chapter two

Bitcoin

Market view

Chart 9. Bitcoin (BTC) 2022 events/milestones

The broader weakness in digital asset markets observed throughout 2022 serves as a reminder that bitcoin remains one of the primary reserve currencies of the crypto economy. This became evident several times during the year when overleveraged players throughout the market – CeFi lenders, hedge funds, and venture capital (VC) funds –became forced sellers of digital assets across the board.

Bitcoin's resilience amid that stress suggests its long-term success is not dependent on any centralized entity either pumping or dumping it. The network continued to process an average of 255k transactions per day in 2022 without downtime or centralized oversight, even under volatile conditions. In fact, it continues to gain traction and adoption regardless of what happens in the markets.

Bitcoin's resilience amid major stress suggests its long-term success is not dependent on any centralized entity either pumping or dumping it.

Further, from a macroeconomic perspective, the value proposition for bitcoin has only strengthened this year as sovereign currencies around the world have shown signs of stress and central banks continue to grapple with policy credibility. In fact, if we Look at the risk- adjusted performance of bitcoin (based on a rolling 90-day window), BTC/USD returns tended to mirror EUR/USD returns in 2021, producing gains when many G10 pairs sold off.

That is partly a reflection of the global liquidity injection during that time. But also in 2022, when all markets tended to be risk-off, BTC actually outperformed most G10 FX pairs to the downside except during the deleveraging events in May, June, and November. See chart 10.

Chart 10. Bitcoin vs euro and yen in terms of risk-adjusted performance (z-score)

It is also important to zoom out and compare this "bear market" to past bear markets for bitcoin. Chart 11 shows that the percentage of bitcoin holders currently underwater on their investments is nearing 50%, just below the historic cyclical highs reached in November 2011, January 2015, and February 2019 (together averaging around 53%). These represent major inflection points for BTC performance, preceding subsequent periods of price appreciation. It should be noted that because the metric tracks UTXO movements, the denominator of the ratio is likely understated given individuals may hold their bitcoin across multiple UTXO sets. Wallet transfers are thus indistinguishable from BTC sales/purchasesz potentially overcounting the number of underwater positions. Still, we believe this metric provides important insights into current cycle positioning.

Chart 11. Percentage of bitcoin holders underwater (1m rolling average)

Also while the drop in BTC has been nearly commensurate with historical cycles, the state of play has shifted dramatically. In 2018, the Lightning Network was in its infancy and institutional adoption was relatively insignificant. Today, Lightning Network channel capacity is near all-time highs and preeminent industry leaders in finance and technology are participating in this space. Further, there are a number of important Lightning-enabled protocols being developed - including Taro and Fedimint - that have the potential to expand the utility of the Bitcoin network beyond a store of value.

Chart 12. BTC and ETH volumes on centralized exchanges by month

Miners as marginal sellers

Despite the positive traction in terms of mindshare, bitcoin prices have oscillated in a tight range for several months, and ASICs (bitcoin mining machines) are being sold at discounted prices. Bitcoin miners were not isolated from the leverage flush observed throughout 2022. Many miners had overextended their balance sheets throughout

2021,and when the market eventually turned, these leveraged players began to struggle, further perpetuating price declines as BTC reserves were liquidated.

As shown in Chart 13, some of the largest public bitcoin miners sold more bitcoin than they mined during 2022, depleting their reserves in the process. Other operators - such as Marathon Digital and Hut8 一 didn't sell any bitcoin during 2022, aided by the relative health of their balance sheets. In aggregate, the 10 public bitcoin miners detailed here mined ~40.7k BTC and sold ~40.3k BTC year-to-date in 2022, with ~34.2k BTC held in their reserves as of November 30.

For context, this cohort of public miners accounted for ~23% of total global hash rate at the end of November.

Chart 13. Public bitcoin miner summary (January 1 to November 30, 2022)

In early December 2022, the bitcoin network experienced its largest downward difficulty adjustment since July 2021 (which at the time coincided with China's mining ban) of 7.3%.13 Challenging conditions such as higher input costs (elevated energy prices) and lower output value have resulted in a highly stressed economic environment for bitcoin miners for the past several quarters. We've observed a number of signals of stress across the industry including:

Meanwhile, economic conditions for miners worsened throughout 1H22, but hash rate curiously kept climbing higher. Part of the explanation for this phenomenon is that many operators - particularly in the US 一 had overextended their balance sheets throughout 2021 in order to build out mining capacity as fast as possible to take advantage of rising prices. Due in part to supply chain constraints, the delivery of incremental hardware (often purchased on credit) was slower than expected. By the time their machines arrived, mining conditions had become tougher, and many of these operators were forced to either amend/ extend their debt obligations or mine near breakeven levels in hopes of a price rebound or competitors shutting down first.

Further, many mining operators in the US arranged prepayment deals with power providers (often for reduced rates), meaning those operators would be willing to mine uneconomically for the duration of those prepaid energy contracts. However, these strategies can only sustain operations for so long and we are beginning to see signs of meaningful capitulation.

Absent a near-term increase in the price of bitcoin, further declines in hash rate (and in turn difficulty), and/or declines in energy prices, it's possible that more operators will be forced to shut down in the coming months - particularly in light of stressed crypto market conditions. As a result, we would expect the mining industry to consolidate even further in the year ahead as more well-capitalized players acquire hardware and capacity at attractive prices. That said, whether hashrate will continue to decline and result in subsequent downward difficulty adjustments remains to be seen.

Outside of the US, it has been reported that Russia has been aggressively buiIding out mining capacity to leverage stranded and cheap energy in the region. Additionally, mining in China has recovered despite the 2021 ban, and while many operators in the region may have access to cheap energy sources, there also may be operators that have decided that it's worth the premium to mine unprofitably due to stringent capital controls in the country. These potential sources of incremental hashrate may counteract the impact of distressed miners in the US shutting down.

State of the Lightning Network

The Lightning Network is a Layer-2 protocol built on top of bitcoin that can theoretically scale to millions of instant transactions per second that cost fractions of pennies to send.

Much of the future adoption of the Bitcoin network, particularly in developing countries, may be driven by the asset's utility as a medium of exchange. In order for this vision to become a reality, the growth and development of Bitcoin's more scalable second layer infrastructure will be critical.

Chart 14. Lightning Network channel capacity growth

The current public node capacity of the Lightning Network - as measured by the amount of BTC locked in public lightning channels - is at all time highs. It is worth noting that an estimated 30% of channels are private, meaning the true value of the network is likely understated by available metrics. Despite being at all-time highs, however, public node capacity in USD terms totals less than $100Mz which pales in comparison to the total value locked on a network like Ethereum (~US$24B as of end-November).

Further, while certain projects 一 such as Taro 一 are actively developing methods to issue stablecoins or other non-bitcoin assets via the Lightning Network, dollar-pegged stablecoins on other blockchains are currently far more widely used as a medium of exchange. Additionally, in order for bitcoin itself to gain market share within the medium-of-exchange use case, it will likely need to grow into a larger, more mature, and less volatile asset. That saidz the growth trajectory of the network is encouraging and there is a robust ecosystem of developers and startups building on this L2.

Mt. Gox disbursements

As we look ahead to 2023, it is worth monitoring bitcoin-related events with potential market impact. One such event is the pending disbursement of bitcoin and other funds from the Mt. Gox rehabilitation plan. Over 11 years since its initial security vulnerability (and over eight years since filing for bankruptcy), the now defunct and much maligned bitcoin exchange Mt. Gox is preparing to potentially distribute funds to its creditors in 2023. The latest notification as of October 2022 (from the committee in charge of the rehabilitation plan) stipulated that the revised deadline for repayment registration is January 10,2023, with disbursements assumed to begin thereafter.

For context, the Rehabilitation Trustee approved a plan in 4Q21 to distribute 141,686 bitcoin (~$2.4B at December 2022 prices) to the creditors whose BTC was lost by the exchange. Market participants continue to speculate about the potential price impact of this large swath of bitcoin supply hitting the market in 2023. However, we believe the situation is more complex than that.