovation. We see a material possibility that this issue will spark a bull run by the end of 2021, led by ETH or possibly even BTC itself, depending on whether the recent explosive growth of the Lightning Network continues in the coming weeks. A rally led by BTC would certainly be a surprise to the market considering NFTs, DeFi, and other smart contracting use cases lately. However, given the recent accumulation of the float in strong hands and the falling foreign exchange balances we have observed, this seems entirely possible to us. Also note that with BTC trading in a key support area around $ 42,000 and BTC market cap dominance at all-time lows of ~ 40%, the technical setup could be ready for an upside reversal by year-end.
Minor issues that we see also need to be watched closely:
- Entry into cryptocurrency from more sophisticated arbitrage traders. It is now clear that volatility arbitrage, basis trading, and other relative value strategies in crypto seem very attractive when compared to comparable returns in traditional markets. These strategies continue to attract new entrants and should serve to lower the cost of capital for the entire ecosystem while reducing trade volatility. Conversely, if we were to observe unreasonably attractive prices on known occasions such as the futures base, it would be a strong indicator that institutional inflows have either reversed or have been undermined by other exceptional market dynamics.
- Correlation with traditional markets. We expect the recent increase in the correlation between crypto and stocks to continue. This is a natural consequence of the increasing cross-allocations of investors with mixed risk in both buckets.
- Bitcoin ETF applications pipeline for decision in October and November. Some of them are purely futures-based, which could increase their likelihood of approval. At this point, we doubt this will have a huge fundamental impact on inflows, but the market could still appreciate the headline. In addition, if a futures-backed ETF is approved and gains market inflows, we can again see an impact on the cash / futures base from broader interest rates, which creates an additional incentive for crossover investors seeking yield, their pace of onboarding into the cryptocurrency to accelerate market.
- US interest rate markets and monetary policy outlook. The recent throttling announcement had a dramatic impact on the yield curve and fueled a bear steepener. While the technical drivers of the rate sell-off seem simple (taper is the opposite of controlling the yield curve), the underlying economic signal of price movement seems less clear. When we finally reach the end of the easing cycle and core economic strength warrants tightening monetary policy, real yields should continue to rise. Rising real returns could spur a rotation from tech assets to cyclical stocks and would likely weigh on the crypto market initially. Given the growth risks stemming from global energy and supply chain issues and the slowdown in China’s onshore real estate market, a reversal of the recent Hawkish Fed pivot also appears to us as a potential upward catalyst for crypto pricing.
- Crypto crackdown in China. The continued enforcement of crypto by the Chinese authorities can still cause market disruptions. However, it appears that there is now significantly less crypto involvement from Chinese domestic citizens remaining, mitigating the impact of further future raids.
- Short-term US dollar strength. This seems increasingly likely in the coming months due to the interest rate differentials and an enormous reduction in global liquidity year-on-year. Forward-looking macroeconomic indicators all point to a rapid slowdown in global growth originating in China. These factors all support a bullish USD view and the DXY is currently attempting a big break in the charts, which if successful indicates a 5-10% rise in the near future. This isn’t exactly bearish specifically for crypto, but dollar strength tends to cause general market volatility (sometimes both ways) and could hold back pricing across all asset classes.
3. On-chain analysis
Every month we dive into on-chain data to explore interesting trends or movements in the Bitcoin network.
On a monthly basis, total Bitcoin on-chain activity increased in September (Table 2).
Table 2: Bitcoin network activity in September vs. August
On a quarterly basis, Bitcoin’s market capitalization increased 22.5%. Even so, we saw a slowdown in on-chain activity over the quarter, with our average daily payments falling 14.7%. However, we saw an overall increase in Blockchain.com payments of 6.3% (Figure 1).
Figure 1: Bitcoin payments using Blockchain.com wallets and platforms compared to Bitcoin payments using non-Blockchain.com wallets and platforms
As a result of reduced on-chain activity, the average transaction fees have dropped from $ 17.50 / transaction to $ 3.01 / transaction – a dramatic 82% drop. Towards the end of the second quarter, we (Blockchain.com) implemented the Segregated Witness (SegWit) scalability upgrade, a highly anticipated advancement. That rollout resulted in an 80 percent rollout of SegWit by the end of the third quarter, which benefited users by lowering fees.
The sharp decrease in the size of the “mempool”, which can be viewed as a “holding tank” for unconfirmed Bitcoin transactions, also illustrates the significant reduction in Bitcoin network activity. Historically, periods of lower relative Bitcoin network activity have proven to be attractive entry points for medium to longer term Bitcoin accumulation by investors.
Figure 2: The size of the Bitcoin mempool (a “holding tank” for unspent Bitcoin transactions) remains low despite the recovery in Bitcoin price in the third quarter
4. Regulatory overview
In the United States, cryptocurrency has benefited from a generally accepted regulatory system for the past decade. Decentralized cryptocurrencies were neatly integrated into the existing licensing regime for money transmitter licenses.
Western law enforcement agencies seem more comfortable with the transparency of major cryptocurrency networks. In a recent discussion on sanctions related to ransomware, the Treasury Department made it clear that it knows that a lot of established cryptocurrency activity is legitimate, but has a special focus on “a subset of smaller emerging exchanges” that it believes are disproportionate for criminal activities are responsible.
The developments in the application of US securities laws to crypto assets are not as clear-cut. The SEC has made it clear that it believes some crypto assets are securities and are subject to the SEC. Chairman Gensler has made a number of statements suggesting a wider application of U.S. securities laws to crypto asset markets if his views on the nature of such assets convince lawmakers.
In addition, the SEC, the Treasury Department, and various government regulators have launched investigations into interest rate programs for cryptocurrencies. If the SEC succeeds in getting its arguments through, there could be a liquidity shock in the market and a possible shift to more decentralized financial credit programs.
Finally, on DeFi, the SEC has also expressed an interest in tracking down the operators of decentralized exchanges, most of whom do not have permits for what is listed and are therefore almost certainly trading in securities. These present a tricky problem for regulators as most decentralized exchanges smart contracts would continue to exist and work in all but the most extreme circumstances. We are closely watching how such regulation could be calibrated in the end.
5. What we read, hear and see