Quarterly Commentary – Q1 2023

Macro

As of the time of writing, the United States’ economy is growing its GDP at 1.75% per annum and is facing major demographic headwinds in the coming years. With the national debt at 220% of GDP and assuming a 2% average interest rate on that debt, the economy faces 4.4% in interest costs annually. Without Fed balance sheet growth (read: more debt), there is not enough cash flow in the private sector to service system-wide debts. Much of this debt is coming due over the next 12 months, and we do not see a viable alternative to QE in some capacity. At this point it would be naive to assume this debt will not get monetized at low interest rates, in our opinion. When looking into the near future, the direction of federal expenditures tells a fairly clear story:

Here is the annual deficit:

Here's a projection of debt-to-GDP into the future that the US Treasury Department released:

On March 12, 2023, the Federal Reserve Board announced the Bank Term Funding Program (BTFP), which allowed banks access to liquidity at the Fed’s discount window with all collateral automatically valued at par. “Something broke” – more specifically, four regulated US banks went into FDIC receivership in what some might argue was an entirely Fed-induced duration mismatch. The result of BTFP was an undoing of the last 6 months of tightening. 

Even in a “QE” world, it is difficult to discern what is investable given the continued confluence of risk vectors in the global capital markets. The failure of Silicon Valley Bank sent a clear message to the world: even “safe” assets carry risk. At this point, it also begs a more existential question about our banking system - what are banks really at this point? If I’m a bank, my deposit protection is socialized by the FDIC, my bonds are socialized by the Fed, and my loans likely come with implicit bail-out protection by taxpayers. Banks are no longer profit-seeking entities - they are pass-through entities for the Fed. This is not fertile ground for innovation and the stage is set for disruption.

Digital Asset Market Insights

"Gone are (most of) the greedy, (most of) the reckless, and (most of) the fraudulent players…In the midst of the chaos, the on-chain economy proved to be more reliable and secure, with transparent, impartial code protecting users' rights, data, and assets. In contrast, the off-chain economy was plagued with principal-agent problems and centralized intermediaries with abhorrent risk management...The contrast is clear: companies make promises, protocols make guarantees." – MJL Digital Equity Fund Investor Letter Q4 2022

Crypto markets exhibited an impressive recovery in Q1 2023, with Bitcoin leading the way amid a particularly chaotic macroeconomic backdrop. The total crypto market cap surged by 49.6% QoQ to $1.24 trillion, while trading volume rose by 89.2% QoQ to $21.63 billion. 

The current rally appears to fit the historical pattern of crypto bull market cycles, which have typically led to new all-time highs (reaching historic ATHs for current portfolio allocations would translate to approximately a 7.14x return on the Fund).  On a relative basis, digital assets have the potential to gather pace under a collection of narratives including the Bitcoin halving which is now just over a year away (May 28, 2024). The recent banking turmoil has only added further tailwinds for the adoption of decentralized financial networks. 

Despite a historic coordinated effort among the White House, Federal Reserve, Treasury, OCC, SEC, CFTC, and other agencies to crack down on crypto, the market has shown its resilience. 

Crypto's correlation to stocks, as measured against the S&P 500 Index, fell sharply in Q1 2023, reverting back to its historical mean. We see this trend as consistent with our expectations and expect it to continue unless there are major macroeconomic or geopolitical shifts.

Ethereum and Various L1s & L2s Rallied Sharply as the Overall Crypto Market Recovered

Ethereum and other Layer 1 and Layer 2 solutions experienced a significant upswing amidst the broader cryptocurrency market's recovery. This growth has been fueled by rising on-chain activity, increased adoption of Layer 2 solutions, and the continued expansion of Ethereum staking.

Key Performance Indicators Quarter ending March 31, 2023

• Ethereum Market Cap +49.86% QoQ ($219.47 billion) 
• Median Daily Transaction Count +1.68% QoQ (1.07 million) 
• Ethereum Fees Generated +72.08% QoQ ($459.86 million) 
• L2 Contribution To Ethereum Fees +1.48pp QoQ (6.23%)
• L2 TVL As A % Of Ethereum TVL +4.30pp QoQ (28.24%)

Sustained Deflation and On-Chain Activity Boost Ethereum

Throughout Q1 2023, Ethereum's on-chain activity resulted in sustained deflation, with the total supply of ETH shrinking by approximately 74,000 ETH since the Merge in September 2022. This deflation indicates Ethereum's economic sustainability, as user fees consistently exceeded validator rewards.

Layer 2 Solutions Surpass Ethereum L1, Paving the Way for Long-Term Growth

As Ethereum's long-term roadmap has relied on L2 solutions like Optimism and Arbitrum for scalability since 2020, it's noteworthy that activity on Layer 2s has surpassed that on Ethereum mainnet. The primary driver for this shift is the lower transaction fees on L2s compared to Ethereum's L1, making them more attractive to users.

Several other factors contributed to the rise of L2 activity in Q1 2023, such as enhanced security, improved user experience, and the migration of prominent DeFi protocols to L2 solutions. This trend is a positive sign for Ethereum's long-term growth prospects and further emphasizes the importance of L2s in the ecosystem.

Steady Rise of Ethereum Staking Ahead of Staking Withdrawals Launch

Ethereum staking witnessed a steady increase leading up to the anticipated launch of staking withdrawals on April 12. The Shanghai Upgrade, which enabled staking withdrawals for Ethereum, occurred on April 12, as this report was being finalized.

Contrary to concerns that staking withdrawals could lead to significant selling, we believe that allowing withdrawals will dramatically expand the market for staking. Investors will be more comfortable staking their ETH without the requirement of indefinite asset lockup.

In Q1, the amount of ETH staked increased by 13.55% to $32.8 billion, and we expect this trend to continue through 2023, despite the enablement of withdrawals.

DeFi Flourishes in Q1 2023, Fueled by Crypto Tailwinds and Regulatory Crackdown on Centralized Services

The decentralized finance (DeFi) sector experienced significant growth in the first quarter of 2023. DeFi staking services, such as Lido (LDO), witnessed a 158% increase in value. Lido, the leading decentralized staking solution with more than 31% of the total staking market share, had over 5,674,656 ETH—valued at $10.4 billion—staked through its platform by the end of Q1 2023. As the SEC continues to target centralized staking service providers, this trend is expected to persist.

Key Performance Indicators Quarter ending March 31, 2023

• Total DeFi Market Cap +49.78% QoQ ($51.00 billion)
• Total Value Locked (TVL) +27.38% QoQ ($47.02 billion)
• Revenue +39.11% QoQ ($218.19 million)
• DEX Trading Volume +27.61% QoQ ($239.02 billion)
• Stablecoin Supply -6.99% QoQ ($128.99 billion)

Uniswap Trading Volume Skyrockets as Trust in Centralized Venues Wanes

Uniswap, the leading DEX application, handled more than $198 billion in trading volume in Q1 2023, as traders lost faith in centralized platforms. Uniswap now regularly processes trading volumes comparable to those of Coinbase. In March alone, the platform processed $72 billion in trading volume—over 1.4 times that of Coinbase.

For Uniswap, increased trading volume translates into higher revenue. In Q1 2023, the DeFi giant generated $197 million in revenue for LPs, a 25% increase quarter-over-quarter. Uniswap has also seen impressive unique user growth, up 52.5% QoQ. While not quite at the all-time-highs of 2021, the current user growth trend is being driven by promising fundamentals (volume, liquidity, LP yields) and exciting new product launches and features (iOS app launch, fiat on-ramp, limit orders).

Stablecoin Activity Soars Despite USDC Temporarily Losing Its Peg

Stablecoins, a crucial component of the DeFi ecosystem, continued to grow at a rapid pace in Q1 2023, even as USDC, the go-to USD-backed stablecoin, temporarily lost its peg to the dollar.

Stablecoin payments and transfers surged, with over $17 trillion in transfers to date and more than $2 trillion in stablecoin transactions in Q1 2023 alone. For context, PayPal processed $2 trillion in transactions throughout all of 2022.

Crypto vs Macro: What’s Next?

So where does this leave us? Let’s review:

1. As the prospect of widespread banking failure and US-default grows, the digital asset market has resumed an accelerating fundamental growth trajectory.
2. Regulators from every major agency in the United States have utilized all tools available to implement Operation Choke Point 2.0.
3. The Ethereum world computer is running on all cylinders, globally accessible 24/7 with zero downtime, and continues to find new relevance for global consumers.
4. DeFi protocols are growing double- and triple-digits YoY and many are generating positive cash flows.
5. The Bitcoin halving is approximately 12 months away, historically a major catalyst for exponential moves higher across the space. Unlike last cycle, Ethereum has also undergone a major tightening of supply.

Here’s the reality: the global digital asset market capitalization is approximately $1.2 trillion today, even with the largest assets (BTC and ETH) down almost 80% from their peak. Elizabeth Warren, Gary Gensler, and Jerome Powell simply cannot alter the reality that this ecosystem has become a critical piece of trustless infrastructure for the global financial system. We are witnessing an incredibly important moment in time for blockchains. Never before has the core use case of transparent, trustless ledgers held more water.

The collapse of FTX was a fraud of historic proportions, costing users tens of billions in value and catalyzing perhaps the greatest coordinated regulatory clampdown on technology in our lifetime.

…and Ethereum couldn’t make a new low? Bitcoin makes a new low and immediately starts rallying aggressively? Let’s not overcomplicate this. We have made it through crypto’s Lehman moment and, as MJL has been asserting for the last two quarters, the selling is dried up.

After all that -  $1.2 trillion in value. The proof is in the pudding. 

Now we have 8 weeks of real fundamental data to back it up. We don't know that the raging bull market will start tomorrow, but we do feel that we are in a highly investable moment in time for this space.