Crypto Trends For 2023
Macro, ETH/BTC, ZK-rollups, DeFi, Liquid Staking and navigating the bear market.
Now that an eventful year in crypto has just about concluded, it’s a good time to look forward, perhaps beyond the bear market, towards the likely emergent trends for 2023 onwards. Let’s talk about markets and more importantly the underlying technological developments that will drive crypto forward in 2023.
Macro
I think whether you like it or not, crypto is now tied to macro. Institutional adoption over the past few years has made this inevitable. As of right now, a very popular macro narrative suggests that it is only a matter of time before a Fed pivot as the rate of inflation slows month over month. This would result in a return to lower interest rates and essentially it is off to the races from there, meaning up-only for crypto once again. This is a dangerous narrative, and historically it has not often proved to be the case. Comparing the target Fed Funds rate and the S&P at weekly close, somewhat of a pattern could be interpreted. There seems to be a small reaction to news of the hike prior to the actual hike, on the order of 5–10%.
Following this, the market trades higher as rates are raised, likely due to expectations of a pivot. Though as the pivot actually occurs, this is where the serious crash happens, of the order 30%+ in the case of the dot-com bubble and GFC. Seeing as in the case of the 2020s, this is the largest rate rise out of both the aforementioned crashes, I expect we could go much lower from here. In terms of macro, I don’t think this time is different, and you never want to bet against macro. If inflation is even slightly stickier than expected, then expect a significant correction in 2023.
ETH/BTC Flippening, L1 wars
The trend everyone has been talking about recently is the potential ETH/BTC flippening. The flippening is the event where in this case Ethereum overtakes Bitcoin in market cap. This comes off the back of the alt-L1 wars which seem to have concluded with Ethereum L1 as a clear winner over alt-L1s who sought to take the dominant spot from the incumbent. There’s also the fact that ETH briefly became the most deflationary it had ever been amidst the FTX collapse, but these gains quickly disappeared post-crash.
Alt L1s such as Solana saw strong traction when it came to NFTs, marketplaces and dapps and simply attracting developers and building out an ecosystem. Solana even announced their Solana Mobile stack, optimised for making crypto more mobile friendly. All this made it a VC favourite to surpass Ethereum. However, mistakes including venture capital investments from FTX led to the token ($SOL) down 93% over the year. This isn’t to say Solana is dead, but the community has seen that it won’t be surpassing Ethereum anytime soon.
The recent resilience of ETH vs L1s and even BTC has driven enthusiasm that it could potentially flippen BTC. Although, I think whether this happens or not depends on slightly more than beating out L1s which have suffered already.
Overall it seems fairly clear by now that ETH is going to be the dominant L1. What we may see in 2023 is the expected trend of ETH becoming the official smart contract layer, with L2s and L3s built on top for other applications e.g. gaming that may need speedier transactions. In fact it seems that popular NFTs such as DeGods have understood this and have begun bridging from Solana to Ethereum.
However when it comes to BTC vs ETH, I think a different question should be asked. It is generally accepted by now that BTC and ETH are not really competitors, rather BTC is targeting the role of digital gold, acting as a store of value and wealth as opposed to a technological platform or payments mechanism. ETH takes the role of smart contract foundation that allows technological developments and apps built on top of it. So I personally think that each asset will be correlated to its traditional counterpart (where such exists). I expect BTC to be a slightly more long term macro driven asset, reacting to trends in inflation etc. whilst ETH may act slightly more like the stock of a tech company, as it develops further product offering and functionality the cyclical fractal will then follow an overall uptrend in proportion.
ZK Rollups
Another underlying trend that is slowly but surely coming to fruition is the adoption of zero-knowledge rollups and technology. The idea is to roll up and bundle transaction data outside of the main blockchain, reducing congestion and improving efficiency.
Vitalik Buterin has been vocal that rollups are the solution to bringing scale to Ethereum.On Ethereum, ZK-based scaling was limited by the lack of easy compatibility with the Ethereum Virtual Machine (EVM). zkEVM is also a decentralised roll-up, which is essentially one where any user may be sure that their transaction is executed. The decentralisation of rollups offers a few benefits such as censorship resistance and ability to remain online, but there are still challenges like potentially adding latency and complexity.
This was expected to be a multi-year project, but with the execution of the Merge and Ethereum Roadmap, rollups may not be so far away to implement with success. The breakthrough known as zkEVM seems to be the way forward into 2023.
Rollups are perhaps the key to transitioning crypto from niche digital internet money to a globally used method of payments and transactions. Historically, crypto lacked real adoption for payments due to its inefficiency and transaction costs, which centralised incumbents such as VISA have no problems with.
Though this is all interesting, a perhaps even more important feature zk-proofs may bring to crypto and the world is the ability to prove identities, credentials, solvency and reserves without explicitly sharing the personal information or internal financials. Think KYC and ID verification but without the need to send an exchange a picture of your driving licence. We also recently had the need for proof-of-solvency and proof-of-reserves very explicitly emphasised, and the solution may be zk-proofs. This resonates very closely with the libertarian original Bitcoin thesis, and therefore I think it is something that should be watched going into 2023.
Some perhaps interesting zk-rollups to look into would be zkSync and StarkNet, who utilise different proofing protocols (SNARKs and STARKs). They differ in setup, scalability and quantum resistance. ZK-STARKs also apparently prove 10x faster, though the technology has yet to fully mature and is thus lacking in generalisability. Though, SNARKs were discovered earlier and have gained adoption faster, having been popularised by Zcash.
Another factor to watch is the competition between Optimistic rollups (optimism and arbitrum) — an L2 construction that aims to scale transactions off-chain. Optimistic rollups currently hold a first-move advantage, though it appears ZK rollups may have more potential. Unlike optimistic rollups, Zk generates a validity proof for every transaction bundle.
Overall it’s a long term trend, something definitely worth paying attention to if you are aiming to be a long term holder or contributor to crypto. Don’t expect huge benefits to be shown overnight. Instead, as with most technology, expect zkEVM to develop slowly, in fits and starts for years before eventually reaching its ‘cambrian explosion’ moment, similar to how AI has finally reached it with chatGPT. Key contributors to keep an eye on include StarkWare and zkSync.
DeFi
The years 2020–2022 can be considered as the experimental trial run of decentralisation versus centralization in the crypto industry. Though we can only analyse one sequence of events, if we believe in natural selection, the outcome is clear. When it comes to resilience during difficult times, DeFi has proven its capacity to survive, an important trait if the crypto industry truly aims to disrupt the current financial system. Decentralised exchanges (DEXs) like Sushiswap saw over 10x growth in total value locked (TVL) from July 2020 to the highs of 2022, and since its launch, Sushiswap managed to gain 10% of the total trading volume market share from centralised competitors.
Another potential conclusion that can be drawn is that centralization is optimal for rapid growth in users due to its ease of use, ease of branding and marketing, and ease of adjusting to customer needs quickly. However, centralization also naturally invites malpractice and deceit, as fewer decision-makers determine transparency and who holds the key to the vault. In summary, while centralization may have its advantages in terms of growth and user experience, decentralisation offers a more resilient and transparent alternative, something that the crypto industry should consider as it aims to upend the current financial system
Liquid Staking Derivatives (LSD)
Recently, there has been a growing hype around liquid staking derivatives on crypto Twitter. One major catalyst for this is the upcoming Shanghai upgrade for Ethereum, which will enable withdrawals of staked ETH. This is a significant development for the Ethereum network, as it will greatly improve capital efficiency and provide immediate liquidity for users, without the need for withdrawal queues.
As the upgrade approaches, many are wondering how many people will choose to unstake their ETH. Looking at the current staking prices on platforms like Dune, it appears that around 80% of people are currently underwater on their staking deposits. It is difficult to predict who is more likely to withdraw, as there is no prior history to reference.
With the ability to withdraw staked ETH, liquid staking derivatives may see a significant increase in adoption. This is because they provide improved capital efficiency and immediate liquidity, without the need for withdrawal queues. Other blockchain networks like Cosmos have implemented similar solutions, but Ethereum’s PoS network is likely to see the most growth in this area.
Ethereum’s current staking rate is around 14%, which is relatively low compared to other networks like Solana. However, with the catalyst of the Shanghai upgrade, this number is likely to jump significantly. Additionally, with assets no longer frozen, users may have more confidence in staking their ETH.
Currently, Lido has about 60% of the market share in the liquid staking ecosystem, followed by Rocket Pool and then Coinbase. Coinbase is actively encouraging its users to stake their ETH, but the trade-off is a 25% fee for the convenience. On the other hand, decentralised options typically charge around 10% as standard. Other players in the market, such as Rocket Pool and Stakewise, have lower TVL/market cap and may pose a threat to Lido’s market share.
Another exciting development in the liquid staking space is governance-free LSDs that are built on the Ethereum base layer. These options maximise yield and potentially improve security as they are developed by Ethereum developers. However, they are not yet fully developed, but they are definitely worth keeping an eye on in the future.
Another factor to consider when choosing a validator is the health and reliability of the validator. A good example is FRAX, which allocates 8% of its fees towards buying back the token. A dashboard that ranks the health and reliability of validators would be a critical tool for users to make informed decisions.
Finally, Lido is implementing distributed validator technology, which is better for security and decentralisation. This is a positive development for the liquid staking ecosystem and will likely be embraced by institutions and other large ETH holders. As liquid staking is adopted, we find ourselves with a huge new source of liquidity, which may very likely flow towards DEXs. Also, given that we also know that token unlocks have mostly already been completed on Lido, it’s definitely one to watch going into 2023.
The app-chain thesis
App chains, such as those on Cosmos, and app-specific roll-ups on layer 2 and 3 protocols are likely to become increasingly popular in the near future. The ability to create your own chain opens up a lot of possibilities for customization and composability.
Cosmos, in particular, allows for more customization at the layer 1 level, and is not tied to the Ethereum or Solana layer 1 protocols. This is expected to lead to a lot of momentum in 2023, as projects like DyDx are moving from StarkX to their own Cosmos chain. If DyDx is successful in this transition, it could inspire other developers to consider building their own chains as well.
In the roll-up space, there are a lot of developments happening. Layer 2 and 3 protocols are becoming a popular launchpad for app-specific chains, as many projects want to remain aligned with Ethereum rather than abandoning the chain altogether. A lot of app-specific layer 2 protocols are being built using the Optimism stack. As the roll-up ecosystem continues to grow and more composability arises, applications built on these protocols are becoming relatively more valuable compared to those built on layer 1 protocols.
Another example of this is DyDx, they are building an app chain to decentralise the exchange by building a decentralised order book, this is something that can’t be done without an app chain. On the other hand, protocols without their own app chains are a lot easier to fork. For example, this has happened with the GMX forks.
In summary, the rise of app chains and app-specific roll-ups is creating new opportunities for big protocols to have specialised chains and roll-ups, which could revive the ‘fat protocol thesis’ and make applications built on these protocols more valuable.
Transition from AMMs to CLOBs
Central Limit Order Books (CLOBs) are a type of exchange architecture that collects limit orders from buyers and sellers, connecting them to execute trades. While CLOBs are relatively new in the DeFi space, they have existed for decades in traditional finance and are widely used in centralised crypto exchanges. However, the scarcity of on-chain CLOBs in DeFi is primarily due to the fact that they require significantly more transactions than Automated Market Makers (AMMs), making cost and speed critical factors that have hindered the growth of CLOBs as decentralised exchanges.
CLOBs utilise a different strategy for price discovery than AMMs. Instead of determining the price based on the ratio of tokens in a liquidity pool, the lowest ask price (sell order) on an order book is used. The more limit orders from market users on both sides of the book, the more liquidity there is, resulting in narrower spreads between the ask and bid prices and more effective trading at certain price levels.
A quick comparison between AMMs and CLOBs reveals some key differences. AMMs are easy to become a market maker and bootstrap liquidity for a pair, but they may experience impermanent loss and lack capital efficiency. CLOBs, on the other hand, have better capital efficiency and no impermanent loss, but it’s harder to become a market maker and bootstrap liquidity for a pair. Additionally, AMMs are better for long-tail assets, while CLOBs are better for fat-tail assets. Yield for AMMs comes from liquidity provider incentives, while for CLOBs it comes from maker reward. Both AMMs and CLOBs are susceptible to MEV attacks.
The use of CLOBs ties in nicely to the app-chain thesis. Returning to the example of DyDx, it appears quite obvious that there is demand for CLOBs for decentralisation. As a result I think it would be reasonable to expect the adoption of CLOBs over AMMs to rise, as the benefits become clear to users and particularly institutions who would have large influence.
Maximal Extractable Value (MEV)
MEV, or maximal extractable value, is starting to appear as one of the longer-term trends that will shape the future of crypto. With the recent merge of the original execution layer of Ethereum with its new proof-of-stake consensus layer, the Beacon Chain, new opportunities and challenges for MEV have emerged. The merge eliminated the need for energy-intensive mining and instead enabled the network to be secured using staked ETH; it was a truly exciting step in realising the Ethereum vision of more scalability, security, and sustainability.
Block space is limited and different positions in blocks are worth more or less. Therefore, we now have a market where people are willing to pay for space in certain locations in block space. This is fairly similar to some traditional trading strategies, especially in the high-frequency world.
MEV also offers a new potentially non-inflationary source of revenue for validators. It is possible to purchase arbitrage opportunities from validators, and the revenue goes to both validators and stakers. Since the prices of arbitrages will naturally go up to the value of the arbitrage, it forces searchers to become more creative with their strategies as the profit is not as worthwhile.
Since the Merge, the actors who actually perform block confirmation have changed. Today, validator rewards stand at around 1,700 ETH split between validators, before the merge that was ~13,000 ETH. This is a big step down. Additionally, the majority of MEV used to be attributed to miners under PoW, but now under PoS, validators take that spot. With this comes a shift of the ‘trust from mining pools to relays’.
The emergence of the ‘block-builders’ and the incoming proboser/builder separation (PBS) is one to watch. Currently, block building is completed by a ‘protocol sidecar’ known as MEV-boost. 89% of validators right now use MEV-boost blocks, and Flashbots dominates this by over 79%. The transition which entails due to PBS, hopefully towards diversity of relays and block builders is a key trend for 2023.
DeFi Security & Hacks
A big trend that has quite honestly been made very explicitly necessary is the absolute requirement for security and crypto insurance.
It is clear that 2022 was the worst year in crypto for hacks. This was largely dominated by bridge hacks, which accounted for 59% of the value stolen in 2022 [DeFi Llama EOY Review]. This is something that quite honestly should have been seen coming. Naturally, with bridges as you add more moving parts, more switching of chains, there will be an additional weakness and point of failure. Simply, there’s more things that can go wrong and more weaknesses for bad actors to exploit. And as we have seen over the years, there is no shortage of bad actors willing to capitalise on novel technology for a quick profit.
As new projects enter the market and hackers become more sophisticated, it’s important for DeFi investors to be aware of the key trends in security going into 2023.
According to a report by blockchain security and auditing firms HashEx, Beosin, and Apostro, the number of hackers will not decrease as long as there is interest in the crypto market. Many new DeFi projects are not thoroughly tested for security before going live, leaving them vulnerable to attacks.
One trend that is expected to continue is the targeting of cross-chain bridges. Last year, these bridges were a prime target for attackers, with $1.4 billion stolen in six exploits. As more projects explore the use of cross-chain bridges, they will likely be a popular target for hackers in 2023.
Hackers are also becoming more sophisticated, as they gain more experience and learn how to look for bugs and areas for exploitation. The crypto industry is still relatively new and it’s difficult to stay ahead of bad actors. The CEO of HashEx, Dmitry Mishunin, also warned that the number of hacks is only going to grow and these attacks may even spread outside of DeFi, targeting crypto exchanges and banks that enter the market offering more secure solutions for storing digital assets.
However, it’s not all bad news. Smart contract security and auditing firm Apostro co-founder Tim Ismiliaev believes that the space will mature over the next five years and new best practices for securing decentralised finance protocols will emerge.
Conclusion
In summary, as the DeFi market expands, security will be a critical aspect for investors to keep in mind. Key trends to watch include attacks on cross-chain bridges, advanced hacking techniques, and insufficient security testing in new projects. Stay informed and take appropriate measures to safeguard your assets. Keep in mind that the DeFi space is constantly evolving, and new security measures will continue to emerge. While security will remain a crucial topic in DeFi well beyond 2023, it’s essential to pay attention to it this year as well.
