Delayed Ethereum Merge Proves Costly

Please note that VanEck may have a position(s) in the digital asset(s) described below.

Bitcoin’s feverish connection to the S&P 500 finally broke in June, with the 30-day S&P/BTC correlation falling from 0.77 to 0.25. Unfortunately for crypto investors, the reason was an industry-specific deleveraging event catalyzed by a duration mismatch tied to Ethereum’s delayed transition to proof-of-stake.

Entities like Three Arrows Capital and Celsius staked Ethereum and received a token stETH in return, which they used as collateral for leveraged positions across crypto. Once Ethereum’s merge is complete, stETH will be redeemable at par for ETH. But when Ethereum core developers announced a delay to the merge to proof-of-stake on June 9, stETH ($5B outstanding as of 6/28/2022) price fell sharply versus ETH, prompting lenders to demand more collateral precisely as retail outflows were accelerating. In all, total TVL (total value locked) in DeFi, a proxy for leverage in the space, fell from $88B on May 31 to $57B on June 30, as lenders called open-term loans and borrowers sold what they could to post collateral on losing positions to avoid liquidations. As Ethereum represents ~65% of the AUM locked in DeFi, ETH was disproportionately sold. Eventually, some of the larger lenders in the space—including BlockFi, Voyager and Celsius—required additional working capital to meet withdrawal requests amidst the market rout, with Sam Bankman-Fried’s Alameda/FTX so far emerging as the only buyer/lender. Zug, Switzerland-based Nexo hired Citigroup and publicly announced they have signed a term sheet with Singapore-based Vauld giving Nexo 60 days of exclusive talks to explore an all-equity acquisition, but as of July 8, no deal has been announced. The fallout may yet continue as the insolvent entities’ portfolios are liquidated to satisfy unpaid debts.

Thus, for the month, Bitcoin price fell 40%, Ethereum 47%, and the MVIS CryptoCompare Smart Contract Leaders index down 34%, vs. the Nasdaq Composite 9%. Year-to-date, Bitcoin is down 60%, Ethereum -73%, and the MVIS CryptoCompare Smart Contract Leaders index down 76%, vs. the Nasdaq Composite -29%.

To illustrate how the leverage unwind changed market structure in June, we can observe the volatility profile of Bitcoin and Ethereum vs. “alt-coins” (Figure 1), which flip-flopped as ETH rose from among the lowest volatility crypto assets to among the highest. As a point of comparison, equity market sector beta also transformed during the unwinding of so-called bubbles—tech in 2000, financials in 2007—as seen in Figure 2. However, we can see that in both cases the relevant sector beta eventually fell back to pre-crisis lows. The same dynamic may play out for Ethereum if our bull thesis proves correct.

Figure 1 - Assorted “Large-cap” Cryptocurrencies: 30-day Annualized Volatility

Source: Bloomberg. Data as of 06/27/2022.

Figure 2: 30 Day Beta vs S&P 500 (9/14/1989-6/27/2022)

Source: Messari, DefiLlama, Bloomberg, blockchain explorers, VanEck research as of 6/27/2022.

Source: Bloomberg, Messari, CryptoCompare, MVIS, VanEck research as of 6/30/2022.

Layer 1 Smart Contract Platforms

Smart contract platforms led crypto lower in June as investors sold what they held the most of to pay debts. In a reversal from previous risk-off regimes, small-caps outperformed large-caps (-24% vs. -30% in the month, respectively) and Bitcoin and Ethereum fell more than any of the five sectors tracked by our index subsidiary, MarketVector Indexes GmbH.

For Ethereum specifically, the delay of the “merge” from proof-of-work to proof-of-stake highlighted operational and design risks for the largest smart contract platform, punctuated by the June 22 bombshell that dYdX, the largest decentralized derivatives exchange, will leave Ethereum’s layer-2 chain StarkWare in order to transition to a purpose-built blockchain based on Cosmos. According to dYdX, which runs a central limit order book exchange, “the fundamental problem with every L1 or L2 we could develop on is that none can handle even close to the throughput needed to run a first class orderbook and matching engine. For reference, the existing dYdX product processes about 10 trades per second and 1,000 order places/cancellations per second, with the goal to scale up orders of magnitude higher. This is where Cosmos comes in. A massive benefit of developing a blockchain dedicated to dYdX V4 is that it offers full customizability over how the blockchain itself works, as well as the jobs that validators perform.” Some developers speculated that dYdX’s move is less about technology limitations than attempting to avoid legal complications, given that the exchange’s orderbooks were heretofore centralized off-chain using starknet validiums, which could represent a vulnerable centralization point in a censorship scenario. In any case, the move was a blow to Ethereum maxis (which we are not).

Among smart contract platforms that comprise the MVIS CryptoCompare Smart Contract Leaders Index, Cardano (ADA) proved among the most resilient, down only 28% in June. With only $141M ADA locked in decentralized lending and borrowing pools, Cardano stands out as the most expensive layer 1 with a ratio of market cap to TVL of 147x vs. Solana at 5.2x, Ethereum 3.0x, and Avalanche at 2.1x. Still, with little leverage to unwind and the Vasil hard fork to anticipate, ADA nevertheless outperformed in the risk-off tape.

Solana (SOL) also outperformed in June, falling 30%, as the fastest monolithic blockchain finally appears to have solved some of its performance and economic issues that have muddled the capabilities and potential of this unique network. On June 15, a Solana runtime update occurred, designed to both speed up the network’s processing time and to cut down network spam that has clogged Solana during periods of high price volatility and NFT minting. This is accomplished by implementing QUIC, which offers asynchronous communication, which results in faster transaction processing fees. Block times, trending up, have dramatically improved with the implementation of the update (Figure 2). The latest update also introduces transaction fee prioritization and QoS (quality of service) of packets by staked weight. Both of these fixes help prevent bots from flooding the network with messages while also giving ordering priority to those who pay higher fees. Prioritizing messaging by stake thusly should increase the cost of spam. At the same time, adding a fee priority mechanism will remove the incentive to spam the network with transactions because those who pay the highest fees will be included in the block space first.

Then, later in June, after a lot of lead up—including the core development team at Solana adding “SMS” to their Twitter handles—Solana announced the Solana Mobile Stack, or SMS. The project’s ultimate goal is to onboard users to the Solana ecosystem through integration of Solana applications and a Solana application store with mobile phones. The suite of technologies offered by SMS includes a software development tool kit to build mobile applications, native phone integrations for wallets and separated private key storage similar to Ledger’s hardware wallets, most of which sell for $79-$179. To spur development, Solana also announced a $10M development fund to support mobile application builders. Alongside the SMS software development kit (SDK), Solana also promised an Android-based phone called Saga, which will ship with SMS natively installed. Saga is designed and manufactured by OSOM, which grew out of Essential, the startup phone manufacturer founded by former Google executive Andy Rubin. The phone will cost $1,000 and is available for pre-order with a refundable $100 deposit and anticipated delivery in early 2023. It will feature a 6.67" OLED display, 12 GB RAM, 512 GB storage, and the latest flagship Snapdragon^® 8+ Gen 1 Mobile Platform alongside a dedicated element to store seed phrases and private keys separated from the application layer.

Both of these developments—the code upgrade and the mobile SDK—appear positive for Solana. Enabling faster block times is important, because it will allow the Solana network to process more transactions, which increases the capacity of the network. Likewise, introducing QoS and fee priority will do a great deal to improve the user experience by preventing network outages from spam attacks and enabling a fairer, more transparent mechanism for transaction ordering. Meanwhile, the Solana phone is an ambitious gambit that communicates Solana’s intent to onboard more users through the important mobile browser user base. For example, Magic Eden, the most popular NFT platform on Solana, sees 50% of its web traffic come from mobile browsers as well as a 30% higher conversion rate than desktop-based browsers. Phantom, the most popular wallet on Solana, already hosts 35% of its active users on its mobile application only five months post-launch. We believe the Solana SMS will spur innovation around an “everything finance” platform that includes crypto, stocks and loyalty rewards, and that has thus been absent in the U.S. market. Long-term, we see potential for Solana to capture the majority of web3 users, thanks to its monolithic design enabling greater speed and inter-application composability, while employing a philosophy to make blockspace plentiful and affordable. Solana’s structure may prove ideal for onboarding the over 1 billion users of public blockchains we project by 2030.

In our valuation work on Layer-1 blockchain tokens, we calculate long-term price targets based on the percentage capture of total revenue from the most compelling blockchain use-case verticals. The four verticals we have identified are metaverse, financial exchange, gaming and global payments. In order to benchmark our revenue estimates for Solana, we calculate transaction revenue per use compared to Web 2.0 user metrics. For example, in the Metaverse category, one of the points of contrast is Facebook Meta. In terms of annual revenue per user, we estimate Solana’s revenue capture per Solana Metaverse user to be $23.92 in 2030. This figure compares to Meta’s year 2021 figure of $39.74. Embedded in our assumption is not only the value per user that accrues to the blockchain, but also the cost savings implied by outsourcing backend infrastructure to decentralized systems. Likewise, we recognize that the cost of service provision will also decrease as computing power and storage costs decrease over time. In our model, we arrive at a SOL base case price target of $230 based upon a discounted FCF yield valuation of 2030 cash flows. In this model, we assume Solana captures an average of 125bps of the hosted applications’ revenue, and that an additional 21bps of total value locked on the Solana chain per year accrues to stakeholders via MEV (miner extractable value).

Annual Revenue Per User

Source: Messari, DefiLlama, Bloomberg, blockchain explorers, VanEck research as of 6/30/2022.

Solana Transaction Revenue Per User, Year 2030 Estimate

Source: Messari, DefiLlama, Bloomberg, blockchain explorers, VanEck research as of 6/30/2022.

Source: Bloomberg, Messari, CryptoCompare, MVIS, VanEck research as of 6/30/2022.

Metaverse & NFTs

The MVIS CryptoCompare Media and Entertainment Leaders Index (MVMELE) fell 20% in June, capping a rare month of metaverse outperformance vs. other crypto sectors. Specifically, Axie Infinity (AXS) fell 13%, as the play-to-earn pioneer restarted its Ronin bridge three months after a hacker exploited the chain for $625M in March. The bridge resumed operation after passing both internal and external audits by blockchain security firms. The upgraded bridge promises a circuit-breaker system to improve the bridge’s security by pausing large-scale withdrawals that may indicate exploits. According to Axie operator Sky Mavis, all user funds are fully backed on a 1:1 basis by the new bridge, and users who lost money in March’s hack have been made whole. Axie’s move to repay victims and lessen token emissions in the wake of the exploit deserve credit, but AXS tokens are still down 93% from their peak.

Separately, Sandbox (SAND), the largest open metaverse project by market, also outperformed most crypto tokens, falling 13% in June. Coinbase listed SAND tokens in late May, Binance launched SAND staking with up to 14.5% yields in late June, and Sandbox airdropped 5M mSAND tokens to LAND owners via the Polygon network to incentivize further activity on the network. Ten thousand unique wallet addresses interacted with the Sandbox smart contracts in June, a 116% increase month over month, according to DappRadar.

Overall in the NFT market, liquidity declined less than prices in June. The average NFT sale was down 30% to $1,000 in June, while the absolute number of sales fell a more modest 13.5% to 149,000, of which secondary sales represent 116k, down 12%. Prices for the top 10 NFT sales in the month ranged from $389,000 to $1M and included three Bored Apes, three Cryptopunks and two Otherside “otherdeeds”.

Still, despite the weakness in overall NFT sales, June saw a slew of corporate announcements that point to widening adoption of NFT technology. These include:

• June 17: Fireblocks, the crypto custody provider, launched a software developer kit called “Web3 Engine”, so that companies can build an infrastructure for NFTs and decentralized gaming.
• June 21: Uniswap Labs, the private company that supports the Uniswap Protocol, announced its acquisition of GenieXYZ, the first NFT marketplace aggregator. Starting this fall Uniswap users will be able to buy and sell NFTs directly on the Uniswap web app.
• June 21: Magic Eden, an NFT marketplace accounting for 97% of Solana NFT transactions, closed a $130M series B, valuing the nine-month old company at $1.6B, according to TechCrunch.
• June 22: Ledger, a crypto hardware and security firm most known for its hardware wallets, announced it is launching a Web3 services platform meant to cater to enterprises, as well as an NFT marketplace called Ledger Market.
• June 22: eBay acquired KnownOrigin for an undisclosed sum. KnownOrigin, which runs on the Ethereum blockchain, is a UK-based platform that allows for buying and selling of NFT artwork. (VanEck was invested in KnownOrigin via our venture stake in Cultur3 Capital, an early stage crypto VC firm focused on founders with a community-first mentality.)

It remains to be seen if any of these emerging platforms can challenge OpenSea’s 90%+ market share. Still, the growing range of competition highlights substantial dynamism and possibly low barriers to entry in the space. We are inclined to access growth in the space through infrastructure investments such as layer 1s—Arweave, ENS and Immutable X, to name a few.

Source: Bloomberg, Messari, CryptoCompare, MVIS, VanEck research as of 6/30/2022.

Infrastructure Applications

The MVIS CryptoCompare Infrastructure Applications Leaders index (MVIALE) fell 22% in June. Chainlink (LINK) was among the better performers, down 20%, after founder Sergey Nazarov unveiled v0.1 of Chainlink staking in a presentation at the Consensus conference in Austin, TX on June 7. Long awaited, LINK’s staking mechanism is now projected to go live later this year, according to Nazarov. The first release will focus on introducing a reputation framework and staker alerting system. That is to say, stakers will be able to raise an alert about ETH/USD feed and get a reward, so long as the stakers prove the valid detection of ETH/USD feeds that sync out of the SLA (service level agreement). After sufficient validation from in-production usage and community feedback, a v1.0 release will introduce additional functionality such as the slashing of stake for cryptographic security and the incorporation of user fees as rewards. Initially targeting a base level of up to 5% annualized staking rewards, after further releases LINK rewards will vary based on user fees and the length of the commitment period. We detailed the long-term thesis on Chainlink in earlier work. In fact, an increasing number of DeFi protocols, including Euler, featured on a recent VanEck webinar, now rely on Uniswap v3 price oracles. These oracles take advantage of the spot price on Uniswap v3 for an asset over some specified period in the past. That is, they give a time-weighted average price (TWAP) for an asset, rather than just the current price. Storing price and liquidity history directly in the pool contract substantially reduces the potential for logical errors on the part of the calling contract, according to Uniswap, and reduces integration costs by eliminating the need to store historical values. Additionally, the v3 oracle's considerable maximum length may make oracle price manipulation significantly more difficult, as the calling contract may cheaply construct a time-weighted average over any arbitrary range inside of (or fully encompassing) the length of the oracle array. Whether the oracle function becomes “insourced” to Uniswap is one of the key debates we will be tracking in DeFi.

Polygon (MATIC) another notable performer in the infrastructure category, fell 32% in June. Polygon comprises a series of sidechains including ZK (zero knowledge) proof-based, optimistic rollups, and MATIC’s flagship plasma proof-of-stake Ethereum sidechain. With a $4B market cap, Polygon dwarves other layer 2 competitors by both capitalization and breadth of blockchain offerings. Recent deals with Stripe, Reddit and Instagram highlight MATIC’s strong business development capabilities and potential to gain scale advantages via Web 2.0 partnerships. Meanwhile zero-knowledge proof-based sidechains continue to proliferate and gain market share as the 2018 invention of STARKs enabled trustless initial setup, eliminating the threat of an open back door for hacks. We believe MATIC is well positioned to take market share vs “layer 1” chains.

In aggregate, the infrastructure category is now the worst performing sector over the last one-year, down 82%, as the scaling solutions and decentralized cloud computing protocols that characterize the space are not yet producing much cash flow for investors.

Source: Bloomberg, Messari, CryptoCompare, MVIS, VanEck research as of 6/30/2022.

DeFi

The MVIS CryptoCompare DeFi Leaders Index fell 20% in June. DeFi TVL (total value locked) fell 35% from $88B to $57B as of June 30 according to DefiLlama, as borrowers sold collateral to repay open term loans called to pay for retail outflows. While no DeFi protocols ceased operations amidst the strain, several used their governance process to change collateral or other rules to avoid distress.

For example, amid the adverse market condition, decentralized exchange Solend’s largest wallet—a wallet borrowed with $170M SOL collateral—was close to liquidation after SOL price fell 74% since April. Binance stepped in to notify the whale to pay down the debt, liquidation of which would have been disastrous for Solend as a market sale of such size would have crushed SOL price. Solend also changed its rules via a sudden community governance action to prevent future whales from dominating protocol liquidity. This event has sparked hot debate over whether DeFi platforms should have rights to overrule the smart contracts in anticipating a liquidation cascade.

During this eventful month, DeFi pioneer Bancor has temporarily halted its Impermanent-Loss-Protection feature on June 19. While the price of BNT, the native token on Bancor decentralized exchange, was stable following the announcement, Bancor’s TVL plunged 70% in June and the protocol’s head of research Mark Richardson told Blockworks that rumors on 4chan about the protocol’s model, short-sellers front running Celsius’ liquidation, and Celsius’ own selling had all contributed to a run on the bank.

Separately, MakerDAO (MKR) approved a new governance proposal to diversity the Maker protocol’s treasury by adding a new real-world asset vault, including U.S. short-term Treasuries and investment-grade corporate bonds, to its investment strategy. In the proposal, Sebastien Derivaux of Maker’s strategic finance core unit wrote that the DAO currently holds 60% of its balance sheet in stablecoins, which “provide no revenues for MakerDAO, provide bad PR, and significant counterparty risk on Circle.” Specifically, MakerDAO proposes a $1B investment in ETFs and/or mutual funds targeting an average duration of two years and a ~1% yield. The proposal represents a major step for MakerDAO as it signals an intent to extend beyond crypto native investments and earn yield from traditional financial investments with its flagship DAI stablecoin.

Lastly in DeFi, THORChain, the cross-chain decentralized exchange, launched its mainnet on June 22. THORChain aims to allow traders to move between different asset pools by using RUNE, its native token, as an intermediary. In June the protocol facilitated an impressive $30M/day in cross-chain swap volumes.

Overall, DeFi trading volumes across all decentralized exchanges totaled $77B in June, down 52% from $160B, after peaking in November 2021 at $205B. As a share of volumes on centralized exchanges, DeFi share has fallen from 16% to 13% through June.

Source: Bloomberg, Messari, CryptoCompare, MVIS, VanEck research as of 6/30/2022.

Source: Bloomberg, Messari, CryptoCompare, MVIS, VanEck research as of 6/30/2022.

Exchange Tokens

Overall, exchange tokens fell 28% this month, modestly outperforming the market overall. KuCoin (KCS), the fifth largest crypto exchange by traded volume, was the worst-performer in the space, down 33%, reversing May’s outperformance which was driven by the Seychelles-based exchange’s $150M in pre-Series B funding at a valuation of $10B. Among outperformers, Celsius (CEL) rose 24% as the beleaguered lender closed withdrawals to protect capital. Unus Sed Leo (Bitfinex), the eighth largest exchange by volume, rose 8%. As a reminder, iFinex, Bitfinex’s parent company, has committed to purchasing and then burning LEO tokens equal to 27% of the company’s revenue, offering holders some defensive characteristics when volumes and volatility rise during down markets.

Source: Bloomberg, Messari, CryptoCompare, MVIS, VanEck research as of 6/30/2022.

Source: Messari, DefiLlama, Bloomberg, blockchain explorers, VanEck research as of 6/30/2022.

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