The Great Reset: Navigating Crypto in 2023

JAN 04, 2023

Kevin Kelly, CFA + 10 others

All authors of this report have fully disclosed their token holdings. Please click here for the disclosures.

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Note: If you’re interested in reading individual sector reports, please follow the respective links below. If you’d prefer to listen to audio versions of the reports, you may use the Listen button just above the Table of Contents on the left. The sector Year Ahead reports were originally published between December 05 – 21, 2022.

The Year Ahead for DeFi

The Year Ahead for Infrastructure

The Year Ahead for Gaming

The Year Ahead for NFTs

The Year Ahead for Markets

Introduction: The Great Reset

This introduction was written by Co-Founder Kevin Kelly to share a few personal thoughts to prelude the full Year Ahead report. Navigate to any sector report using the Table of Contents above.

We titled this year’s report The Great Reset because we believe that’s what 2022 represented for crypto — a great reset in prices, expectations, and speculative interest all across the industry. Every major tailwind that propelled the crypto market higher from Q2 2020-Q4 2021 turned against it, resulting in one of the sharpest and quickest price drawdowns we’ve seen to date.

Bull markets are where most investors make their money, and bear markets are where you fight to preserve those gains. But long drawdowns have a silver lining in that they encourage deeper reflection, giving all of us a chance to re-evaluate what really matters and where we really want to spend our time.

‘Tis the season where everyone predicts what next year — and the years to come — will bring. For me, I spent the majority of my holiday brainpower thinking about the big picture: 1) because I’m a macro guy at heart, so I can’t help but think big picture, and 2) because I believe we could be on the cusp of a serious inflection point, one that could accelerate the trajectory of this industry and shorten the timeline for Web3 to really move the needle beyond today’s small (yet enthusiastic) user base.

Crypto has largely been a speculator’s market, and that’s still true today. But speculation isn’t inherently evil. The term “speculation” tends to carry a negative connotation. But, like most things, it sits on a spectrum. Hype and excitement drive interest, which attracts capital, which gives entrepreneurs the resources to build innovative products leveraging new technologies. Without speculation, capital wouldn’t flow to such risky ventures (and society would still be stuck in the Stone Age). In fact, I’d argue speculation is more than beneficial — it’s imperative at this stage.

The truth is there aren’t many people who are really driven to build boring products with boring use cases that offer boring returns. We need the visionaries, the hungry entrepreneurs who see the sky as their north star, not their limit. The ones who breathe life into those around them, creating waves of excitement with ripple effects that extend far beyond their own reach.

Now, not all entrepreneurs are created equal — this year we saw firsthand how an entire industry can fall victim to a select few who let ego or profits get in the way of progress and purpose. But history is littered with examples of hubris (and even outright fraud). Innovation attracts a wide array of actors — some good, some bad, some in between.

All innovation cycles start off being extremely speculative. The dotcom frenzy of the late 90s culminated in one of the most infamous market bubbles of the last century. Inflated expectations stoked higher valuations, and when market conditions turned, these 90s high-flyers were hit the hardest. Like all hype cycles, speculation got ahead of reality, and fundamentals needed time to catch up.

Fast forward twenty years and the tech sector is now home to many of the largest and most profitable companies in the world. But today’s corporate behemoths weren’t overnight successes. At the height of the dotcom era, Amazon’s market cap was north of $34B before it surpassed $1B in annual revenue. AMZN subsequently suffered a 94% drawdown in the depths of the dotcom crash, even as its revenue growth and market share expanded. Price multiple compression was the primary driver of the equity market’s initial decline in 2000, similar to what we just witnessed in 2022.

Crypto is facing a similar challenge, and it would be naïve to say the crypto market’s rapid valuation expansion over the last several years was driven by pure fundamentals over speculation. The question now is whether crypto is in an analogous period of dejection akin to the post-tech bubble, or if this is all just smoke and mirrors without any underlying substance.

Crypto Innovation Cycles

The crypto industry itself has gone through multiple hype cycles, each fueled by speculation on the back of new innovation triggers.

Bitcoin experienced a short-lived spike in 2013, but its true mainstream hype cycle happened in 2017. The “digital gold” narrative gained traction, as macro conditions were ripe for a new type of digitally-scarce speculative asset to thrive. Risk was in vogue, financial conditions were easing, the dollar dropped >10%, and equity volatility hit a multi-decade low as stocks kept marching higher.

The launch of the first smart contract protocol — Ethereum — drastically simplified the process for creating new crypto assets (via its standardized ERC-20 contract), laying the foundation for the ICO craze of 2017 (which also benefited from the same favorable macro backdrop).

The launch of more sophisticated DeFi protocols like Uniswap, Aave, Compound, and Synthetix made trading, lending, and borrowing crypto assets much easier than archaic alternatives, and the advent of liquidity mining (and the copycat projects that spawned from its early success) paved the way for “DeFi Summer” in 2020.

Gaming and NFTs caught fire in 2021 as attention shifted to more mainstream and consumer-friendly use cases beyond DeFi speculation. Game developers and creators alike leveraged fungible and non-fungible tokens to build new ecosystems and engagement models (some even used a combination of both). The hype behind this new wave of assets and use cases — again coupled with extremely favorable macro tailwinds — pushed crypto markets to new heights once again.

Additionally, this surge in transaction activity led to spikes in transaction costs, which accelerated the “L1 wars” narrative and sparked critical debates around the optimal blockchain architectures for different application types (you’ll find plenty of in-depth commentary on the tradeoffs between modular vs. monolithic chains in this report too, don’t worry).

The point is, each of these hype cycles brought more attention, users, and capital to the crypto ecosystem and built upon the advances made by those prior, expanding the capabilities of what’s possible with crypto/Web3 technologies.

We needed all of these innovations for different reasons. We needed highly secure protocols to facilitate open, permissionless transactions on a global scale. We needed standardization to optimize the creation of — and interaction between — digital assets that operate on top of these protocols. We needed decentralized financial applications to create more efficient, liquid markets for acquiring, selling, lending, and borrowing these new asset types. We needed non-fungible token standards to introduce more uniqueness, specificity, and customization to digital assets. And we needed to show that the design space of applicable use cases goes way beyond just trading DeFi tokens on DeFi rails with other DeFi traders.

There’s a lot we still need, too. We need more mature derivatives markets for hedging and risk management. We need standards around decentralized identity to unlock new primitives like unsecured lending and credible reputation systems. We need more UX improvements and abstraction (where appropriate). We need more regulatory clarity. We need…a lot of things.

But I believe we’re finally at a point where there are enough puzzle pieces — that can be reconfigured in enough ways to meet a wider spectrum of needs and use cases — to put us on the cusp of another, even bigger, creative explosion. One that will once again redefine what’s possible (and bring back some speculation to a market that, frankly, could use it).

We’ve all heard the rallying cry of the crypto faithful that “bear markets are where you build.” This mantra has a lot of merit — many of today’s prominent protocols and applications were built in the depths of prior downturns. In the early stages of any emergent technology, a lot of attention has to be focused on the technical aspects of what’s being built. Without that upfront investment, nothing else that could come after matters.

But building is only one side of the equation. Demand is what’s needed to maximize the value of all the sweat equity that goes into bear market building. Demand leads to more usage, which leads to faster feedback cycles, which leads to better products, which leads to more demand and more usage. And the reality is, we’re facing a demand shortage right now.

If we really want to shift the Web3 demand curve, we need to think about ways to meet the world where it is today and bring it along this journey with us. In order for us to get to this phase, we need more examples of how this technology can benefit more people beyond just leveraged speculation. Web3 products need to provide valuable utility in order for people to understand the potential applications that are possible in this new world.

That’s one reason why I’m so bullish on the long-term prospect of NFTs. Their relatability makes them uniquely positioned to attract a broader audience, which will bring in new sources of demand and buying power. The creation of new asset types will also benefit the entire crypto economy by increasing the total surface area for new participants to interact with digital assets (which I believe will be the gateway for the next wave of Web3 enthusiasts).

If we want to show the world the power of what’s being built here, we need to give the world more reasons to care. That means creating more products that more people want to engage with and getting those products in front of the very people who are most likely to find value in using them. That’s how we move the needle, at least in my view, because changing consumer behavior is a tall task without relevant and rewarding experiences to catalyze it.

That’s enough from me, now onto the good stuff. This Year Ahead report is broken down by sector and focuses on the major trends and themes our team is tracking heading into 2023.

DeFi Year Ahead

By Ashwath Balakrishnan and Jordan Yeakley, CFA

The State of DeFi and Where It’s Going

DeFi was the golden child of 2020, acting as the first true narrative of the last market cycle. Its initiation into the crypto mainstream has now endearingly gone down in history as “DeFi Summer.” Any of you who were involved in crypto at the time probably remember the sleepless nights as project after project launched to guaranteed short-term success. Yet, 99%+ of those projects probably never made it to the end of the year — or even the end of the month.

While we’ve seen groundbreaking innovations, there have been even more thoughtless clones in DeFi. The root of the issue sits between the rise of actors focused on short-term profits and the problems of user acquisition/onboarding. This is the double-edged sword of permissionless innovation.

In this report, we look to highlight some key opportunities and challenges for DeFi and spell out the reasons we remain optimistic that DeFi will thrive. But before that, let’s take a look at how the industry has fared.

Broadly speaking, DeFi tokens have had a tumultuous year. Ethereum DeFi, which is the largest DeFi ecosystem, saw some of its highest-rated coins take a beating.

The past six months saw crypto as a whole get shaken up, with several key players taking large losses or blowing up entirely. Despite DeFi’s mechanisms protecting users from this fallout, DeFi tokens didn’t manage to scrape through unscathed.

While TVL has fallen almost 75% from its peak, DeFi still accounts for a large portion of capital in on-chain products. Compared to the broader finance industry, DeFi is still a drop in the pond. The highest traction products are DEXs and money markets.

DEX volumes were on a tear in 2021. So much so that, just by looking at the above chart, you can hardly decipher how much monthly volume Ethereum DEXs did in early 2020. May 2021 was the absolute peak, followed by a temporary rise in Q4 2021. The compounded annual growth rate (CAGR) of Ethereum DEX volume from January 2020 to November 2022 is 402.4%.

Skipping to the present, we’ve had five straight months of declining DEX volume leading up to November 2022. But the hidden silver lining is that despite this massive fall from grace, DEXs on Ethereum still did about $30-40B in monthly volume — no small feat.

Aave, Compound, and Maker have seen incredible growth over the past three years. And yes, demand for leverage has tapered off significantly — an expected byproduct of a brutal market downturn. People just aren’t in the market for fresh DAI or obtaining leverage to yield farm and margin-long assets. But let’s not discount just how far these protocols and DeFi have come.

A concept that was once laughed at is now the reason for the lion’s share of crypto’s flows. But it’s not as though everything is rosy and perfect. DeFi has its problems.

The primary obstacles can be briefly boiled down to:

  1. All DeFi products with traction are speculation-based primitives (we’ll explain why this is a necessary first step later).

  2. Onboarding new users is a cumbersome process, requiring deep education.

  3. Retaining users sustainably is a challenge in itself (as is the case with all new products/applications).

  4. The overall UX of the space is far from ideal.

The evolution of DeFi is not something that’s going to happen over the next few months. It will be a multi-year process of painstaking innovation and building. But the end goal is arguably as righteous as they come: self-sovereign control of one’s assets/finances and the ability to scale finance into a transparent, borderless system – a system that actually seeks to enrich its users.

It’s easier than ever to be a DeFi pessimist. And if you fall into this camp, we hope to show you the other side of the coin (pun intended). In this report, we’ll highlight some key themes we believe will prove vital to the space over the next year or so — many of which are rooted in the current state of DeFi.

Pushing DeFi Forward: Themes for the Future

Theme #1: Tailwinds for DEXs — A Loss of Trust in Centralized Platforms

An overarching theme of this report revolves around users losing trust in centralized platforms — specifically with respect to crypto markets.

The collapse of FTX posed a systemic risk to crypto markets, and the exchange’s demise brought down a number of big players in the industry. We will continue to feel the wreckage from this event for months and years to come. But there’s a fairly obvious silver lining for decentralized counterparts.

Hayden from Uniswap cannot touch user funds sitting in Uniswap pools to buy the naming rights for an NBA team or to sponsor major sporting tournaments. Antonio from dYdX cannot touch user collateral in the platform to give his hypothetical investment fund a large loan. In short, the principles and structures of DeFi platforms do not give way to the same centralization and risks that led to the downfall of FTX, i.e., one or a few people with totalitarian control. As time goes on and the wounds from FTX heal, we believe more and more people will start to see this as well.

The underlying transparency provided by public ledger blockchains makes DeFi protocols auditable in real-time, and there are several potential paths DEXs can take over the coming years.

DEXs like Uniswap, 0x, Curve, dYdX, and GMX have stood tall in light of recent events. Seeing more crypto native participants move from centralized exchanges to self-custody could entail higher volumes on DEXs going forward. In all honesty, DEXs being a saving grace is a fairly obvious takeaway. But given the massive difference in UX between CEXs and DEXs today, it’s unlikely we will see this materialize in a big way anytime soon unless that gap narrows considerably.

There are some larger implications for DEXs on the path forward from here, specifically for how volumes shift from CEXs to DEXs. How do DEXs best position their exchange designs to capitalize on the current situation?

Take, for example, the plight of professional market makers right now. An exchange they (and everyone else) believed to be healthy and solvent ended up collapsing while many of these entities still had funds in their accounts. If FTX was doing shady things behind the scenes, the next natural question is which other exchanges are doing something similar? Perhaps market makers will now see how DEXs are the path forward for price discovery and trading in crypto.

The flipside is that these protocols are only as strong as their weakest line of code, and they run the risk of being hacked.

That aside, what is the best way to attract market makers to your DEX, assuming they start to allocate more capital toward providing liquidity on DEXs?

The most obvious answer seems to be orderbook-based DEXs like 0x, dYdX, Injective, Sei, and Zeta (among many others). Market makers are intimately familiar with orderbooks and would be more comfortable with the flexible nature of being an LP on these DEXs versus AMMs with pre-determined pricing curves.

Will a meaningful exodus of market making capital from CEXs prove to be a valuable opportunity for orderbook DEXs? Perhaps.

Right now, AMMs are the clear winner in the battle for DEX supremacy. And the chart above doesn’t even consider numerous other AMMs like SushiSwap, DODO, Osmosis, and Balancer that have significant liquidity and facilitate billions of dollars in cumulative volume.

On the other hand, barring 0x and dYdX, there aren’t too many active orderbooks doing equally well. Injective and Sei (Cosmos chains) are beginning efforts to kick off volume, while Serum has all but withered away thanks to FTX. However, there is considerable hope in the Solana ecosystem over Openbook — a community-led fork of Serum.

Keep in mind, neither 0x nor dYdX run fully on-chain stacks. 0x relies on a number of market makers hosting their own orderbooks, while dYdX currently uses a centralized orderbook and matching engine.

Even just pitting two of the top AMMs against some of the only healthy orderbook DEXs shows us that AMMs have continued to gain more traction. Perhaps AMMs will continue their run of dominance and find ways to optimize for better liquidity provision.

Given the amount of volume on Uniswap v3, and the ability for LPs to configure how they deploy their liquidity thanks to concentrated liquidity, maybe more professional market makers will take the time to understand how all of this works and devote more resources to Uniswap.

It’s difficult to estimate the exact direction DEXs move in, but there’s a sizable opportunity for them to capitalize on the current situation.

Theme #2: DeFi Blue Chips Rise From the Ashes

2022 was a brutal year for DeFi blue chips, but these projects still dominate their respective sectors. Since value will likely gravitate to the application layer over time, it seems worthwhile to explore the blue chip rebound thesis. If and when fundamentals start to actually matter, this theme will be even more salient.


Despite Uniswap’s tight grip on the DEX market, momentum from v3 has dried up completely. Hesitance in activating the fee switch and a cabal-like governance structure have brought the token’s utility into question. UNI has steadily declined with a lack of new tailwinds.

Uniswap has an experimental fee switch proposal currently making its way through governance. This proposal only impacts three pools and will not distribute fees to UNI holders at this time. The fee switch will likely be a lingering debate throughout 2023, but remains far off as an avenue for UNI value accrual.

Uniswap’s recent launch of its NFT marketplace aggregator marked the beginning of Uniswap’s horizontal expansion into NFTs. Such expansion could provide the UNI token with tangible utility while avoiding the slippery slope of the fee switch. Alternatively, Uniswap could grow vertically, acquiring wallet apps and building infrastructure to directly onboard users.


At a glance, Synthetix may have the most romantic use case of any OG DeFi dApp. The promise of a full-stack, permissionless derivatives platform that democratizes access to the $630T derivatives market propelled SNX to a $4B market cap in early 2021. Progress has since slowed and expectations have waned, but Synthetix has quietly been fostering a healthy ecosystem on Optimism.

The Synthetix ecosystem was a first mover for sustainable governance, liquidity mining, synthetic assets, hedged AMMs, cross-asset atomic swaps, and more. The imminent Synthetix v3 will feature a complete redesign of the protocol that will allow Synthetix to continue its leadership as a test-in-prod environment for novel DeFi concepts.

As the sole form of collateral and recipient of platform fees, SNX features the most straightforward value accrual and utility of any major DeFi token. A continued bear market coupled with DEX tailwinds could cause a flight to quality for tokens like SNX that have consistent cash flows and exciting deliverables in 2023.


The launch of Aave v3 in March headlined an incredibly eventful year for Aave. Aave is once again taking a leadership role in pushing crypto forward, with a complete disregard for token price. The launch of its institutional DeFi platform Aave Arc, the development of decentralized stablecoin GHO, and the incubation of decentralized social graph Lens Protocol signal a focus on business development and long-term thinking.

These additions may seem insignificant at first, but they will be foundational elements in Aave’s final vision. The AAVE token has the bleakest near-term outlook of the blue chips mentioned here, but if their plans come to fruition, the token stands to benefit.

Theme #3: 0-1 Speculation Primitives

Speculation primitives have ample runway for progress in 2023. The lack of convenient, capital-efficient access to leverage has been problematic for a while now. Users are forced to utilize makeshift techniques such as recursive borrowing in order to fully capitalize on opportunities that call for spot leverage.

Gearbox allows for composable, capital-efficient leverage through its credit accounts. These credit accounts essentially act as margined leverage wallets for approved protocols. Gearbox v2 streamlines liquidations and gas costs, dramatically improving overall UX and scalability. Gearbox’s utility will exponentially grow as more protocols are whitelisted and new primitives are built. Gearbox could even allow previously infeasible applications to flourish.

Forex is a massive market that is highly gated in traditional finance. Despite ideal conditions, attempts at bringing forex to DeFi have failed, suffering from low demand and poor design.

Given the current macro landscape, it would seem that if forex is ever going to be a thing in DeFi, it will begin to show some promise in 2023. This could occur through two approaches:

  • Synthetic assets utilizing the oracle model: Gains Network and GMX offer the easiest way to get leveraged exposure to synthetic assets. These projects have to implement creative solutions to mitigate tail risk, which are accompanied by various drawbacks. Still, this model is easy to implement and is already demonstrating the growing demand for forex in DeFi. Forex trades made up the majority of Gains Network volume in September and October. With GMX’s much larger user base and impending launch of synthetic assets, we could see forex volume explode in 2023.

  • Collateralized stablecoins pegged to various currencies: Collateralized stablecoins would benefit from composability within the broader DeFi ecosystem. Existing attempts such as Iron Bank Fixed Forex and have struggled due to the limited utility of spot foreign-currency exposure. The lack of convenient ramps prevent personal finance use cases, and the inaccessibility of spot leverage pushes users towards synthetic perps for trading. This is a great example of the Synthetix and Gearbox value-adds discussed above. Without liquidity pools consisting of synthetic assets, peg stability must be hard-earned through incentives and arbitrage. Oracle-fed prices for synthetic assets can shoulder this burden for forex stablecoins through liquidity pools. Gearbox’s credit accounts allow for potential utility beyond non-levered trades on Uniswap. With additional improvements in complementary dApps and on/off-ramps, this more organic avenue for on-chain forex adoption could start to gain traction.

Theme #4: Undercollateralized Money Markets

We’ve written about undercollateralized money markets like Maple Finance, Clearpool, and TrueFi over the course of the year. They serve the speculation use case by funding market makers and hedge funds with accessible leverage. Unlike banks, they use on-chain holdings as a means of gauging an entity’s balance sheet health and ability to repay. Their impact on providing the market with more liquidity is evident, but projects operating in this space haven’t really found the right model yet.

As we’ve noted through our coverage of this sector, it’s no riskless endeavor for lenders. Effectively, lenders are giving out unsecured loans to market makers and hedge funds considered to be of “high stature.” Not repaying their loans is akin to burning their entire reputation in crypto. Barring insolvency and a legitimate inability to repay funds, it’s unlikely for a fund to willingly burn their reputation for a few million dollars.

However, given the frequent occurrence of tail events in crypto, the actual risk for lenders is likely higher than the perceived risk.

If we compare overcollateralized money markets like Aave and Compound to unsecured money markets like Maple Finance and Clearpool, there are certain types of risks that are heightened in the latter.

Default risk is the most obvious, given the unsecured nature of these loans. Counterparty and concentration risk are a close second. For example, Maple’s design is one in which a pool delegate decides who to loan lender capital to. If too much is given out to one party, lenders in that pool are exposed to greater counterparty risk. This is all the more important in the case of Clearpool, where each pool is exposed to a single borrower and therefore has higher inherent concentration risk.

In the interest of your time, we won’t delve into the designs and risks inherent to these protocols. Delphi subscribers interested in learning more about these can view our previous coverage of undercollateralized money markets, Maple Finance, and TrueFi.

For this report, the core focus is why this could turn out to be an important part of DeFi. We can all agree that liquidity is the lifeblood of a well-functioning market. When used correctly, leverage is a powerful tool. Unsecured lending remains the easiest way to unlock capital efficiency for professional investors and traders in crypto.

The core customers of unsecured money markets are market makers. They need efficient access to spot leverage to fulfill their role. It’s unlikely that traditional banks and financial institutions are going to give Wintermute, Folkvang, or GSR a large loan to market make crypto assets. But even if they did, it would be a time-consuming process marred by the bureaucracy banks are infamous for. While the evaluation process differs from protocol to protocol, on-chain undercollateralized loans are usually issued based on an on-chain balance sheet.

The other side of this coin is that if you believe banks have strong risk assessment and evaluation frameworks, it would hold true that entities that cannot get a bank loan will look to less stringent alternatives. This would be the essence of the crypto lending market — traditional finance institutions won’t give them capital, so they have to turn to crypto-native lenders. But the process of issuing loans against verifiable on-chain holdings, and monitoring the on-chain balance of an entity, could act as a mitigant by helping lenders/underwriters decide on when to take action. It’s just a matter of discovering the right business model to do all of this.

You’re probably familiar with the blow ups of institutional lenders like Celsius, BlockFi, Hodlnaut, and Babel Finance, as well as the potential ill-fate awaiting the likes of Genesis and several others. Traditional lenders run opaque operations. There’s no transparency to lenders as far as how much and to whom their money is being lent out. Capital providers to these lenders cannot evaluate concentration risk to a single borrower, and apparently they can’t rely on the lending intermediary to act with caution and diligence. Borrower concentration was what wiped out a number of lending books.

Admittedly, unsecured lending via DeFi does not fix all of this. It wouldn’t necessarily have stopped lenders from giving big loans to a single hedge fund, but it may have. Lenders could have seen a single entity getting huge loans from every platform available and started public discourse to pressurize these platforms to cut off their credit lines. Or in the case of TrueFi, which uses governance to sanction loans, token holders could’ve started voting no on further credit lines to that entity.

So maybe the music would’ve stopped earlier and caused significantly less damage.

An example of this happened just this week. Last week, Auros missed a repayment of its ~$3M loan from Maple’s platform, triggering widespread concern. The situation only escalated from there.

Earlier this week, a user tweeted out how Maven11’s pool on Maple gave $30M worth of loans to Orthogonal Trading. The first of these loans was tenured for 60 days, and Orthogonal didn’t repay it. As noted, the pool delegate model Maple employs does not necessarily fix the issues that took down BlockFi and Celsius. But it does enable a transparent loanbook, which allows creditors to track ongoing concerns in real time, rather than long after things have gone wrong.

While the premise of undercollateralized lending stands to improve DeFi markets, there isn’t a ton of confidence in the models that exist today. In a nutshell: TrueFi has been using token governance to approve loan issuance (possibly changing soon), Maple affords a lot of power to pool delegates (thus centralizing loan issuance), and Clearpool has borrower-specific pools which doesn’t allow lenders to diversify their exposure.

But unsecured DeFi platforms offer the easiest way for market makers and hedge funds to obtain spot leverage. Centralized operations like BlockFi and Celsius used customer deposits to loan out capital to institutions. DeFi platforms of a similar nature also do this, except lenders can be aware of their risk profile and where their capital is being deployed. The core difference is unlocking a greater degree of transparency — and, hopefully, the ability to demand certain actions in the future.

While counterparty, concentration, and default risks will exist in any unsecured lending market, at least DeFi platforms offer an unrivaled degree of transparency. These platforms thus act as a formidable competitor to businesses like BlockFi, Nexo, and other institutional lending operators.

When the crypto market starts to take off again, there will be a large volume uptick for on and off-chain trading venues. Platforms that offer institutions leverage with a predictable cost of capital could prove to be an important piece of infrastructure for markets. As crypto users look to deploy capital into passive (and not risk-free) opportunities, in a time of healthy demand for leverage, unsecured on-chain lending protocols could offer prospective users competitive yields versus their centralized counterparts.

Playing devil’s advocate, it’s possible the efficiency benefits from this model are not worth the risks they entail. Maybe DeFi shouldn’t be trying to mimic TradFi, and should focus on its core goal of trustless and decentralized financial infrastructure. While unsecured credit helps indirectly enrich markets and the on-chain versions of these products enable greater loanbook transparency, decentralizing these platforms is proving to be difficult.

We recognize this is a theme with a relatively higher chance of failure, but finding the right model to balance underwriter expertise and process transparency could enable more liquid markets in DeFi.

You can find more of our thoughts on how to scale undercollateralized lending in the “Futuristic Ideas” section towards the end of this report.

Theme #5: Improving the State of Passive LP Products and Emphasizing Delta Neutrality

Uniswap v3 and the decline of SushiSwap marked the end of incentivized LP staking. LP management protocols such as Charm and Visor have done little to demystify concentrated liquidity provision for passive users. DOVs capitalized on option AMM’s inability to protect LPs, but still carry high risk over prolonged periods. Liquidity providers have been left with few options to safely chase material returns, but 2023 is bringing a new wave of DeFi projects that are catering to neglected LPs.

Lyra Finance’s Avalon update brought the first delta-hedged AMM to DeFi. The ability for an AMM to hedge its obligations has been a game changer for LPs since launch. Delta hedging is extremely difficult to implement, but more delta-neutral AMMs and sustainable yield projects are starting to emerge.

GammaSwap allows users to long volatility in order to speculate or hedge against impermanent loss. LPs on XYK AMMs are effectively long volume and short volatility. Volatility in excess of returns from trading fees results in impermanent loss. Since AMMs don’t allow the borrowing of liquidity, longing impermanent loss is not as straightforward as shorting spot tokens via money markets. GammaSwap is building a user – AMM middle layer that will allow for the manipulation of LP tokens.

Using GammaSwap, users can borrow an LP position and separate the tokens, gaining positive exposure to impermanent loss. Liquidity borrowers pay a funding rate to GammaSwap LPs, which results in a payoff structure that beats the vanilla LP position in all scenarios.

Rage Trade is attempting to address some of the prior issues with vAMMs and provide stacked yield for LPs through recycled liquidity. Rage Trade allows users to deposit LP tokens into various 80-20 vaults. 80% of the TVL remains untouched on the original platform. The remaining 20% collateralizes concentrated LP positions on a Uniswap vAMM to support Rage Trade’s ETH perpetual market. The payoff resembles the original yield plus a Uniswap v2 ETH-USDC LP position.

A key theme for these emerging projects is that they deliver concrete improvements over the status quo. LPs are still exposed to impermanent loss and drawdowns, but receive supplemental income by powering innovative new products.

Theme #6: The Rebirth of UX Aggregators: A Front End for DeFi

The current state of DeFi’s — or rather, crypto’s — UX is far from ideal. Right now, the general process flow is as follows: plugging a piece of hardware into your computer, using a browser extension to control the flow of funds, and visiting an array of different websites to conduct one’s activity. Traditional tech UX designers lost a piece of their soul reading that.

Using crypto is hard. And the harder it stays, the thicker the wall between this industry and mainstream adoption.

Zooming in on financial services, what exactly does the UX of traditional finance look like? It differs from person to person. But typically, you would have one app for your brokerage (investments), one or a few banking apps, one or a few payments apps (Apple Pay/Google Pay), and maybe an aggregator of sorts to help consolidate information and pay off multiple credit card bills from a single interface. At most, the average person probably has 4-5 financial apps they use to get everything done.

But why is this the case? Well, different banks operate upon their own infrastructure and do a great job of gatekeeping features. Aggregation apps can only aggregate certain feature sets like credit card payments. For most things, you have to use a bank’s website/app. Or even worse — visit a branch.

DeFi sits upon a few transparent infrastructure legos. Ethereum, Solana, Avalanche, and Arbitrum are a few examples of those base layers. These networks are home to non-custodial networks, where the highest degree of custody you would be subjected to is smart contract custody. And even in that case, every user has control over when they can deposit/withdraw funds.

Because of this, we don’t need to live in a future where users have to go to the Uniswap front end to access swaps, or the Aave front end to find yield for their idle assets. We have the ability to create UX aggregators that act as a unified front end for all of DeFi.

First of all, unlike banks and brokerages, there usually is no single app crypto users visit. If you want to buy Apple stock, it doesn’t really matter if you use a Charles Schwab brokerage account or a TD Ameritrade account. Either way, your order still goes to the NYSE orderbook. However, in DeFi, there is no central trading venue. There are hundreds, if not thousands, of DEXs with liquidity to trade assets on. Depending on your trade size, you will find different execution prices for a token you want to purchase on Uniswap, Curve, 0x, Bancor, SushiSwap, etc.

Liquidity aggregators fix this. Protocols like Matcha, 1inch, and ParaSwap pull quotes from a variety of DEXs in order to find users the best execution price. A rational user would visit one of these liquidity aggregators rather than visiting different front ends to find the right quote or being loyal to a single trading venue.

As explained in the introduction, DEXs have seen the greatest degree of product-market fit thus far. And thus, DEX aggregators have been successful. In the future, as DeFi grows, we expect to see liquidity aggregation expand further than DEXs. Aggregators for borrowing, lending (or yield in general), options, perpetual swaps, and other products are bound to pop up. The large number of protocols facilitating each of these activities necessitates this.

But wait, if we have liquidity aggregators specific to each sector of DeFi, does that mean users will have to visit different aggregator front ends for each of their needs? Who’s going to aggregate aggregation?

UX aggregators sit atop all these liquidity aggregators, joining all their features into a unified interface. Imagine visiting a single front end, connecting your wallets, and being able to instantly find the best venues for: a specific swap, yield-bearing opportunities, borrowing rates, execution for perpetual futures, the cheapest option premiums (or most expensive for prospective sellers), and more.

Even for power users, UX aggregators offer a dramatic step forward in the ease of using these applications. Products like this don’t necessarily cater to new users unfamiliar with the space — a concept we’ll touch on later in this report. Considering users will still have to use hardware wallets and browser wallet extensions, the core customers for pure UX aggregators are people who already know how to use these things. But making life easier for the current cohort of users is not something to be taken lightly. Every step towards improving DeFi’s ease of use is a welcomed step.

For newer crypto users who use their own wallets to trade, UX aggregators offer some cool benefits. For starters, access is limited to protocols deemed to be “safe” from rug risk. Zapper is unlikely to integrate some new farm spitting out a 4-digit APY with a high risk of the team pulling off a rug. More savvy users who understand the risks of these farms will have no qualms occasionally visiting a new front end to indulge their inner degen. However, since the entire experience is non-custodial, there is a large degree of autonomy. For example, one could still swap into high-risk tokens using a UX or liquidity aggregator by overriding the warning that pops up. You get warned, and that’s it. Nobody stops you from doing anything.

With different aggregation layers, the DeFi stack looks something like the above graphic. Rather than thinking about Uniswap, Aave, 0x, and other protocols as consumer dApps, we believe it is more accurate to term them “liquidity infrastructure.” The main point of these dApps is to house liquidity and help users get efficient execution for their activities. Their core customers should be considered liquidity providers rather than traders. Catering to traders/investors and discerning the best trading venues is the job of liquidity aggregators.

Importantly, this hierarchy also means that UX aggregators will own the customers, as they are the layers with which users interact. Now, this may prompt one to think these are great businesses to own, but monetization is not that simple.

This isn’t Web2 where Facebook can bombard users with advertisements. There are already tons of UX aggregators like Zapper, Zerion, and DeBank, and given that a user owns their information via their on-chain addresses, switching costs are incredibly low. If one UX aggregator attempts to monetize via advertisement — something frowned upon by most crypto proponents — the cost of moving to a different UX aggregator is negligible to the user.

Overall, we believe UX aggregators are primed to become the primary user-facing layer in DeFi. The timeline to this happening is dependent upon when they introduce the kind of feature sets consumers want. Zapper, Zerion, and DeBank already enjoy fairly deep user bases given the number of active on-chain users. Now, it’s just a matter of figuring out a novel monetization mechanism that doesn’t infringe on usability.

Theme #7: Ditching veTokens for More Sustainable Alternatives

VeTokenomics burst onto the scene with Curve’s yield farming frenzy at the tail end of DeFi Summer. The ensuing Curve wars fortified Curve’s position as DeFi’s liquidity moat. Today, dozens of other projects are starting to embrace veToken designs. There is now over $10B TVL in projects that have implemented or plan to implement some form of veTokenomics.

At their core, veTokens are creating market inefficiencies (binding illiquidity to optimal yield) that are intended to relieve sell pressure from aggressive liquidity-mining programs.

Typically, mature veToken structures such as CRV, CVX, FRAX, and BAL result in around 50% of token supply being locked – an undeniable benefit for token holders. When applicable, steep emissions elegantly charge a funding rate to token holders that provide no value to the project. Theoretically, long-term thinking by ve-lockers drives additional value. This benefit breaks down as individual users are outdone by aggregators which further separate incentives.

Once veCRV was launched, Convex created a liquid wrapper called cvxCRV. Convex allowed users to stake their Curve LP tokens to enjoy boosted yields without the veCRV commitment. This accelerated Convex’s accumulation of veCRV, as individual users tended to avoid the unnecessary sunk cost. Users who locked CVX for 16 weeks in exchange for vlCVX controlled the gauge votes of Convex’s veCRV and avoided the linear decay. This separation of veCRV’s utility allows vlCVX to wield massive voting power, with 1 vlCVX controlling over 5 veCRV. Individual veCRV holders are diluted, with veCRV’s utility spread too thin by comparison.

Since Convex requires users to lock CVX for vlCVX to steer gauge voting and earn bribes, the need for an additional liquid wrapper is born. Redacted Cartel’s Pirex creates liquid wrappers for locked-token schemes such as vlCVX. Pirex allows for the auto-compounding of rewards and the tokenization of future voting events. It will soon incorporate GMX along with – ironically – its native revenue-locked BTRFLY.

Bribe markets such as Votium and Redacted Cartel’s aptly named Hidden Hand allow users to sell governance votes for money. With the market for veTokens set to skyrocket in 2023, the market for voting boutiques undermining these designs in favor of equilibrium could benefit tremendously. Votium currently dominates the market for Convex, with over $200M in cumulative bribes paid on the platform.

During Votium’s early rounds, bribers were able to steer over $5 in CRV emissions per $1 spent on bribing. This situation is particularly convenient for projects like Frax, who own a significant amount of CRV and CVX while using bribes to direct emissions towards their pools. vlCVX ownership offers a rebate for bribe expenses, as Frax essentially pays themselves. Emissions per $1 spent on bribes are now around $1.40, and will likely settle at or below $1.

While emissions per dollar decrease, the portion of mercenary voters will likely remain stable or increase. vlCVX delegation has remained steady at around 80% since inception. Users don’t lock veTokens to govern, they lock to earn monetary benefit. This is further supported by the mere ~18% of veCRV holders who have voted in Curve governance. Votium’s decreasing market share is likely more a result of the miserable bribe-claiming UX rather than a declining appetite for bribes. Pirex’s collaboration with Llama Airforce solves this issue with uCVX, which auto-compounds earnings into pxCVX.

As additional aggregation layers continue to emerge, users will opt for the outermost layer rather than deciphering the convoluted mess of unlock schedules and who controls who. Frax-like ownership at the metagovernance layer will be less practical, as NAV will be made up of unrelated businesses. Bribe markets will resemble native token dumping as a service as the increasingly transactional shadow market is relegated to the back end. As we are already starting to see with sustainable yield and principal-protected products, the market will squeeze everything it can out of these high FDV gauge tokens to support compressed yields.

The veToken design was purpose-built for Curve’s business. It works as well as it ever will for Curve. Now, projects are implementing veTokenomics as a levered liquidity-mining program without any concrete objectives or KPIs. Like pool 2s, Ohm forks, and LUNA clones, the manic copycat phase of adoption tends to exhaust the market appetite for tokenomics fads. What is left is strictly the fundamentals. With veTokens, the fundamentals are just multiple layers of red tape propping up on-chain Feudalism.

VeTokenomics aren’t inherently bad, they’re just pointless. There’s so much more to crypto than token unlock schedules. The rise of veTokens is a symptom of the widespread lethargy in DeFi over the past year. Market inefficiencies will inevitably be undermined and abstracted away from view. All roads eventually lead to a laissez-faire approach. In the meantime, there is a lot of value to be extracted while inching towards this equilibrium. Playing this narrative correctly could be incredibly lucrative.

What Surprised Us

Surprise #1: Underwhelming Derivatives Traction

dYdX had a breakout year in 2021, finding strong footing on the back of its StarkEx validum network and a much-anticipated token launch. In the first 10 months of 2022, dYdX facilitated a whopping $419B of perpetuals volume. While that’s still much lower than the likes of FTX and Binance, it’s still commendable.

Sadly, dYdX is the only obvious example of getting on-chain derivatives markets right. Other models of perpetuals from the likes of Perpetual Protocol, Drift, MCDEX, and others were far from successful. A lot of projects aimed to incorporate the virtual liquidity model, owing to the ease of setting up a market and the ability to bootstrap without tangible liquidity.

We’ve noted the massive shortcoming of this model in a previous report shining light on decentralized perpetuals at large. And while a few of us at Delphi believe this style of liquidity structuring is done and dusted, we’re still seeing projects pursue the virtual AMM (vAMM) model.

Apart from new names like Rage Trade, there isn’t much design-level innovation happening with decentralized perpetuals. Because of this, a few of us on the Delphi DeFi team have begun to suspect that on-chain orderbooks will see strong traction.

Options were another standout on the year — but not for good reasons. We’ve been chasing DeFi options for nearly two years now, with very little results to justify the capital, resources, and effort put into these endeavors. As someone keeping a close eye on the space, it seems as though AMMs were the wrong solution to the options liquidity problem.

Upon discovering Zeta Markets and the high-throughput environment of Solana, it was tough not to be convinced that orderbooks were the path forward. Liquidity was flexible and priced at what individual actors deemed a fair value to be — unlike AMMs where pricing was forced. The optimal path forward seemed to be a native volatility surface on the DEX and some form of Black-Scholes pricing to ascertain the fair value of an option. Moreover, most options DEXs did not truly understand their customers.

Until Zeta, no options exchange offered futures contracts with expiries matching all options contracts. Futures are essential to options dealers in order to hedge their positions. Without futures, trading operations would have to be fragmented, with one leg of the trade on the option DEX and the other leg on FTX or another venue with delta-one products.

Our thoughts on the feasibility of options AMMs were challenged when our analyst, Jordan, published a fantastic piece of research on Lyra. In a nutshell, Lyra has created vaults that offer a delta-neutral experience for liquidity providers. That means that hoarding delta and hoping price moves in your favor is no longer how DeFi options LPs have to make money. Instead, they can simply extract spreads and fees with minimal delta risk, i.e., no additional exposure to price movements.

Lyra has some drawbacks, the most prominent of which is its reliance on Synthetix for hedge liquidity and Synthetix’s inherent limitations on liquidity (limited by the size of the debt pool). But otherwise, it was the first time I had seen a truly sustainable approach to creating AMM-based options that didn’t leave LPs for dead.

Towards the end of 2022, we’ve seen the design space for on-chain derivatives take a necessary step forward. There are a handful of projects creating handy experiments that could end up being the future of DeFi derivatives. Rage Trade introduces a unique liquidity provision mechanism for perpetuals — one that allows LPs to deposit existing LP tokens to compound yield. Their 80-20 liquidity split also stands to possibly offset impermanent loss, but that remains to be seen in practice.

Overall, though 2022 was a mostly dreadful year for DeFi derivatives (and DeFi as a whole), we’re seeing a lot more cool designs get put into practice and battle-tested. While we’re at the mercy of the market, we expect a lot more of the same product innovation in 2023, if not actual traction and an expanding user base.

Surprise #2: Saturation of the Structured Products Space

When Ribbon Finance launched in Q2 2021, it was a revelation. Every budding finance nerd knew of structured products and how they were gatekept for wealthy investors in TradFi. Ribbon broke the locks off the gate by introducing systematic option-selling vaults as an on-chain primitive. This meant the strategy was completely transparent. The first two strategies were simple: covered calls (sell calls against the underlying spot asset as collateral) and protected puts (sell puts against stablecoin collateral).

By the end of 2021, there were probably over 20 teams that had raised capital to build on-chain structured products. In hindsight, all of us should have seen this coming. It was a lucrative thing to do. Build some strategies, incentivize market makers to give your users the liquidity they need, and rake it in via management/performance fees. Of course, all of this is assuming the project was able to attract depositor capital.

To expand on the “incentivize market makers” point from above, all of these platforms basically rent liquidity from Deribit. Since on-chain options haven’t taken off, structured products create deals with market makers to get the liquidity they need. Market makers will, for example, buy calls from Ribbon depositors at a certain price, then sell an equivalent amount of calls with the same specs (expiry, strike) to hedge. By doing this, they capture a spread — essentially the difference in the price they buy from Ribbon at and sell on Deribit.

We got on-chain options-based structured products before on-chain options, which is peculiar to say the least. This makes the saturation even more surprising.

While these products enjoyed capital inflows going into Q2 2022, this began to reverse. It wasn’t just a tapering off, but a large outflow of capital alongside principal erosion in USD terms as crypto assets got beaten down. Soon, the amount of capital managed by these products had fallen by anywhere from 60-90%.

It seems counterintuitive for yield-bearing products to see a deterioration in capital managed as crypto asset prices and lending yields took a hit, right? Selling options to generate yield was probably the only way left to generate returns in crypto. But there is another side to the story — the side of tail risk.

Selling options is not free money. Far from it. In fact, some of the most experienced and knowledgeable options traders think selling options is overrated from a yield-generation perspective. Many use the old analogy of it being akin to picking up pennies in front of a steamroller. In this context, the steamroller is the notion of tail risk — which is far too common in crypto.

One bad week can erase months of steady gains. Look no further than the performance of covered calls. This is precisely the kind of tail risk selling options entails.

But if you think about it logically, it does make sense that we saw mass outflows in the aftermath of market-wide contagion driven by the Terra and 3AC collapses. But on the flipside, once this tail risk had played out and the market had quieted down a bit, these vaults likely showed a healthy return, since the “black swan” had played out and price stagnation started to settle in.

And that’s exactly what we saw. Cash-secured puts fared well from late June into November, until FTX threw a wrench in the market’s plans.

Overall, what was surprising was the sheer number of projects building on-chain structured products. Realistically, the industry probably wasn’t ready for this. The concept of portfolio construction is still a bit of a reach in crypto. And structured products are not a place to park all your idle assets, but rather a piece of the puzzle that is optimal portfolio construction.

We’ve seen projects like Cega pop up that introduced complex yield-generation strategies (via options) to the DeFi market. I know this may come off very Gensler-esque, but are these products truly suitable for retail investors? Just because you can, doesn’t necessarily mean you should. A covered call is simple and easy to grasp. You just need a basic understanding of options.

But when you bring fixed coupon notes, barrier options, and other exotics into the equation, it becomes a lot more complex for the average user to follow.

Real yield is a very important narrative, because we all know relying on token incentives doesn’t lead to long-term favorable outcomes. At the same time, these real yields come with their own set of very real risks, and those who treat them like an Aave money market pool may unfortunately have to learn about these risks the hard way.

Futuristic Ideas

Idea #1: Envisioning a Consumer-Grade DeFi Experience

In the section on unified UX layers for DeFi, we described a tool that allows users to retain full custody of their assets while improving the experience of directly interacting with DeFi protocols. This kind of setup is ideal for power users who are comfortable with the trade-offs for self-custody. But in order to allow the average Joe to get comfortable with DeFi, we need something slightly more custodial and risk-tuned.

The idea is pretty simple — but there is a big and obvious caveat. Imagine a Robinhood-esque app plugging into different DeFi protocols, simply providing some degree of custody and facilitating user interactions with underlying liquidity. Revisit the graphic in the UX aggregation section that visualizes the DeFi stack. Instead of a simple UX aggregator at the top, we slip a centralized solution in there. Yes, it does need to be a somewhat centralized solution. Ideally, the setup is semi-centralized, with a multisig wallet where the platform holds 1/3 keys and the user holds 2/3 keys.

Perhaps users start off with the platform having custody of their assets and slowly move towards a more self-custodial model. Initially, they can rely on the platform and gradually learn about self-custody, what it entails, and why it matters.

In this case, the application is just a unified front end with risk-limitation features. Given the number of scams in crypto and the inability of new participants to separate the wheat from the chaff, this should be a welcome feature. It could have only certain DeFi protocols and actions enabled on the platform, cutting off access to the numerous honeypots and scams that exist in the space. It could also have some additional value-add features baked in; maybe an anti-liquidation mechanism like DeFi Saver and stop-losses for spot positions (unwind position if market price hits a certain price threshold).

Given this platform would be structured akin to a centralized exchange, it would (ideally) be regulated and have access to banking services, thus enabling the flow of funds from fiat in a bank account to stablecoins in the user’s wallet. Really, the custody fallback if a user loses one of their keys and the rails to move from fiat to crypto would create a much cleaner user experience for those looking to start tinkering with DeFi and crypto at large.

What are some examples of what a user on this platform could do?

  • Simple swaps via DEX aggregators.

  • Staking ETH via Lido/Rocket Pool.

  • Access to automated liquidity-provisioning services.

  • Relatively safe yields and access to low leverage using Aave/Compound.

  • Higher and riskier yields using Yearn, Ribbon, Maple Finance, TrueFi, etc.

  • Maybe even perpetuals trading on dYdX for users in accepted jurisdictions.

At this point, every reader of this report is aware of what happened with FTX. This event has caused a lot of uncertainty with how centralized platforms manage user funds. BlockFi was an industry darling targeting an IPO earlier this year, and now it’s bankrupt. So how can users trust a platform like this, where some or all funds are custodied by the platform?

Well, realistically, it boils down to finding a profitable business model without having to rely on customer funds the way platforms like BlockFi and Celsius did. The platform’s job is simply to custody funds and facilitate the usage of decentralized applications/infrastructure.

Employing a management fee in the range of 0.2-0.5% based on funds held would be one driver of revenue. Slapping a small markup on transaction fees would be a potential second source of revenue. Another interesting idea could be implementing a freemium model, where free users have to custody with the platform (giving them more custody-centric fees) and paying a subscription would enable users to use the multisig where they hold 2/3 keys and the platform holds 1/3 keys.

Whatever the exact model, it’s important that they act as custodians like Coinbase and Anchorage (hopefully) do and not touch customer funds. As mentioned before, their job is to do two simple things: custody some/all assets and facilitate interactions with decentralized tech.

Regulation creates a big question mark over the viability of such a business, and we’re not going to act like we know how this would be perceived by global financial regulators. Nevertheless, a platform like this could prove to be a major boon for crypto usage, enabling less financially and tech-savvy users to start exploring the space at their own pace.

The eventual goal of this would be to help people learn about the importance of decentralization, self-custody, and censorship-resistance firsthand. Hopefully, this would pave the path for more people to directly interact with decentralized software.

Idea #2: How to Scale Undercollateralized Lending

DeFi has built most of the primitives that are currently possible. We have protocols that facilitate whitelisted undercollateralized lending. But if DeFi is ever going to truly rival traditional finance, we will have to tackle mass-scale undercollateralized loans eventually. Such a system may seem several years away, but it isn’t as far-fetched as it seems. Self-sovereign identity and Sybil resistant primitives hold the key to unlocking this. From there, we can begin to construct an undercollateralized lending system that onboards crypto’s next billion users.

We have three crucial objectives:

  • Sybil resistance: An individual cannot beat us more than once.

  • Incentives, game theory, and crypto-native recourse: The proportion of individuals that choose to hurt us will be below a sustainable threshold.

  • System architecture: An individual cannot beat us too badly.

Utilizing decentralized identifiers and verifiable credentials to improve crypto’s Sybil resistance is paramount to building any undercollateralized lending ecosystem. Let’s take a look at some potential methods.

Biometric Authentication

Biometric authentication is highly accurate, scalable, and versatile. Biometrics offer permanent, portable authentication that traditional passwords cannot provide. Biometrics can utilize numerous physical and behavioral features to verify identity with a high degree of confidence.

Biometrics are gaining major traction in Web2 with governments and the private sector alike. Understandably, there is growing pushback towards the use of biometrics. Skeptics cite dystopian scenarios and the honeypot risk associated with storing large amounts of sensitive data in centralized databases. Additionally, industry-leading biometric authentication products such as Apple’s FaceID have been exploited under lab conditions. Despite a high degree of accuracy, the rare instances where a malicious actor succeeds are far more detrimental than other authentication methods. Once an attacker fools the authentication system, there is little to prevent them from scaling their attack with numerous fake identities.

Whether we like it or not, biometrics have arrived and will continue to entrench themselves in our phones, airports, and cities. Crypto has the potential to implement biometric authentication far more effectively than in Web2. Biometric templates can be locally encrypted into hash functions that are then shared, allowing the user’s biometric data to remain private.

Social Graphs — Webs of Trust

Social graph analysis is easier to fool in one instance than biometrics, but offers strong resistance to large-scale attacks. Compromising an entire social graph would take an enormous amount of time, capital, and coordination.

Biometrics and social graphs will likely co-anchor the winning identity solution. They both scale effortlessly and cover each others’ weaknesses. Homomorphic encryption and zero-knowledge proofs can allow the user to retain sovereignty over their data. Given transparent and cryptographically verifiable trust assumptions, users will likely be willing to offer more revealing info that they would normally shield from Web2 giants.

Turing Tests — Pseudonym Parties

Turing tests involve using CAPTCHAs to separate humans from bots. These tests are difficult for a computer to solve while being simple for a human. Turing tests are very effective at discerning humans from bots, but less effective at preventing a human from imitating several humans.

Pseudonym parties involve various forms of periodic IRL meetups. Pseudonym parties are perhaps the most-ironclad proof of personhood method, since humans cannot be in two places at once. Pseudonym parties offer poor scalability though, due to the increasing difficulty of in-person meetups as the network grows.

Existing solutions often incorporate elements of both pseudonym parties and Turing tests. These methods could be used to complement an already-formidable identity system, but cannot be solely relied upon.


Existing on-chain implementations of these methods are promising. For now though, these projects have failed to generate users due to their unambitious goals. Focusing identity solutions around DAO tooling just adds overhead to widespread governance apathy. Focusing on pie in the sky solutions like UBI only serves to undermine the legitimacy of the project. Refocusing efforts towards more relevant experiments such as accountability for anonymous developers, high-profile NFT launches, and undercollateralized loans could allow these projects to gain traction in 2023. Aggregating these identity methods into a multifactor authentication solution like Gitcoin passport could help accelerate the growth of these projects and streamline their integration with prominent dApps.

Incentives, Game Theory, and Crypto-Native Recourse

In traditional finance, loans are secured by the guarantee of recourse. This recourse is given in two ways:

  • Gating of financial privileges via credit scoring. The threat of being locked out deters malicious behavior.

  • Punishment and/or repossession of assets. This threat is backed by the state’s monopoly on force.

There are a number of tools at our disposal to select good borrowers, incentivize good behavior, and make delinquency as unpleasant as possible.

Securitization and tranching will be crucial in the manipulation and repackaging of risk into more palatable chunks. The social graph will supercharge predictive analytics and allow for highly creative slicing of risk buckets. Alpha hunting and on-chain sleuthing will grow to encompass finding mispriced risk factors based on demographics, lifestyles, geographic locations, behaviors, etc.

Auctioning off bad debt via junk bonds is a logical continuation of the subordinate tranche, and marries the onboarding of higher risk appetites with a much-needed sink for distressed debt. Buying junk bonds would represent an extremely asymmetric bet on the long-term viability of the system as a whole. If the system is successful, it becomes more entrenched in society, costing users more to leave. Paying off bad debt to rejoin the system becomes a bigger priority and is cheaper than the investment necessary to forge a new identity. Scouring the social graph for mispriced junk bonds deemed likely to be paid off would become an incredibly lucrative and extravagant enterprise.

Doxxing: The threat of doxxing is one of the few crypto-native recourse options we have at our disposal. Doxxing the user to the owner of junk bonds after X days and/or doxxing to the public after X days serves to increase the attractiveness of the junk bonds.

Permissioned expenditure: Setting constraints on how borrowers spend protocol funds can increase transparency and predictability. Through a partnership with Web2 fintechs or the creation of a proprietary, permissioned stablecoin, borrowed funds could be directed to stickier goods such as car payments or mortgages, rather than consumables. This would result in a more concrete paper trail, leaving the door open for further recourse as the ecosystem matures.

This option comes with costs, however, as the lending activity would remain isolated from broader DeFi, sacrificing the composability and second-order innovation possible with a more permissionless system.

System Architecture

Users progress through a tier-based system, gradually earning a longer leash as the protocol allows itself to become more vulnerable to default. This stepped-program will stagger the progression of user cohorts, allowing a beta test-like diagnosis of any weak points.

As seen above, the progression system would look like this:

  • Status quo on Aave/Compound/Euler.

  • Payday loans:

    • Due to the low time-lag of payday loans, they would carry relatively low risk. Coinbase supports direct deposit and has made strides towards this type of infrastructure.

    • Experimentation with payroll custody is currently limited to prepaid debit cards. More progress needs to be made here.

    • Payday loans could be amortized by payment streams via Sablier/Superfluid. This would dramatically lower borrowing costs, providing a credit card-like experience for those with no access to credit.

    • Low probability of default allows capital-efficient use of credit delegation for guarantors. Aave’s seldom-used credit delegation feature that was introduced in v2 would find product market fit.

  • 110% LTV capped at $ or % of net worth with guarantor.

  • Removal of guarantor, progressively increasing LTV and borrow caps.

By the time a user reaches the latter tiers, they would be strong power users. They would have likely paid hundreds of dollars in interest over a few years, lowering the protocol’s loss given a default. Prominent lending platforms such as Aave, Compound, and Euler will implement their own flavors of this system, using a variety of levers to taper progression.

Why does this all matter?

Overcollateralized (or secured) lending has dominated DeFi to-date. Yet overcollateralized lending is inherently prohibitive for those who don’t already have access to ample capital. If you need $100 to borrow $50, then secured lending only benefits those who already have $100. Those seeking a $50 loan to invest in productive uses (like starting or expanding a business, for example) are out of luck. Unsecured lending aims to increase accessibility to funding to creditworthy borrowers with lower capital requirements.

Access to financing and credit is a core tenant of every major developed economy. Efficient markets for lending and borrowing increase capital efficiency and allow excess capital to flow to more productive use cases. The problem is unsecured lending requires a large degree of trust, much more than secured lending because these types of loans are often undercollateralized (or uncollateralized in the case of some personal loans). The difficulty is determining a borrower’s “creditworthiness” in a model that relies more heavily on trust rather than their ability to pledge adequate collateral.

Unsecured lending, when operating properly, has several benefits. Although the risk of undercollateralized loans is higher, they can also generate higher returns for lenders to compensate for said risk. It also enables more opportunities for credit creation, which increases an economy’s money supply and the number of viable investment opportunities that can be funded. The expansion and contraction of credit has tremendous impacts on economic growth and business cycles, and the crypto economy is no different.

Idea #3: The Advent of True On-Chain Arbitrage

Arbitrage is crucial to the health of any financial ecosystem. It keeps prices tight and fair for all participants. In traditional finance, a simple arbitrage opportunity may look something like this:

  1. Sell an overpriced derivatives contract.

  2. Borrow cash to construct an offsetting basket of securities.

  3. Calculate profit X, borrow X net of interest to get paid today.

The limited capital burden and ability to earn profit instantly leads to efficiently priced and liquid derivative markets. Arbitrage opportunities that remain are hard to find and only offer a few basis points of profit. This is a testament to how important arbitrageurs are to efficient markets.

Without the ability to borrow uncollateralized, on-chain arbitrage in crypto is very cumbersome. For now, it takes place in 2 forms:

  • Flash loans.

  • Buy low/sell high, hold to maturity. Capital is tied up for the duration of the contract, and profit is realized at maturity.

Aave’s GHO stable coin is very promising. One overlooked aspect of its potential is facilitator #3: delta-neutral positions. There are some exciting possibilities for this in the future. Aave’s portal feature and incredibly deep liquidity are ideal for facilitating the settlement of multi-currency cross-chain offsetting derivatives contracts. The synergies between Aave’s lending business and crypto’s immature derivatives markets are tantalizing.

Today, typical arbitrage for crypto options may look something like the above. Buy low, sell high, hold to maturity. This is inefficient due to the collateral required to short an option. For arbitrage purposes, options must be fully collateralized. Otherwise, the setup is exposed to the price action of the underlying and no longer offers risk-free profit.

By deploying a borrowing module on top of options AMMs or a derivative-backed stablecoin on top of lending protocols, on-chain arbitrage can start to resemble the real deal. A user purchases offsetting derivatives contracts, earning profit on the mispriced premiums immediately. The user then deposits the contracts into the lending platform’s arbitrage module to free up collateral, net of interest costs.

An obvious flaw with this idea is that for higher strike prices and longer maturities, interest costs will severely eat into profit, rendering the method impractical. Lending reserves would quickly be tied up collateralizing delta-neutral derivatives baskets, which would be a deal breaker for the lending platform. To account for this, options AMMs could whitelist lending protocols that have adequate procedures to have uncollateralized options or more generous liquidation procedures for partially collateralized positions. Alternatively, improvements could be made at the contract level to allow options to be collateralized by other derivatives contracts.

The options protocols are getting the most value from this arrangement, so it is in their interest to create a palatable situation for the lending platforms. Options platforms would receive much more efficient pricing and liquidity, likely making significant headway in their battle against CEXs. The lending protocol would gain utility for its idle reserves and product-market fit for its stablecoin (without expensive liquidity-mining programs).

AMMs could use GHO in other ways, too. Say the protocol wants a user to wait 7 days to withdraw funds. The pool is adequately delta hedged, so it mints 5,000 GHO and lets the user withdraw 5,000 GHO less a borrowing fee for 7 days. In 7 days, the protocol converts an equivalent amount of pool reserves to GHO, which is then burned. The pro rata earnings of that 5,000 GHO go to the safety module or the rest of the pool’s LPs in exchange for assuming disproportionate risk.

One can’t help but wonder, could this put Deribit in DeFi’s crosshairs? Deribit’s settlement currency and non-fungibility of positions are the only things preventing a $10B vampire attack for the ages. Still, the potential synergies of a borrowing module on top of a delta-neutral stablecoin facilitator are fascinating to explore. On-chain derivatives are starting to simmer heading into 2023.


We could talk about several other themes that we believe will shape the industry. At the top of our minds: the need for payment rails, better on and off-ramps for crypto <> fiat, the emergence of DeFi app-chains, the implications of applications owning their infra layer, and many others. Additionally, the DeFi bull case and how resilient it’s been in light of recent market carnage is top of mind.

We chose to focus on a few key themes based on DeFi’s historical usage patterns and what is necessary to fully construct the base building blocks.

There’s a lot to be excited about. DeFi stands on the precipice of some of the greatest opportunities (and challenges) the financial industry has seen. We believe that decentralizing the financial system and creating permissionless access to an array of financial products will prove to be key endeavors over the next decade. Regulation poses the most obvious of challenges – especially given the importance of U.S. regulators’ stances and the prevalence of lobbies who have a vested interest in squashing DeFi.

As investors, researchers, and builders, our job is to exercise cautious optimism and find a way forward for products we believe can change the world. The themes we’ve outlined in this report will prove vital in attracting users to DeFi by improving the general state of the industry.

Infrastructure Year Ahead

By Can Gurel and Ceteris


A popular takeaway regarding the FTX drama has been that it was not a DeFi problem, but a TradFi one. It’s absolutely true that custody risks apply to CEXs and not DeFi. Yet, given the size of the collapse, we find it important to ask why, despite all their inherent custodial risks, CEXs continue to attract capital at such higher orders of magnitude.

Reflecting objectively on this question, it becomes evident that current infrastructure rails are immature across a number of fronts. When combined, these result in an inferior user experience compared to centralized solutions. We identify the major ones as follows:

Unsurprisingly, the existing shortcomings of these verticals also hint at where some of the biggest opportunities lie in crypto. In light of this, we’ll first summarize the current landscape across these four verticals, identify the current pain points, and highlight promising solutions/projects working to improve them.

In the second half of this report, we’ll cover an emerging crypto-native vertical that will remain at the center of blockchain operations – MEV.

Access Control

The inconvenient UX of self-custody continues to be one of the primary reasons why people prefer custodial solutions. Today, access control in blockchains is static and binary. A typical user either has complete and exclusive control over her funds or has none. There is no in-between and no recourse if her private key is lost. This is understandably a very inconvenient experience for many.

Two ways to improve on the current UX of self-custody are smart contract wallets and MPC wallets. This post isn’t meant to be a comprehensive overview of MPC vs. smart contract wallets. Those interested in that can see this great overview.

In this post, we will summarize some main focus areas and trends across these verticals as well as highlight solutions gaining momentum.

Smart Contract Wallets

Smart contract wallet adoption is highly dependent on the VM and/or consensus layer design of the underlying chain.

Today in Ethereum, smart contract wallets are regarded as second-class citizens. They can’t operate on their own; they need an externally owned account (EOA) like MetaMask to originate a transaction and pay for gas in order for them to trigger an action, and they are more gas-intensive.

The reality is that for smart contract wallets to be widely adopted, chains need to be redesigned accordingly. The Ethereum community has been actively seeking solutions here for many years. These efforts can be summarized as account abstraction.

Account Abstraction (AA)

Account abstraction is a true game changer. To understand it, we must first revisit how accounts work on Ethereum.

There are two account types on Ethereum: externally owned accounts (EOAs) controlled by private keys and smart contract accounts controlled by code. All transactions must originate from an EOA and may trigger smart contracts that execute arbitrary code.

Under account abstraction, EOAs and smart contract accounts that were previously separated become unified. Put another way, they are abstracted away. Let’s see how this works at a high level.

AA can be simply described as bringing programmability to transaction validity rules. Every transaction mined on Ethereum can trigger an arbitrary code stored in smart contracts. The results of transactions are therefore fully programmable. However, for transactions to be mined on-chain in the first place, they must conform to some validity rules. They need to have a proper nonce, gas amount, signature, and syntax

Today, these validity rules are fixed and not programmable.

Account abstraction also allows validity rules to be programmable. Under AA, smart contracts not only determine the effects of transactions, but can also determine whether or not they are valid, and thus be the agents that authorize them.

Motivations for Account Abstraction

For the end user, AA means a dramatic improvement in UX. Today, in the absence of native AA support, even the simplest UX needs are out of reach for on-chain users. For example, a typical Ethereum user has to sign three different transactions via MetaMask to LP on Uniswap – two to approve tokens, and a third one to deposit them.

Smart contract wallets, combined with native AA, remove these frictions along with many others that currently make our lives harder. AA will allow for an on-chain UX approach on par with Web2 – without sacrificing self-custody. 

When Account Abstraction?

AA is nothing new. It’s been around since 2015. Yet, to date, the Ethereum developer community hasn’t been able to converge on a particular solution. This is because it’s not an easy problem to solve and can result in unexpected second-order effects.

Transaction validity rules protect the network against attacks; gas prevents spam, nonce prevents replay, and signature prevents theft. Under AA, it becomes harder to reason about these protections. Proper gas accounting, in particular, can become challenging and potentially expose the network to griefing and/or DDOS attacks.

Another challenge with implementing AA is breaking backwards-compatibility with existing applications.

Given these challenges, it’s fair to not expect Ethereum to natively support AA anytime soon. The good news is L2s can be free from backwards-compatibility constraints. Also, they have a much lower bar for social coordination. This allows them to act fast and benefit from all the work done on AA throughout the years.

Account-Abstracted L2s

zkSync and StarkWare are among the first L2s to have native AA support in their protocols, making their smart contract wallets quite powerful. Argent has been by far the biggest pioneer here, promoting and actively pushing for AA for many years. It supports StarkWare and will also support zkSync once it launches. Cartridge is another wallet that leverages AA to enhance the on-chain gaming experience on StarkWare.

Another chain that supports native AA in its VM is Fuel. FuelVM is designed to support UX-enhancing features previously mentioned such as batched transactions, native multisig support, gas-sponsored transactions, privacy-enhancing features, etc. 

MPC Wallets

So, we have seen that smart contract wallets mostly rely on protocol-layer changes to gain adoption, but what about MPC wallets?

In very simple terms, MPC wallets allow multiple parties to collectively operate a public-private key pair without a single point of failure. The private key is split, encrypted, and held among multiple parties as secret shares. The private key does not exist in its entirety on a device anywhere in the process. Yet, a threshold of parties can generate a signature corresponding to the key using their secret shares.

A signature generated using MPC is indistinguishable from a signature generated by an EOA. This unique property of MPC brings numerous advantages. First of all, it makes them first-class citizens just like EOAs. Unlike smart contract wallets, MPC wallets don’t need to wait for protocol-layer changes to reach their full potential and they don’t have extra gas overhead compared to EOAs. MPC solutions are also domain-agnostic. They can easily apply to all chains and even be extended to Web2 platforms.

However, consumer hardwares manufacturers like Ledger and Trezor don’t support MPC. Ledger has extensively written on why they don’t consider MPC as a truly ready solution, highlighting numerous security issues. Lack of consumer hardware support has held back MPC wallets from getting adopted by retail. So far, MPC has (for the most part) been used as an enterprise solution.

MPC-Based Key-Management Networks

In the last two years, however, significant funding has been applied towards new forms of MPC solutions catered towards crypto users. These solutions can best be defined as decentralized MPC-based key-management networks. Lit Protocol, Entropy, and the newer protocol Odsy fit into this category. 

Entropy and Odsy: Entropy and Odsy are app-specific blockchains with smart contracts where the user’s key pair is split and shared between validators of the chain and the user. A valid signature can be formed when both parties (validators and users) sign their secret shares. Users can instruct validators to sign their shares when some arbitrary conditions in the smart contract’s code are satisfied. This opens up the design space for truly programmable and dynamic access control; typical examples include conditional payments, spending limits, whitelists, etc. More sophisticated and interesting use cases are also possible; DAOs may manage their internal policies by dynamically adjusting privileges for members. Illiquid assets like locked/bonded tokens can be traded on-chain, etc.

Given the complexity of their technical stacks, it’s hard to estimate timelines for these protocols. However, our best guess is that, as the more mature of the two, Entropy is likely to launch within the next year.

Lit Protocol: In Lit Protocol, there is a single private-public key pair. The key generation and distribution happens among Lit nodes when users mint an NFT on-chain. Whoever holds the NFT can instruct Lit nodes to sign transactions with the generated key pair.

The access control managed by Lit nodes can be programmed through Lit actions, which can be thought of as Lit’s version of smart contracts; they are immutable Javascript code that live on IPFS and can be deployed by anyone. By using Lit actions, users can create access control logic for all sorts of use cases, including conditional payments, recurring payments, automated on-chain actions, etc.

A unique ability of Lit actions is that they make HTTP requests. Thus, unlike smart contracts, they can also access and work with off-chain data. This allows Lit to unlock exciting use cases that bridge the Web2 and Web3 worlds. An exciting category of use cases involves bringing Sybil control to Web2; think NFT-gated Shopify stores, Tesla/Airbnb doors, Twitter polls, Google Drive files, etc. Plenty of innovative use cases can be found here. 

Lit Protocol currently operates as a centralized network. Starting next year, it will transition to a federation and then to a fully permissionless network where nodes stake protocol tokens to participate in the network. Lit Protocol intends to use Celo chain for staking. 

Limitations of MPC-Based Networks

MPC also has fundamental limitations which we haven’t discussed yet. Broadly speaking, what’s common in decentralized MPC protocols is that users manage key pairs with a decentralized network of nodes. As we saw, the benefit here is programmable and dynamic access control, and users typically have to sign their own shares to authorize transactions (which means nodes can never steal funds). 

However, there is an inherent trade-off. While users don’t rely on nodes for safety of funds, they may rely on them for liveness, i.e., it’s possible for user funds to get stuck if nodes stop responding to them. Workarounds typically include introducing crypto-economic security, more cryptography to discourage node collusion, and recovery methods. Inarguably, this brings more complexity into the protocol.

Access Control Wrap-Up

To summarize, we think smart contract wallets combined with native account abstraction result in the most secure, clean, and flexible UX for on-chain self-custody. However, they will take significantly more time, and the progress will differ vastly from one chain/VM to another. In the meantime, decentralized MPC solutions can offer a hacky way to get there faster. While they can’t offer the full flexibility and security that account abstraction promises, they are domain-agnostic and can therefore unlock new use cases that span across all chains and even expand to Web2. In reality, it’s likely for both solutions to complement each other.

Cross-Chain Interoperability

The multi-chain world we live in today is living proof that a single chain can’t serve everyone’s needs. Cross-chain interoperability is thus at the heart of scalability. 

Unfortunately, bridge security remains a major pain point and a fundamental problem for the industry. The last two years have shown that bridges are scary. In aggregate, bridge hacks have resulted in close to $2.5B of losses.

Most of these hacks have been due to implementation bugs, and some have been due to key compromises which can be seen as part of the security model of the bridge (no fallback mechanism).

Natively Verified vs. Externally Verified Bridges

When evaluating bridge designs, it’s tempting to see the security model and implementation as disjointed factors. However, moving forward, we would argue that the healthier (and perhaps more realistic) approach is to consider them in conjunction.

At a high level, bridge designs can be categorized into three buckets: third party, light client, and rollup bridges. Third-party bridges are externally verified, while light client and rollup-based bridges are natively verified.

Most bridges in the last two years have been externally verified bridges. These bridges are often developed and maintained by arbitrary teams each building their own designs. There is little to no cooperation between them in terms of code scrutiny. Furthermore, because they compete for market share, they are inclined to boost TVL by handing out rewards during the first few days of launch. This leads to a perfect environment for black hats.

This is why we no longer think it’s a good idea to consider bridge designs in isolation from how they are likely to be implemented. We know by now that the threat model is nation state-level black hats. While we can never be certain that vulnerabilities don’t exist, the winning solutions are likely to be the ones that encourage maximum cooperation and code scrutiny. This brings us to natively verified bridges.

Natively Verified Bridges Rising as Standards

The antidote for bridge hacks is standardization. Natively verified bridges (light client and rollup-based) have notable characteristics that make them more likely to evolve into standards than externally verified bridges. 

Natively verified bridges not only function as general message-passing protocols, but also serve other fundamental needs and primitives such as mobile wallets, fast syncing, reducing reliance on centralized RPC services, etc. Given that they are ecosystem-centric, natively verified bridges are relied upon and scrutinized by a larger number of teams and developers in their respective communities. Their roadmaps revolve around developing ecosystem-wide standards considering the maximum mutual benefit of ecosystem participants. 

Inarguably, the most successful example of this is IBC. IBC isn’t immune to implementation bugs, but its development greatly benefits from the mindshare and attention it receives from a large number of diverse Cosmos teams. Considering how a critical incident was flagged and patched recently, we can count this as an important factor for its survival.

IBC’s Traction

IBC had undeniable success in 2022, emerging as the canonical bridge for Cosmos. Today, 53 chains rely on IBC to pass messages to each other. In the last 30 days, IBC accounted for more than $0.7B of cross-chain volume and was ranked third-highest in volume after Multichain and Arbitrum.

Given its existing network and lindy effects, there is now increasing interest in extending IBC to Ethereum and other ecosystems. 

IBC to DotSama

IBC’s first extension beyond Cosmos may be through the Centauri bridge developed by Composable Finance. Centauri will bring IBC to DotSama (Polkadot and Kusama). The first implementation will be between Picasso (Composable’s Kusama parachain) and Cosmos chains early next year. Centauri is well positioned to become the canonical bridge between the Substrate and Cosmos chains.

IBC to Ethereum

A major challenge for light client-based bridges is cost of verification. The fundamental limit here is that for each block where the source chain sends a message, the destination chain needs to verify the header of the source chain. This involves the verification of validator signatures.

For example, if the source chain is a Cosmos chain with 150 validators, the destination chain verifies 100+ signatures (>2/3 validator votes) on-chain for every block where cross-communication takes place. This can be astronomically costly if the destination chain doesn’t natively support the signature scheme of the source chain and has expensive gas.

This is the key reason why the Cosmos<>Ethereum IBC connection has historically been infeasible. However, thanks to recent advancements in zk-tech, there is now a viable path to bringing IBC to Ethereum!

Zero-Knowledge IBC

Instead of Ethereum smart contracts directly verifying the header on-chain, the computation of verifying the header is done by off-chain provers using beefy machines. These provers then generate a succinct validity proof that can be cheaply verified by Ethereum smart contracts. This technique is coined as consensus proofs. Notable pioneering teams here include Electron Labs and Polymer Labs.

For the sake of clarity, the use of zk-proofs doesn’t change the existing trust model of the bridge. The proofs are used to reduce the verification costs of proving consensus *without* introducing new trust assumptions. Our light client-based bridge would still rely on source-chain consensus (>2/3 validators) for the safety of funds. Thus, it would still not be as trust-minimized as rollup bridges (which prove every state transition). That said, given its narrower scope, proving consensus can perhaps gain momentum much sooner with widespread usage of zk-proofs.

Augmenting IBC bridges with zk-proofs is very exciting because it can bring IBC to any smart contract blockchain lacking native IBC support. There is even a possible future where consensus from multiple chains could be aggregated into a single proof using recursive zk-proofs. This would drive the amortized costs of cross-chain messages further down and become the ultimate solution for the relayer incentivization problem of IBC. Perhaps this gives us a glimpse into what IBC will look like in its end state. 

ZK-Based Ethereum Light Clients

So far, we have discussed how Tendermint consensus can be cheaply verified on other ecosystems. But what about verifying Ethereum consensus?

An on-chain light client for Ethereum was out of the question for PoW Ethereum. However, with Ethereum transitioning to PoS and advancements in zk-proofs, this has recently become possible.

In fact, tremendous progress has been made this year by pioneering teams like Succinct Labs and zkBridge. Both teams are close to having working products. Succinct Labs has already demonstrated a two-way on-chain light-client bridge between Ethereum and Gnosis chain in testnet. Gnosis was chosen because it has the same consensus protocol as Ethereum. Similarly, zkBridge has built an initial version of a SNARK-based Ethereum light client.

Cross-Chain Apps

Shifting our focus to the application layer, one trend we expect to see next year is cross-chain apps. Today, the application layer is multi-chain but it’s not yet cross-chain. Next year, we expect to see the first major cross-chain apps. We see this playing out in multiple ways.

  1. Siloed deployments composing with each other.

Today, major dApps exist across multiple chains. This is especially common in the EVM world with blue chips like Uniswap, Aave, Synthetix, and Compound. However, these instances are mostly siloed.

There are multiple reasons for this. First, it is mostly an artifact of the bull market where teams prioritized market share above all else, with little focus given to cross-chain composability. DeFi protocols looking for bridge partners had in-depth discussions yet struggled to commit given there were no clear winners. Bridge hacks exacerbated the problem even further. However, given the bull-market hype is seemingly over, this landscape may change next year. 

One catalyst here will be Chainlink’s cross-chain interoperability protocol CCIP. For large communities like Aave, Synthetix, and Compound, it’s easier to decide to rely on Chainlink as a cross-chain interoperability partner given that they already rely on it for price feeds. This would further reinforce Chainlink’s standing in DeFi.

LayerZero is another protocol that’s well positioned here. Their recent integration with Chainlink oracles can be a catalyst, as applications can permissionlessly spin up bridges with Chainlink oracles. We also note that Sushi is already using LayerZero through its integration with Stargate earlier this year. Rage Trade is another promising derivatives platform that will use LayerZero for its cross chain offerings.

       2. Existing cross-chain applications offering more use cases. 

A cross-chain protocol well positioned to capitalize on its already established market fit is THORChain (see here for our report from April). THORChain is making new integrations with existing DEXs and wallets. The goal here is to abstract THORChain away from user flow. Users can use their favorite wallets/DEXs without even realizing that their cross-chain swaps are going through THORChain. Pangolin, Trader Joe, and Kyber were integrations completed earlier this year. Very recently, a major integration was announced with Trust Wallet, one of the biggest wallets in terms of user base.

Aside from integrations, THORChain is also expanding its cross-chain offerings. It recently launched a savings product, which can be thought of as a decentralized version of BlockFi. It’s currently the only major DeFi product that offers yield on native Bitcoin. Next year, THORChain plans to deploy a new cross-chain lending/borrowing product with zero liquidations and interest. With more integrations and offerings, THORChain is taking important steps towards becoming an economically sustainable protocol (we note that most of these THORFi offerings change the tokenomics of RUNE in an unprecedented way, and thus may involve unforeseen risks that must be carefully considered).

Another protocol well positioned here is Axelar. Axelar is not an app-specific protocol like THORChain, but a hub for generic message-passing. Axelar is uniquely positioned because it supports Ethereum and other EVM chains as well as IBC. So far, it has been a major contributor to Cosmos by acting as a direct hub between Ethereum and numerous Cosmos appchains. Following its launch early last year, Axelar was selected as the canonical bridge for Osmosis, and has since been among the top chains in terms of IBC volume. Next year, Axelar can potentially benefit greatly from increased Cosmos adoption.

       3. New applications starting cross-chain from the get-go.

Finally, there is a new set of dApps that will start cross-chain from the get-go. Some notable ones which chose this path include Mars Protocol, Prime Protocol, Composable Finance, and Rage Trade.

Mars and Prime are both cross-chain lending/borrowing applications enabling users to borrow on one chain against their collateral on another chain. Mars will be a Cosmos appchain leveraging advanced features of IBC such as interchain accounts and queries. Prime will be offering a similar use case but targeting EVM L1s and L2s and leveraging Axelar for cross-chain interoperability. 


Scalability is a moving target. Much like the internet, blockchains will continue to struggle to scale as they onboard new users.

Put another way, scalability solutions take different shapes and forms at different levels of user demand. Today, various different blockchain architectures coexist to accommodate the current user load. It’s possible to categorize these architectures into four buckets.

Today, user adoption is mostly dominated by general-purpose monoliths. As we move forward, we expect this to gradually change and for user adoption to shift towards appchains and modular chains. Given their maturity, we predict appchain adoption to materialize in the near-term, perhaps within the next 1-3 years, and imagine modular chains as the end state architecture where blockchains become mainstream. A comprehensive overview of the motivations behind the appchain and modular chain theses can be found in Delphi Labs’ Finding a Home For Labs report and Delphi Ventures’ Dawn of the Modular Era post.

This is, however, not to say that we expect general-purpose monoliths to die off anytime soon. While we see a shift towards modularity and appchains over time, we recognize that there is a benefit to the synchronous composability and permissionless innovation in the sandboxed environments that general-purpose chains enable. By no means do we expect these to go away completely.

Indeed, we expect these different designs to coexist for a very long time. There will be winners and losers in each category. In this post, we will highlight the ecosystems and projects that (in our opinion) are likely to thrive in their respective categories.  

For general-purpose monoliths, we still consider Solana the biggest contender in this category despite all the hits it took after the FTX implosion.

What’s Next for Solana?

The recent FTX collapse hit the Solana ecosystem harder than any other. Saying that Solana DeFi has had a rough couple of months is an understatement. In October, Solana’s largest DeFi protocol (Mango Markets, >$100M TVL at the time) was exploited, with the FTX collapse happening a month later. During the fallout, there were also concerns around FTX-led Serum, so the community came together to fork it and take control, deploying a new CLOB DEX called OpenBook. Since most of Solana DeFi was built on top of Serum, many DeFi protocols had to pause/go offline due to the lack of liquidity. Solana DeFi has truly gone through a full reset, with NFT activity responsible for retaining Solana users for the time being. So, should we write Solana off as dead, or are there catalysts on the horizon to turn it around?

We should start by noting that Solana is becoming a more modular ecosystem in and of itself, not with respect to the Solana chain, but with the Sealevel Virtual Machine (arguably Solana’s best innovation) becoming a rollup standard through Eclipse and Nitro. If you believe that a big part of Ethereum’s moat is the EVM, then the SVM becoming widely adopted should be no different for Solana, and the data backs this up.

Outside of Ethereum, the Solana Web3-developer package is the most widely adopted. Adoption has also continued to increase week over week, from 87k weekly downloads a year ago, to 200k in June, to 365k the first week of November, and most recently to 420k the first week of December. It has continued its consistent uptrend even with FTX’s collapse.

Besides SVM, there are reasons to be constructive on the Solana L1 itself.

First, network performance has been getting better over time. Average block times on Solana have come down significantly over the last half-year. While some of this is due to a higher vote/non-vote transaction ratio (as votes are less computationally demanding), there have also been numerous software upgrades to the network. The NFT minting/spam issue that took Solana offline on multiple occasions has not impacted the chain to the same degree it did in the past, and it should only keep getting better with solutions like QUIC, fee markets, Jito, and Firedancer all going live.

There were still some performance issues during the FTX collapse (like publisher oracle updates not going through), but the chain performed much better than it would have six months ago and stayed up throughout the chaos and massive bot liquidations stressing it. While non-vote TPS are down, this is mainly due to lower overall activity – something we’re seeing on all chains, not just Solana.

Still, with ~300 non-vote TPS, and removing the ~100 from oracles, Solana is doing ~200 real TPS, significantly ahead of all other chains. Their 15-20M non-vote transactions/day are still in a league of their own when compared to other blockchains.

TPS is by no means a perfect metric, even when excluding votes/oracle transactions, but it’s still a rough signal for overall demand. We also shouldn’t completely disregard the oracle transactions, as Solana’s sub-second block times + cheap fees enable these fast oracle updates (something no other chain has live today) and, subsequently, unique products — specifically in the derivatives space.

As a preferred metric for demand, we would look to compute units per block, which is a representation of both the number of transactions and their complexity. Seeing this metric go up over time will be a good signal for real usage of Solana. With Serum offline and overall demand for blockspace falling over the last few months (see Ethereum gas fees), this metric has settled into a lower floor. As a note to the chart below, Solana blocks have a max of 48M compute units per block.

More important developments are on the horizon, with the major ones highlighted here:

  • Jito: Jito open-sourced their validator at the end of October (to be discussed in-depth later in the MEV section). At a high-level, the Jito validator not only enables a more efficient MEV market, but also filters spam, with the Jito relayer acting as a separate transaction processing unit, by extension reducing the burden on validators and improving Solana’s network stability. Spam (i.e., transaction floods) has been responsible for two of the four times Solana went down, and slowing the chain/causing high transaction-failure rates on other occasions.
  • Firedancer: A new, independent Solana validator client in development by Jump Crypto. Built by a completely separate team than the Solana validator, Firedancer will help client diversity on Solana and make things like client or execution-layer bugs less likely to halt the network (overlap of the same bugs in both clients is low, so if one fails the other can keep running). Firedancer’s main difference is in its modular architecture, running many individual C processes called tiles (compared to the Solana Rust validator that runs as a single process). For a more complete breakdown, you can watch the presentation and demo from Breakpoint and read the latest blog post. Firedancer is probably the most important near-term development for Solana.
  • OpenBook and Ellipsis: Spearheaded by the Mango Markets team and others in the Solana DeFi community, OpenBook is a community fork of the Serum DEX with the goal of replacing Serum as the backbone of Solana DeFi. Contributors come from a diverse group of protocols across the ecosystem, and there have even been discussions around whether SOL should be the token for OpenBook instead of creating a new one, making it a true public good. There are a lot of interesting proposals for how to incentivize development of OpenBook. For more details, refer to the first community call notes. Currently, volume is a fraction of what Serum was doing. Part of this is due to so many protocols built on Serum going offline and needing to integrate OpenBook. The other part is due to removing Alameda’s >50% of maker activity — something that will not come back overnight (this is one of the downsides to CLOBs that rely on large MMs vs. passive AMMs). OpenBook isn’t the only new CLOB on Solana though, with another promising competitor Ellipsis also in production and planning to go live in Q1.
  • Mainstream UX: Stripe fiat-to-crypto integration was recently announced, with 11 of the 16 partners being protocols building on Solana. These include Magic Eden (NFTs), Glow Wallet, Orca (DEX), and more, offering direct fiat on-ramps to these protocols. Fiat-to-crypto on/off-ramps are arguably the most important pieces of infrastructure. In the long-run, these should be the only centralized points crypto needs to rely on. Solana also partnered with Discord, becoming the first blockchain to do so. The Saga mobile phone is also upcoming, which will be discussed in the “Futuristic Ideas” section at the end of this report.
  • NFTs: While there was an initial sell-off during the FTX implosion, Solana NFT activity has bounced back quite well. Solana has consistently had the second-largest NFT ecosystem for some time now, with 30-day volume of $60M vs. Ethereum’s $400M, more than 4x the next ecosystem, ImmutableX (which is made up of one collection). NFTs were not in the original pitch for Solana, so it’s quite notable that activity has passed NFT-specific chains like Flow. There’s a deeper meaning here for what NFT adoption implies about Solana. Did users come to Solana because they liked NFTs? Or did they come to Solana because they liked the UX of the chain, and then moved to NFTs because there was more upside and better risk/reward than with DeFi tokens? While the DeFi ecosystem rebuilds, NFTs will need to continue to onboard and retain users, although Solana can’t rely solely on NFTs forever.
  • Base-Layer Upgrades: QUIC, stake-weighted QoS, and isolated fee markets all improve Solana’s stability. QUIC and stake-weighted QoS are already live, while isolated fee markets are in production. The new fee markets will, theoretically, isolate network fee spikes to the most in-demand areas on Solana. For example, fees would spike for minting an in-demand NFT but would not rise at all for simple token transfers. This is in contrast to most other blockchain designs that have global fee markets (an NFT mint causes fees to rise for everyone). Solana also introduced a new “fee with bump” transaction which saw an uptick in adoption during November (see chart in the MEV section).

It’s no secret that Alameda/FTX were a big part of Solana’s rise, and we can probably say with confidence that a lot of the SOL price action in 2021 was due to them, and not real/organic. But losing Alameda, while it will hurt on-chain liquidity for the time being, is not a deathblow. Solana is unique in that it was designed from an engineering perspective rather than academic. While we have seen some of these design decisions hurt them over their first couple years, they have also unlocked unique use cases that not all other chains can achieve. Network stability has been getting better, TPS (excluding votes) are still significantly higher than any other chain, and the aforementioned improvements should continue to improve stability. Still, you should probably expect Solana to go down again at some point.

Solana is a truly differentiated product in an industry with so many copycats, and if you’re going to pursue the monolithic vision, it would probably look something like Solana. It’s also important to point out that so far, all blockchains have failed to scale. Ecosystems going through what seem like existential crises are nothing new; both Bitcoin and Ethereum went through their own challenges (Mt. Gox for Bitcoin and the DAO hack for Ethereum). It’s now Solana’s turn with the FTX collapse, and while surviving is by no means guaranteed, if they do, they’ll come out of the other side better for it. Encouragingly, DeFi protocols like Mango, Drift, and Zeta, among others, are all working towards new versions, with plans to go live soon.

Solana is dead. Long live Solana.

The Appchain World: Cosmos Gaining Momentum

A major component of appchains involves restricting access to state. Contrary to general-purpose chains, which allow anyone to permissionlessly launch new applications, appchains decide which applications they will run through social coordination. Similarly, cross-chain communication requires social coordination. Chains shake hands to establish IBC connections.

There is an inherent trade-off here. Appchains lose the agility of permissionless innovation, but in turn gain sovereignty over their applications. Furthermore, they get to optimize their chain for the particular use case(s) they want to address and thereby offer a more reliable UX.

Another major aspect of the appchain thesis involves incentives. On general-purpose chains, revenue often leaks to the underlying gas token. Even the most popular dApps fall short in capturing most of the revenue they generate. Dan Elitzer’s Inevitability of Unichain is a great study which presents this case for Uniswap.

To further illustrate this point, we look no further than CoinGecko. It’s remarkable to notice how rare it is for pure app tokens to be among the top 100. Appchains fix this incentive misalignment by unifying app and gas tokens.

When we think of appchains today, we think of Cosmos, as the Cosmos SDK is the most production-ready toolkit to permissionlessly build a new chain from scratch. In the long-run, we expect appchains as rollups (or rollapps) to gain adoption as the tech becomes more mature. Some notable live and upcoming appchains today are:

dYdX: A pure DEX appchain, it’s currently live as a StarkEx Ethereum L2 and will be shifting to Cosmos as a standalone chain in the new year. There is a massive opportunity in 2023 for the Cosmos ecosystem through dYdX, and FTX’s implosion (while obviously terrible) could not come at a better time. Trading is being “pushed” on-chain as centralized entities all throughout crypto blow up, and as the top DeFi derivative DEX today, dYdX has the most to gain (and lose). The launch of dYdX will be around the same time as the Cosmos Hub’s “asset issuance” consumer chain. This chain is where Circle will issue USDC, with dYdX being the largest first customer (dYdX currently has $430M USDC on their StarkEx L2). This will heavily bootstrap the amount of native USDC on the Interchain — something that has always been lacking throughout Cosmos and IBC. In essence:

  1. dYdX growth is good for native USDC growth on Cosmos.
  2. Native USDC growth on Cosmos is good for the growth of activity through the Hub’s economic zone as an Interchain Security provider of the asset issuance chain.
  3. Growth of the Hub as an ICS provider is good for the adoption of other consumer chains, and native USDC makes bootstrapping them quicker.
  4. Native USDC growth and the growth of the Hub’s economic zone is good for overall liquidity to grow to other appchains in the ecosystem.

Osmosis: The “liquidity hub” of Cosmos, Osmosis is the most active chain in IBC, with the highest TVL (~$200M) and IBC volume (>$1B per month). It also acts as the backbone for liquidity for Cosmos chains tokens. Osmosis’ first main innovation was Superfluid staking, a module which allows the underlying OSMO in liquidity pools to simultaneously be LP’d and staked to secure Osmosis. The latest Fluorine upgrade adds some more features like a stableswap AMM, IBC rate limiting, and multi-hop routing. IBC rate limiting is a response to the numerous bridge hacks we saw in 2021-2022, putting a cap on the percentage supply of a token that can move in/out of Osmosis during a defined window. Multi-hop routing adjusts LP fees to account for swaps going through multiple pools. For example, a swap of USDC for ATOM would go through the USDC/OSMO pool and then the OSMO/ATOM pool. Instead of charging the 0.2% swap fee that both of these pools charge, the fee will be cut in half to 0.1% to charge 0.2% total. Osmosis has more in the pipeline for 2023, including a concentrated AMM, MEV mitigation through threshold decryption and a partnership with Skip to “internalize” MEV (i.e., have the protocol complete arbs against itself), the launch of Mars Protocol for borrowing against LP tokens, Interfluid staking (similar to Superfluid, but staking the underlying LP tokens of non-OSMO tokens), mesh security, and more. A lot of Osmosis’ growth can be attributed to their high supply issuance/inflation, but the upcoming features and integrations in 2023 offer paths for more organic traction while becoming the liquidity backbone throughout IBC.

Sei and Injective: As “DeFi-optimized” chains, Sei and Injective sit in the middle between pure appchains and something more general purpose. They’ve built orderbook logic into the base layer and have permissioned apps built on top. A key difference between dYdX and these two is that dYdX is a pure appchain focusing on derivatives, while Sei and Injective are just the infrastructure layer for things like perps, options, stablecoins, and more to be built on. Sei is also aiming to be the base layer for both the SolanaVM and MoveVM rollups. For a deep dive on Sei, you can read our report from September.

Interchain Security

Finally, one of the biggest catalysts for appchains will be infrastructure that makes it easy to launch new chains. Enter Interchain Security, which allows appchains to spin up without bootstrapping an entire validator set. With ICS, new chains are able to lease security from the Cosmos Hub’s (ATOM) validators and stakers in return for some percentage of the tokens and fees generated on their chains (percentages are variable). For more on ICS, you can reference our Cosmos report here. ICS is expected to go live in January, with the first chains launched in February. Notable consumer chains include:

Neutron: A PoS smart contract chain secured by the Hub, slated for launch shortly after ICS goes live in Q1 2023. Neutron gives the Hub (ATOM) a smart contract platform to try all of the new/experimental things they want to use and develop. This includes things like CosmWasm contracts, ICAs for cross-chain operations, and ICQs to read data from other chains, along with using these in tandem for innovative products like an Interchain DEX, all while keeping the Hub isolated. In a nutshell, it’s a fully permissionless general-purpose smart contract chain secured by the Hub. Really, anything that can be developed on a CosmWasm smart contract chain can be deployed on Neutron, a breeding ground for smart contract dApp innovation within the Hub’s economic zone. One of the first notable projects to be launching will be Lido, issuing their ATOM liquid staking derivative on Neutron. Neutron is currently in testnet on the Hub’s “Game of Chains” ICS testing ground, which has recently moved to phase three.

Asset Issuance Chain: Sometimes described as a USDC/Circle consumer chain, this will be a chain secured by the Hub for generic asset issuance. USDC will be the first asset to launch, but any centralized asset wishing to issue on the Cosmos ecosystem could choose this chain as the canonical one. As this chain will be onboarded by CEXs, it’s likely to be the central point for these assets to issue their tokens.

Duality: A DEX appchain that aims to become a sort of hybrid between AMMs and CLOBs. Duality’s core feature is the ability to create AMM pools that allow swaps at a constant price. This differs from a typical concentrated AMM where price ticks determine a range. Duality allows liquidity to be placed at specific prices, resembling limit orders on a CLOB. Any arbitrary curve can be built on top of a Duality pool, and traders can utilize market or limit orders to access the underlying shared liquidity between all pools. Like Osmosis, their main competitor, Duality aims to internalize and redistribute arbitrage profits from MEV back to LPs. Duality is planning to go live in Q1 2023. 

Stride: Liquid staking is a big focus of the ATOM 2.0 whitepaper, and Stride is the first to market. While Stride is a standalone chain today, it will become a consumer chain once ICS is live (to get economic security from the Hub). When you think of a liquid staking token, it’s imperative that the security of the underlying asset is not jeopardized by a chain with a low-market cap token and less-tested validator set securing it. Stride has issued the liquid staking tokens stATOM, stOSMO, and stSTARS, all of which have incentivized pools on Osmosis. The main competitors to Stride will be Lido (when they launch on Neutron) and Quicksilver, another Cosmos-native liquid staking solution coming to market. Quicksilver just announced their launch date of Dec. 16th.

Polymer: zk-IBC, discussed in the section above.

FairBlock: “Bad” MEV prevention through an identity-based encryption (IDE) scheme, discussed in the MEV section later.

While ICS is a great tool which allows new chains to bootstrap, it also allows a wider range of products to be built for the Cosmos Hub in their own “economic zone.” These early consumer chains will give ATOM a general-purpose smart contract chain, an asset issuance platform for stablecoins and other assets, a fully customizable high-performance DEX, liquid staking, and more. ICS scales the Hub in a way that couldn’t be done before.

Appchain Wrap-Up

Before we move on to modular blockchains, we would like to share our conclusion for appchains and the Cosmos ecosystem. Overall, we notice developer activity on Cosmos is more lively than ever. Cosmos infrastructure is already ready to onboard new applications by horizontally adding new chains to their IBC ecosystem. The asset issuance (USDC) chain and IBC tapping into other ecosystems can bring significant inflows to Cosmos. Next year, considering other ecosystems continue to suffer from bridge exploits, Cosmos will be well positioned to increase its market share.

Modular Blockchains

The rollup-centric vision set forth by Ethereum has been the biggest catalyst of smart contract rollup development. Last year, Celestia broadened the rollup definition by introducing the notion of sovereign execution and/or settlement rollups as well as Celestiums.

Today, we refer to these different architectures as modular blockchains; blockchains that outsource at least one of their core functions (execution, settlement, consensus, data availability) to another blockchain.

While we expect the modular blockchain thesis to materialize over a very long time, there have been significant developments this year and there are many in the roadmap for next year.

Ethereum Ecosystem

L2 adoption on Ethereum over the last year has been impressive. The most reliable way to see this is to look at how much of the base-layer gas fees have been consumed by L2s. We notice that their share of L1 gas consumption has increased from less than 1% in the beginning of the year to 4% today.

As L2 gas consumption increased, so did their TPS. This year, L2s have flipped the Ethereum base layer in terms of TPS.

Contrary to major EVM L1s like Avalanche and Polygon, which have lost significant liquidity since the beginning of the year, TVL on Arbitrum and Optimism has been consistently increasing. This is a trend we saw starting in the summer and has only increased since.

EIP-4844, AKA Proto-Danksharding

EIP-4844 will be a major milestone for Ethereum L2s (particularly rollups) next year. EIP-4844 is going to be a pivotal moment for Ethereum because it will significantly reduce transaction fees for rollups.

Rollups have two separate costs — execution on L2 and data on L1. Currently, the highest-cost item for Ethereum rollups is posting data to Ethereum. EIP-4844 will reduce this fee by increasing the data capacity of Ethereum by an order of magnitude.

Today, data posted by rollups is stored by the L1 forever. However, forcing the L1 to store old, stale data doesn’t really bring any meaningful security to L2s (for example, ORUs can’t be rolled back to a state that’s older than the fraud proof window, ~2 weeks). The L1 just needs to store L2 data for a reasonable time so that anyone interested in joining the rollup network can do so as it progresses. 

EIP-4844 relaxes the data requirement on Ethereum L1. It introduces a new type of blob-carrying transaction where the blob of data doesn’t need to be stored forever, but only for ~2 weeks. This increases the data capacity that can be posted on L1 and, in turn, reduces data costs for rollups. Post-EIP-4844, Ethereum will have two separate fee markets, one for execution and one for data availability. 

EIP-4844 will reduce rollup fees by an order of magnitude. This will encourage more dApps to migrate to rollups and accelerate developer mindshare across modular blockchains.

It’s important to note that EIP-4844 is a step before Danksharding. It will increase the data capacity of the base layer by relaxing a requirement which is deemed unnecessary. However, each node will still store the full data. Therefore, EIP-4844 doesn’t introduce data availability sampling; the core tech that brings true scalability. Data availability sampling, where nodes store shards of data, will be introduced with Danksharding. 

EIP-4844 likely won’t be ready in time for the Shanghai hard fork, which is optimistically expected around March next year. EIP-4844 will be the next major update after Shanghai.

Those interested in Ethereum’s roadmap for next year, can check  ‘Hitchhiker’s Guide to Ethereum‘  where we comprehensively cover it in layman terms. 

EigenLayer: A unique project that could play an important role for Ethereum is EigenLayer. EigenLayer can be considered Ethereum’s version of Interchain Security. It will enable Ethereum validators to re-stake their ETH in order to offer additional services which could be helpful for Ethereum L2s as well as the base layer. By re-staking their ETH, validators will make it subject to additional slashing conditions against malicious behavior (which will be enforced by Ethereum base layer). In turn, validators will receive rewards from the services they provide.

In Interchain Security, consumer chains are selected by the provider chain’s consensus. In EigenLayer, Ethereum validators will be free to opt-in to provide any service they want, which is great for permissionless innovation. Use cases planned range from a hyperscale data availability layer for L2s to BFT protocols.

One application that actively works with EigenLayer is Mantle. Mantle is a modular execution layer which intends to use EigenDA (EigenLayer’s data availability service) for data availability. This hybrid approach may enable a sweet spot where Mantle doesn’t pay expensive data costs like rollups do yet can still have superior security compared to sidechains; a solution that could be appealing for gaming and many other applications. Mantle also plans to implement EIPs that improve the UX to solve many of the issues discussed earlier in the access control section. As noted in their announcement, Mantle is a product of BitDAO. And, as gas for its execution layer, it intends to use BitDAO’s governance token BIT.

Given that EigenLayer services are run by Ethereum validators, a competitive advantage of EigenLayer is to offer services related to the Ethereum base layer. One exciting use case here involves credible commits, which enable validators to commit to MEV strategies. Generally speaking, EigenLayer services can supercharge the rate of innovation at the protocol level.

Celestia Ecosystem

We initially covered Celestia in depth in the beginning of the year in our Pay Attention To Celestia report. Since then, the Celestia network has significantly evolved and is planning to go to mainnet around Q2 2023. With this, Celestia is expected to become the first truly modular blockchain network in production. The mainnet launch of the base data availability layer will be followed by a number of modular settlement and execution layers, kickstarting user-facing applications. Based on their current roadmap, some of those projects include Fuel, Astria, Eclipse, and Dymension

Fuel is an ambitious and comprehensive project destined to become a major player in the modular stack. The Fuel team has been developing FuelVM from scratch to create the fastest modular execution layer. We are highly impressed and excited by the design choices Fuel made on their VM. Those interested in a more comprehensive overview of Fuel can refer to our report Is Fuel the Best Modular Execution Layer? Unlike the execution layers mentioned above, Fuel’s first instance will not be a rollup, but a PoS sidechain to Ethereum. From there, the roadmap involves launching multiple versions of Fuel, including a smart contract rollup on Ethereum as well as a sovereign rollup on Celestia. Fuel may also operate as a settlement layer in the future.

Astria (previously known as Cevmos) is a purpose-built settlement layer which runs a restricted EVM. Astria will only execute fraud/validity proofs for execution rollups that settle on it, and will not run other applications. Astria is a good option for rollups looking for a cheap EVM settlement layer.

Eclipse recently completed its seed round and will be running SolanaVM both for the settlement layer and the execution layers that will run on top. For this, Eclipse will be working on an ambitious goal to make SolanaVM fraud-provable. Given their value-add to the Solana ecosystem, Eclipse is also supported by the Solana foundation, receiving a grant from them to build IBC messages for SolanaVM. Eclipse plans to launch three testnet chains in Q1 and plans to launch mainnet roughly around Q2. 

Dymension is also a settlement layer. But, unlike Eclipse and Astria, it’s not a rollup — it’s a Cosmos appchain. Dymension wants to make it very easy to bootstrap new app-specific rollups known as rollapps. Rollapps will settle on Dymension, which will allow them to access IBC.

Rollups Are in Their Infancy

While all of these developments are exciting, it’s important to realize that rollups are still in their infancy, and are likely to operate with training wheels for the foreseeable future. Almost none of the optimistic rollups have permissionless fraud proofs, and all rollups have safety-critical upgradability paths in their contracts, making their bridges non-trust minimized. The tech stack of modular chains is challenging, and it will take years of research and engineering efforts for modular chains to unleash their full potential. See ‘The Complete Guide to Rollups‘ for a deeper dive.

Highlights From Other Modular Ecosystems

Polygon is a major ecosystem that strongly supports the modular vision. The core team has been heavily investing in numerous modular execution layers including several different zk-rollups: Hermez, Miden, Zero, and Avail (the data availability layer). It’s hard to comment on timelines for these projects. However, among all of them, the Hermez EVM-compatible zk-rollup seems to be the most mature. The project is currently in public testnet. 

StarkNet plans to have its re-genesis by early next year. This will make fundamental improvements in the StarkNet infrastructure including the full transition to Cairo 1.0. Recently, StarkNet also deployed its token on Ethereum. As per the announcement, the tokens aren’t for sale. However, some tokens will start circulating by the end of next year and the foundation will determine and announce the distribution strategy for its allocation at a future date.

Similarly, zkSync plans to have its full launch alpha early next year, and plans to decentralize parts of the network including proof generation, block production, etc., within the next year. For a complete overview on zk-rollups see our report from June.

We also expect new ecosystems to adopt modular architectures. One such ecosystem worth following is Sei — a DeFi-focused high-performance Cosmos appchain. 

Nitro SVM and Paddle are two highly performance-optimized rollups that plan to launch on Sei; the former runs SolanaVM and the latter runs MoveVM. Indeed, Paddle is going to be the first rollup to run MoveVM, a relatively new smart contract platform. MoveVM has already been adopted by fast monoliths like Sui and Aptos and is considered to be among the fastest and most secure VMs. 


The openness of public blockchains is a double-edged sword. From a solvency and transparency standpoint, openness is a feature, and one of blockchain’s greatest strengths. Being able to audit protocols in real-time and check their solvency in a few seconds solves the black box opaqueness we see with centralized institutions — a lesson learned quite painfully in 2022.

After the FTX collapse, we saw DeFi protocols like dYdX post proof of reserves on Twitter, hammering home the point of why DeFi is worth building. You can’t run into a Celsius or FTX situation with fully collateralized on-chain protocols. A one-click audit of dYdX’s entire reserves is something that will never be achievable in CeFi, regardless of how robust the PoR process is or the diligence and reputation of the audit firm.

However, a 100% transparent financial network is not without its trade-offs. When it comes to personal financial privacy, this transparency is not a feature, but a bug. Not only does having your history 100% on-chain leak profitable trading strategies to the public (leading to alpha decay), but it can be dangerous from a personal safety standpoint. With FTX’s collapse a general theme of this report, we look no further than mainstream media outlets like Bloomberg, The New York Times, and Financial Times filing to dox all creditor information publicly.

Publicly revealing creditor information in this case is extremely dangerous, as it has the potential to leak not only customer information and account balances at FTX, but on-chain addresses used as well, giving bad actors the ability to tie someone’s entire financial history together, especially when this data can be cross-referenced with other leaks. We shouldn’t have to further explain why someone’s entire financial history and residential address becoming public is a problem. It’s clear we need to come to a middle ground — one where the auditability and solvency of protocols is available 24/7 but personal data is private and safe from the public’s eyes. We expect privacy to come back into focus as a major theme, with the battle not only being a technical one, but a regulatory one as well. You can draw parallels to the war against encryption.

Penumbra: As a fully private DEX, Penumbra acts as a shielded pool within the Cosmos/IBC ecosystem. Their shielded swaps prevent certain MEV-like front-running and sandwich attacks and utilize a sealed-bid, batch execution that clears orders at a single price. Their v1 AMM utilizes a concentrated liquidity design, and market makers can deploy strategies privately without having them leak. Being connected through IBC, future use cases (like private governance voting on Cosmos chains with Interchain Accounts) will allow users to vote privately from their Penumbra accounts on any connected chain. While trade/transaction history is fully private publicly, users can decrypt their entire history on demand. Penumbra is expected to go live in 2023.

Aztec: A privacy-first zk-rollup on Ethereum, Aztec is different from other zk-rollups like StarkNet, Scroll, and zkSync in that it uses zero-knowledge tech for privacy rather than scaling. Their flagship product is Aztec Connect, which is unique to other rollups because instead of having its own smart contracts, dApps, and liquidity, it just acts like a VPN to use the Ethereum L1. Ethereum protocols can integrate with the Connect SDK to allow Aztec users to use their protocol privately from Aztec. Connect acts as a type of private pool; multiple users on Aztec submit encrypted transactions like swaps which then get batched together into one and executed on Ethereum. Not only does this batching provide privacy, but it can reduce gas fees by amortizing the cost among many users and transactions. Since all liquidity stays on Ethereum, there’s no fragmentation of liquidity, contract redeployment, or the need to re-audit any code. Their product started with just simple transfers, but has now expanded to a wider range of DeFi activities like staking, swaps, and borrow/lend. Currently in the works are expanding to private NFTs and the launch of their new zero-knowledge language Noir.

Aleo and Mina: Blockchains increasingly move away from a model where everyone re-executes everything to one where computation happens off-chain and verification happens on-chain. We see this play out in the modular world with Ethereum L2s. But there are also L1s that are built with this principle from the ground up. Aleo and Mina are two such blockchains. 

Both projects are ZKP smart contract platforms. Programs are run off-chain via a network of provers who submit zk-proofs on-chain that smart contracts can efficiently verify. Both are building infrastructure for general-purpose applications, but with slightly different primary focuses. Aleo’s primary focus is privacy whereas Mina’s is scalability.

Aleo: The most unique aspect of Aleo is that it is the first-ever private-by-default smart contract platform. What this means is that developers don’t have to think about privacy considerations when developing dApps on Aleo, they get it for free by default. Nonetheless, they retain the ability to decide which aspects of their applications they want to display publicly.

Aleo is the largest project in the privacy space in terms of scope. It has raised a record-high $200M as a privacy project and is building an entirely new tech stack including its own language Leo — a SNARK-based virtual machine and OS.

A well-thought-out aspect of the project is its hybrid usage of PoW/PoS; PoS for instant finality and PoW to scale the performance of the proof generation. Aleo distributes a portion of block rewards to decentralize and open up proof generation to an open network of SNARK provers. On the other hand, instant finality allows easy interoperability with other chains — a crucial factor for the adoption of a standalone privacy chain.

Aleo just recently announced its incentivized testnet and will go to mainnet in 2023. The main challenge for Aleo will be bootstrapping a developer community around its new tech stack and programming language. We are excited for what Aleo is set to unlock and are looking forward to seeing how this will unfold for them.

MEV: What Is It Good For? (Absolutely Everything)

As one of (if not the) most important topics in crypto, we’d be remiss if we did not cover MEV in this report (“wait, it’s all MEV?” alwayshasbeen.gif). This section won’t be a complete deep dive on what MEV is, but rather how the MEV landscape looks today and how it may develop in the future. For a deep dive on the technicals, you can read the MEV Manifesto. For this report, we’ll start with Ethereum and how the market looks post-merge. Then, we’ll take a look at MEV-Boost adoption, relays, builders, censorship concerns, and round it out with some recent developments from Flashbots. After that, we’ll look at MEV on Solana and what Jito is doing there. Finally, we’ll explore the nascent MEV ecosystem in Cosmos while covering some projects that will help shape how it develops over the coming years.

Ethereum MEV Post-Merge

As a high level overview, Ethereum blocks can be built either locally or externally. Local block building is simple: it’s the default process where validators receive public mempool transactions, package them into a block, and then broadcast this block to other validators in the network. This is all done by the validator in isolation.

In external block building, validators outsource the block-building process by running MEV-Boost, a “sidecar” piece of software that allows validators to profit from MEV without any knowledge, sophisticated systems, or relationships with builders. MEV-Boost is simply an aggregator of relays that will choose the highest bid (i.e., most profitable) block from the relays the validator has connected to. The main stakeholders in this supply chain are searchers, builders, and relays.

  • Searchers: Run MEV strategies and send bundles (sequences of transactions) to builders. They want to integrate with profitable builders that have high inclusion rates and need to trust builders to not steal/front-run them. There’s a trade-off here, because submitting to more builders increases inclusion odds but also increases the number of builders that searchers need to trust.
  • Builders: Aggregate transactions from searchers and other sources to build blocks. Builders try to build the most profitable blocks and then pass them through relays to proposers. They need to trust relays to pass along their block if it’s the most profitable, and they want to connect to relays that have a high number of validators connected to them. If they build the most profitable block but the current proposer is not connected to the same relay, their block won’t be executed.

Relays: Receive blocks from builders and send them to proposers. Proposers put trust in relays to accurately assess and send the most profitable blocks, and to reveal the block and pay them upon signing. Some relays have had issues since the merge, like bloXroute sending invalid blocks, a Manifold exploit that allowed builders to submit phantom bids to win blocks, and a vulnerability in which malicious builders could prevent MEV-Boost blocks from landing on-chain.

In the long-run, Ethereum will have enshrined PBS and relays won’t be needed. For now, they’re a critical cog in the chain. Relays also vary in their censorship (i.e., OFAC inclusion) and how permissionless they are for builders, as some relays only allow their own builder to connect (Eden, bloXroute, Blocknative).

The TL;DR of all this is that MEV-Boost allows validators to maximize their staking rewards by selling their blockspace to an open and competitive market of block builders. For large staking providers like Lido, this means a consistently higher staking yield, with boosted execution layer rewards generating >5x the typical amount of execution rewards that a vanilla/local block would.

Execution layer rewards are the validator rewards for, well…executing transactions. Consensus layer rewards are the inflation/block rewards for securing the network. Execution rewards vary significantly, consensus rewards are more stable.

Besides a higher floor staking yield, the upside can be substantial, with the highest MEV-Boost validator payment so far being ~430 ETH ($516k) won by Lido. This is the financial incentive to get people to run home validators — not that they can get a consistent yield on their ETH (they can do so with a liquid staking provider) — but that they can have a shot at being the proposer of a high MEV block, a block that they would never be able to build locally. It is no surprise that MEV-Boost has seen fast adoption since the merge, with nearly 90% of validators already running it after just two months.

Back to Ethereum’s MEV design, the motivation for proposer-builder separation (PBS) was to prevent centralization of validators. If only sophisticated validators could extract MEV, then it would become uneconomical for smaller validators who would eventually be forced out. They would be better off just delegating to these top validators instead. This centralization is dangerous, as a small set of validators could more easily censor transactions. To combat this unavoidable centralizing force of MEV, centralization was pushed to the builder role instead, deemed a valid trade-off as long as proposing blocks is decentralized. But a centralized builder role is not without its own downsides.

While isolating centralization to the builder role prevents centralization of validators (and makes base-layer censorship harder), builders can still extract MEV from end users. Block building has a feedback loop where a builder could get access to private order flow, in turn allowing them to create the most profitable (and winning) blocks, and thus leading to more exclusive agreements and private order flow until no one else can compete. MEV is inherent to blockchains; what remains to be seen is how the profits are shared.

A competitive builder market would result in a more balanced distribution of MEV as builders compete on execution guarantees, split profits with users, offer rebates for order flow, etc. A monopoly, on the other hand, would allow a single builder to keep more of these profits themselves, as there would be nowhere else for users to go.

This will be one of the most important areas to watch in the MEV economy in 2023. Today, it’s dominated by about five builders, but recent encouraging signs have emerged as the Flashbots builder is down from 75% to 25% market share, and new builders like builder0x69, beaverbuild, and 0x4737 picking up substantial market share. Flashbots has also recently open sourced their builder to encourage competition.

Block building since the merge has mostly been a battle for market share, as builders were passing basically all of their profit (and sometimes even subsidies) to validators. As we discussed above, there are positive feedback loops in being a successful builder, so some have chosen to extract zero or even negative rent for the time being in order to win flow. Bucking this trend are two new builders on the scene — beaverbuild and 0x4737 — who both started building profitable blocks the week of the FTX implosion. Little is known about either (besides beaverbuild’s killer website), but they’re ones to watch in the coming year as competition heats up. The builder market can be summarized as follows:

  • Flashbots: Run their own builder (which they have open sourced) and the Flashbots relay. Both their builder and relay censor OFAC-sanctioned addresses. The Flashbots builder has connected to other relays to help boost adoption of non-censoring relays.
  • bloXroute: Runs their own builder and has three relays: max profit, ethical, and regulated. The max profit relay is the only one with significant adoption, ~18% of relay share.
  • Eden: Builds the most profitable blocks on average but has a relatively low inclusion rate. Their relay only allows their own builders.
  • builder0x69: Started operations mid-October. Operated at a loss for a while before beginning to turn a profit recently, and now makes up ~20% of blocks. They subsidize blocks to increase order flow (discussed below) and created the relayooor non-censoring relay.
  • beaverbuild: New builder that started in November and already has the most cumulative profit to date.
  • sendbundle.eth: Newer builder that has been able to garner a consistent 5-10% builder share, although does so by operating at a loss.
  • 0x4737: New builder that started around the same time as beaverbuild and has also been quite profitable.
  • Manifold: Runs a builder, relay, and RPC service. There have been talks of Sushi integrations to capture, distribute, and share MEV with “SushiGuard,” although it is not yet live and TBD.

When a builder bids on a block, any MEV they keep directly impacts the size of their bid. For example, if two builders each build blocks worth 1 ETH, and one builder bids 0.9 ETH to the proposer (to keep 0.1 ETH themselves) and the other bids 1 ETH (to keep 0), then the 1 ETH bid will win. To be profitable with most builders breaking even or losing money is impressive. Are these profitable builders getting private order flow?

An important aspect to the nature of MEV (and by extension block building) is that it leads to lumpy rewards. An analysis done by Flashbots showed that 35% of MEV-Boost blocks had a profit of <0.05 ETH, 70% had <0.10 ETH, and 90% <0.24 ETH. We see this in the builder data, as even the profitable ones like builder0x69 and beaverbuild have a median profit per block of 0 or negative, but their average profit skews higher due to outlier opportunities. Winning these large MEV blocks is key to a builder’s success. The rest of the time, they are mostly breaking even or losing money.

Interestingly, builder0x69 subsidizes the majority of their blocks but still makes a profit overall. Subsidized blocks are builders increasing the bid size by paying out of their own pocket. The subsidized blocks increase their inclusion rate, which in turn can increase their order flow (searchers like submitting to builders with high inclusion rates) and thus is able to offset the losses from subsidized blocks by generating a profit from a few high-value blocks.

The table below compares builder0x69 vs. beaverbuild over the 7-day period from Nov. 22nd-29th. Notice how a high percentage of 0x69’s blocks are subsidized while beaverbuild’s aren’t, while also building nearly 2x the number of blocks. This subsidy of 10 ETH paid off, as the 280 ETH profit more than made up for it, the majority of profit coming from two blocks: block 16067709 for a 76 ETH profit and block 16067699 for a 139 ETH profit.


You can look at subsidized blocks as a sort of operating or marketing expense. Lastly, note that the Flashbots builder does not make or lose money, they simply pass all ETH rewards to proposers and do not subsidize at all.

The builder market started out extremely concentrated with Flashbots, bloXroute, and a few others, but has diversified a bit more over time. The relay market, on the other hand, is still dominated by Flashbots, which is a concern given the relay’s censorship. As mentioned before, relays sit between builders and proposers. Builders just want to get their bids seen by as many proposers as possible, which means connecting to relays with lots of validators and a good track record of reporting bids. Proposers want relays which are connected to the most profitable builders and ones that deliver the most profitable blocks/pay them accurately. Being the MEV pioneer with a long track record, Flashbots fits the bill.

This has a feedback loop, and as such, the Flashbots relay generates higher median execution rewards vs. other relays; every builder and validator is financially incentivized to connect to it. Some promising new (non-censoring) relays include relayooor (built by builder0x69) and the two announced on Nov. 30th — Agnostic by Gnosis and the Ultra Sound Money relay. Notably, the Flashbots builder will be supporting both to bootstrap growth. While these blocks by Flashbots’ builder will still be censoring, validators will be incentivized to connect (and thus non-censoring builders as well).

As a note on the chart below — while Eden has higher execution rewards than Flashbots, it is not permissionless for builders to join (only their own builders may use it), and thus has a lower inclusion rate (number of blocks).

As a consequence to this Flashbots dominance, since most MEV-Boost transactions (63% of payloads) go through the Flashbots relay, there has been a consistent increase in censored blocks. If you overlay the MEV-Boost adoption chart from above, the base-layer censorship/OFAC-compliance rate (chart below) has tracked it pretty much 1 : 1.


There are solutions, though.

  • In the short-run, builders and proposers can connect to as many trustworthy relays as possible, specifically the ones that are non-censoring and permissionless for builders (i.e., allow any builder to join besides their own). Proposers can also utilize Flashbots’ “min-bid” threshold in MEV-Boost (to be discussed in the Flashbots section).
  • In the medium-run, with enshrined PBS, there will be no such thing as relays. Proposer-builder separation will be built directly into the Ethereum protocol. Validators will then be able to add crLists (censorship resistance lists) to force transaction inclusion from builders. Note that the risk of censorship is not 100% removed here, especially if we end up with a builder oligopoly.
  • In the long-run, a truly decentralized builder network that has not only many builders, but builders who engage in a collaborative process and work together, each building partial blocks to combine into one (to be discussed in the Flashbots section).

There’s reason to believe the OFAC-compliant percentage has peaked. The last few weeks seem to suggest this, as both the Flashbots relay dominance and OFAC-censorship rate have been decreasing. Still, pressure will need to remain to keep this trend going in the right direction.

To further illustrate what this censorship looks like, has a great visual that tracks which relays process blocks that include Tornado Cash transactions.


Since running an ETH validator is expensive (32 ETH) and there’s no in-protocol delegation, it has inevitably led to centralized (and hybrid centralized/decentralized in the case of Lido) operators controlling a large amount of the ETH stake. Many of these are regulated, centralized US entities and have high censorship rates, with some censoring all blocks as they are not comfortable taking any legal risk at all. While many argue for base-layer neutrality, actions speak louder than words, and pressure will need to be put on these entities to connect to non-censoring relays.

For now, ~72% of all blocks are OFAC-compliant. This doesn’t mean censored transactions won’t go through, but they will do so with a delay. With a 72% censorship rate, a 50% inclusion probability for a censored transaction is ~36 seconds (3 blocks). At 99% compliance, this increases to >13 minutes.

There are two levels of censorship to be concerned with:

  • Weak Censorship: Censored transactions are delayed but still eventually land on-chain.
  • Strong Censorship: Validators not only do not propose blocks with OFAC transactions, but also ignore all blocks with OFAC transactions proposed by others. A majority of validators could in effect prevent these transactions from ever landing on-chain.

Today, we are mostly concerned with the weak form, as we’ve noted that validators do not believe they are legally required to actively censor. In the extreme scenario of strong censorship becoming a reality, Ethereum could end up slashing these validators through a user-activated soft fork, although this is a situation we would obviously like to avoid.

While PBS was a great first step to isolating MEV centralization to builders, there are still ongoing concerns with how the market is developing on Ethereum — the two most important concerns being censorship and builder centralization. So, what actions are being taken to combat these forces? Some recent announcements from Flashbots offer a path forward.

Flashbots: Solutions to Censorship and Builder Centralization

One of the tragic ironies with the ETH PoS design is that encouraging home staking actually made the protocol less censorship resistant. To take a step back, a brief history on how the MEV supply chain worked in Ethereum PoW: Miners would run MEV-Geth to get bundles from searchers and then combine these bundles with transactions from their local mempool to build out a block. Flashbots bundles would censor/not include OFAC transactions but miners could just include these censored transactions from their local mempool anyway. Searchers needed to trust miners to not steal their MEV, so Flashbots whitelisted a set of permissioned mining pools to participate, which could be done because there were only a few large ones.

With PoS and hundreds of thousands of validators, this is infeasible. Searchers would realistically only be able to trust large validators, so the home validators would be left completely out of the supply chain. To combat this, MEV-Boost implemented a commit-reveal scheme, requiring validators/proposers to sign and commit to a block before they see the block body (i.e., transactions). This removed the need for builders to trust validators, but came at a cost (in that a validator needed to commit to the entire block). This meant that they could not add censored transactions from their local mempool afterwards. The entire block was built either externally (MEV-Boost) or locally.

To combat this, Flashbots added an optional minimum bid threshold to the MEV-Boost client. Recall the Flashbots analysis mentioned above that showed 35% of MEV-Boost blocks had <0.05 ETH profit. Also remember that MEV rewards are lumpy, and a few outlier, high-MEV blocks make up the majority of rewards. If validators build blocks locally for low-profit blocks but outsource for high-MEV blocks, we can reduce the censorship rate at the base layer while at the same time not having validators forgo the opportunity cost of MEV. Using the recommended threshold of 0.05 ETH, if the top bid through MEV-Boost relays is <0.05 ETH, validators will build local, uncensored blocks. If the top bid is above, they outsource building to capture the rewards. It’s not perfect, but it’s a clever middle ground. According to Flashbots’ analysis, this could reduce the censorship rate from ~72% of blocks to ~47%.

The next (and more significant) announcement from Flashbots is their new appchain SUAVE. SUAVE’s main goal is to facilitate a competitive builder market — one where builders compete with bids on the open market and without exclusive PFOF agreements. Consider two different builder markets that play out:

  • Competitive: There are five builders. These builders have no exclusive order flow (EOF) but collude with each other to keep bids low (keep more profits for themselves). A new builder comes in and is able to outbid them easily while still making a profit. The five bidders could include this one in their inner circle, but now they all have to increase their bids a bit. Then, a new builder comes in and the cycle repeats. The end state is a diverse market competing on price and/or features.
  • Anti-Competitive: Same five builders, but they all have exclusive agreements for order flow that the new builder cannot access. No matter how good the new builder is, they are unable to compete with the incumbents, as the users who have agreements with the incumbents are not incentivized to give flow to a new builder with a low inclusion rate. The new builder cannot compete and eventually shuts down operations.

SUAVE’s goal is to keep the builder market as close to competitive as possible, otherwise these dominant builders will extract the majority of MEV profits. It’s likely that the builder market ends with a few dominant players. What is undetermined is how the profits are shared with users, searchers, and validators. What is also under-explored to this point is the user’s role in the MEV supply chain. There is no MEV without users and their intentions, so what if we could create a market where searchers and builders actually bid for user flow instead of merely extracting it?

This is part of the premise behind SUAVE, a standalone “plug-and-play” appchain that unbundles the mempool and builder role from existing blockchains. Instead of having separate searcher/builder infrastructure set up on many separate chains, it’s consolidated into one on SUAVE. Some benefits to this architecture are:

  • Builders on a single domain won’t be at a competitive disadvantage to those who operate on multiple domains.
  • It decentralizes the sequencing stack for blockchains.
  • Builders/searchers have open insight into user transactions and cross-chain MEV.
  • Users get better execution guarantees.

SUAVE has three main components:

  1. Universal Preference Environment: Surfaces and aggregates transactions from all users and searchers into one centralized, encrypted mempool.
  2. Optimal Execution Market: “Executors” listen to the SUAVE mempool and compete on giving users the best execution.
  3. Decentralized Block Building: Builders leverage the encrypted preferences from the network to compete and build partial or full blocks.


SUAVE will be a completely open mempool where users can sign not just transactions, but preferences as well. This is a similar concept to Anoma’s intent-centric design. For example, a user could sign a preference that says “execute this transaction on chain A but only if you can also execute this one on chain B, otherwise execute nothing.” SUAVE’s mempool is intended to surface as much of this type of information as possible and enable “executors” to compete in auctions to provide users the best execution, taking all user preferences and executing them via the optimal path.

Executors can compete by paying gas fees on behalf of users, kicking back some of the MEV their transactions/intents create, etc. For builders, they take these optimized execution paths uncovered by the preference environment (mempool) to build blocks across all domains. Not only will this enable a more open and decentralized builder market, but it has the opportunity to create a decentralized block builder in itself, with a variety of builders building partial blocks independently to combine them into one. To put it simply:

A utopian outcome is by no means guaranteed, and there are a lot of open questions surrounding SUAVE and, by extension, the trajectory of Ethereum’s MEV market.

  • How does SUAVE reach mass adoption?
  • Can it scale if it truly becomes the global mempool for all EVM chains?
  • What will happen to the MEV created on SUAVE itself?
  • Can we avoid a centralized and entrenched PFOF builder market?
  • Is a truly decentralized block builder feasible?
  • Will builders launch tokens to capitalize on their growth? Would this centralize the market further?
  • What about on the regulatory front, will there be more clarity around base-layer censorship?
  • How will things like threshold encryption, frequent batch auctions, and other mitigation techniques develop over time?

All of these and more are arguably the most pressing questions in crypto today, and the coming year will be the most transformative in Ethereum’s existence. But these dynamics are not unique to Ethereum, it’s just where the most economic activity is today and thus the most MEV to extract. On this front, the developing ecosystems of Solana and Cosmos will go through challenges of their own.

Jito: The Flashbots of Solana

When it comes to Solana MEV, Jito is the leader. The Jito-Solana validator is a fork of the Solana validator that allows bundles as a primitive. Jito solves two main problems for Solana:

  1. It facilitates an open market for MEV, optimally distributing profits to validators.
  2. It reduces spam and improves network efficiency.

The first one we don’t need to say much on. For the second, Solana has had a lot of issues with network congestion. Since Solana was designed with fixed fees (which they are changing), bots can spam the network with millions of transactions, which has at times caused it to halt. Part of the Jito suite is the relayer, which acts as an outsourced TPU unit, filtering transactions that come through and verifying them on a separate server. The block engine then connects searchers, relays, and validators as part of an off-chain auction, relaying the most profitable bundles to the leader (validator). Jito ran their validator for six months on mainnet before open sourcing it at the end of October.

This off-chain market reduces network congestion because instead of spamming the network, searchers can now send transactions with tips to Solana validators, something bots spamming the network cannot compete with. The more validators that run the Jito-Solana validator, the less successful these spam transactions will be, eventually ceasing operations. This spam has been a serious problem for Solana, as most of the spikes in the chart below (with >15 GB/s of network ingress) are from spam traffic. MEV on Solana has historically been just this, spam. By reducing the spam problem via creating a more efficient MEV market, you are not only able to more efficiently distribute profits, but aid in increasing Solana’s chain stability as well.

source: Certus One, Jito

Jito has essentially created an off-chain fee market for a network that was designed without one. If there’s one thing we know, it’s that you cannot avoid the natural forces of markets. Whether it’s Ethereum not having in-protocol delegation (which arguably led to Lido and centralized exchanges taking a larger share than they naturally would have), or Solana having fixed fees (which led to spam, network halts, and an off-chain fee market), markets will always find a way.

While not at the same level as Ethereum due to less overall economic activity, there has been a developing MEV economy on Solana. The timing of open sourcing the Jito validator at the end of October and launching JitoSOL (their liquid staking token) was prescient, although for unfortunate reasons. Over 70% of Jito’s tracked arbitrage volume came in November, as the increased adoption of their validator coincided with the FTX implosion.


Also seeing adoption during this time was Solana’s “fee with bump” transaction. This was a new transaction type created due to the congestion/spam issues that plagued the network, allowing users to increase their transaction fees over the fixed standard. While adoption was low for a few months, usage spiked in November, reaching >35% of fees paid on Solana. Fee with bump is essentially a priority gas auction (PGA)-type mechanism, an unsophisticated form of MEV extraction.

Looking at the top arbs, six of the top ten occurred in November, but four were actually before the FTX implosion. This timing was just a coincidence with Jito open sourcing their validator, however, as we had the FOMC on Nov. 2nd and Solana’s Breakpoint on Nov. 5th, both being events that naturally increased volatility. The largest arbs were still after the implosion, which was to be expected as extreme market events widened spreads and created significantly imbalanced pools, opening up arbitrage opportunities in the process.

In addition to the validator, Jito launched their own liquid staking token. If you want a deeper dive into Solana’s liquid staking market, we wrote a piece in April and, aside from the entrance of Jito, the competitive landscape hasn’t changed much. Jito’s token differs from the others in that all of the validators they delegate to run the Jito validator. This has the potential to give them a higher APY (Jito estimates ~20bps) vs. some of the larger incumbents, although there’s currently little MEV revenue right now as they bootstrap their validator (chicken & egg with getting searchers and validators to join). They also suffer from a lack of liquidity and DeFi integrations, part of this being that Jito doesn’t have a live governance token like MNDE or LDO to incentivize usage (although there is always a “future airdrop” option embedded in protocols without a token). In the long-run, all Solana validators will be running an MEV-optimized validator like Jito’s, so other liquid staking protocols can delegate to capture MEV as well. Jito is differentiated today because using it is a requirement for the JitoSOL validators they delegate to.

Note: The chart and above paragraph were edited post-publication on 12/18

Jito open sourced their validator at the best and worst time. It was good to have more validators running Jito during the FTX implosion, but liquidity on Solana has dried up after the fact. As Alameda was routinely >50% of the daily on-chain market-making volume, it will take some time to build back up. Community initiatives like the Serum fork OpenBook are encouraging long-term signs, and more base-layer upgrades like localized fee markets and QUIC will hopefully help improve network stability. MEV on Solana is still in its infancy, but if the Solana monolithic vision comes to fruition, there will be a massive economy with its own unique challenges to solve in the future.

Into the Interchain with Cosmos MEV

As it stands today, there is no real MEV within the Cosmos ecosystem. Almost all of it resides on Osmosis in the form of priority gas auctions (PGAs), and estimates have it at less than $7M to date and <$100k/month since the Terra implosion. PGAs are just competing for MEV by bidding up the highest gas price to validators. It’s the most basic, unsophisticated form of MEV, and how MEV first started on Ethereum. However, the Cosmos ecosystem is expected to go through a significant growth phase over the next two years, with chains like dYdX, Sei, Injective, Osmosis, Duality, Neutron, and more all increasing the amount of economic activity in the ecosystem along with the launch of native USDC.

Also, as an ecosystem comprised predominantly of appchains, there are two main differences between MEV in Cosmos and other ecosystems. First, appchains can theoretically internalize MEV. This means that token holders/stakers of these appchains can accrue MEV directly to themselves instead of leaking to another token (e.g., MEV on Uniswap does not go to UNI). Second, Cosmos opens up a relatively under-explored domain: Interchain MEV. While cross-chain “non-atomic” MEV exists in other ecosystems, it will naturally be higher in Cosmos due to a higher number of interconnected chains and interchain activity. One stakeholder flying under the radar in Interchain MEV is relayers, a role that has historically been a public good (i.e., operate at a loss) but is in position to extract a lot of Interchain MEV in the future.

Of course, appchains can still have off-chain markets develop where validators bypass internalizing MEV and share none with stakers. Some Cosmos chains have taken to governance/social coordination to try and prevent these off-chain markets from developing.

  • Osmosis has proposed slashing validators who engage in off-chain MEV extraction while they work on their own internal solutions like threshold decryption, joint block proposals, batching, and more.
  • Juno has made sandwich attacks a slashable offense and coded a minimum (10%) and maximum (75%) amount of MEV rewards that validators can earn.

In the case of Juno, making sandwiching effectively illegal is quite an aggressive (and arguably ineffective) stance, as it’s possible that sandwiching can actually improve social welfare anyway. But this highlights the uniqueness of sovereign chains, showing an angle of control/pressure on validators that you can’t have with monolithic chains. However, it’s possible these social slashing strategies just turn into witch hunts and do not end up being particularly effective.

Most Cosmos chains are developing/testing their own internal solutions to mitigate MEV, like Osmosis’ threshold decryption and Sei’s frequent batch auctions, but there are projects working in the Cosmos MEV space specifically that we want to highlight here.


Skip develops on-chain and off-chain MEV products for Cosmos communities, with the goal of shifting the distribution of MEV to validators and stakers. They received a grant from Osmosis to capture and shift on-chain arbitrage revenue from bots/searchers to Osmosis validators, stakers, and the DAO. This module gives the protocol the ability to complete arbitrages against itself. Instead of relying on searchers to rebalance pools, the protocol will do it automatically and distribute profits to the community.

They’ve also created software that chains like Evmos and Juno have adopted, allowing validators and searchers to run Skip and participate in off-chain auctions. They’ve created a dashboard for all chains they operate on where you can see which validators run Skip and the percentage of MEV profits they share with their delegators.


Mekatek is a competitor to Skip, the main difference between the two being their philosophies around MEV. Skip believes that “bad” MEV should be prevented, whereas Mekatek makes no such distinction (MEV isn’t bad or good, MEV simply…is). For example, Skip does not have front-running or sandwich-type bundles, whereas Mekatek puts no such restrictions. Mekatek focuses purely on off-chain marketplaces, their first product Zenith being a centralized single-chain block market, similar to Ethereum’s PBS in that it outsources the builder role from the validator to a competitive builder layer. In the long-run, they aim to move to a fully decentralized market called Pulzaar, although not much is known at this time. Mekatek is currently live on Osmosis, Juno, and Evmos.


DFlow is a standalone Cosmos appchain. However, unlike the two protocols above, it is not exclusively focused on the Cosmos market. In fact, the first blockchain it will service is Solana, with EVM chains, Cosmos, Sui, Aptos, and others to come later. DFlow is an order flow market that aims to segregate non-toxic order flow (retail) from toxic order flow (institutional takers), giving institutional makers the ability to pay a premium for the non-toxic flow (similar to PFOF).

By having an open and permissionless order flow market, DFlow prevents private order flow deals (which lead to centralization) and helps redistribute profits from MEV. This leads to better execution at a lower cost for retail traders. DFlow is similar to SUAVE.


Having received funding from prop 72, FairBlock is an upcoming Cosmos Hub (ATOM) consumer chain focusing on “bad” MEV prevention with their distributed identity-based encryption (IDE) scheme. IDE aims to prevent front-running with minimal bandwidth overhead. Their consumer chain, named “FairyRing,” will allow users to send encrypted transactions, giving them pre-transaction privacy because transactions aren’t decrypted until after ordering is finalized. Besides mitigating “bad” MEV, it will enable other features like sealed auctions/voting, private governance, NFT minting, time-locked encryption, and more.

Longer-Term: Interchain Scheduler

Lastly, we should mention the Interchain Scheduler, a promising idea from the Cosmos Hub that is likely still a few years away. Focusing on consumer chains, the Interchain Scheduler will be a blockspace futures market. You can read more about it in our ATOM 2.0 report.

Wait, It’s All MEV?

MEV started out as a niche idea on Ethereum, but has more recently taken center stage and become one of the most critical problems for blockchains to solve. At a high level, blockchains create economic activity and thus MEV — this will be the main value-accrual driver for every chain, just sliced in different ways. As an aside, for an inside look at an MEV operation, we recommend this piece recently published from the former top MEV operator on Avalanche.

MEV will always be inherent to blockchains, it’s just the distribution that is undecided.

Futuristic Ideas

We have now done a complete overview of the current state of the space and what to expect next year. Before we conclude, we would like to share some futuristic (and potentially unrealistic) projects under development that we’d love to see actually materialize in a significant way.

Saga: The current crypto UX is tailored towards desktop users. Whether it’s opening a browser wallet extension like MetaMask or Phantom, signing with a USB hardware wallet like Trezor or Ledger, or trading NFTs on OpenSea or Magic Eden, they’re all optimized for a desktop experience. But most users are mobile-first, a trend that will only continue (and at an increasing rate). Saga fills this void, a crypto-first Android phone specifically tailored to crypto/Web3.

On the hardware side, the Solana phone utilizes an isolated secure element called the seed vault, where users can safely generate seeds and private keys in isolation from the rest of the phone. On the software side, Saga will have native dApps, allowing users to trade NFTs, swap on a DEX, etc., all without using a browser extension. The most important part of the Solana mobile stack is the dApp store, a Web3-friendly store that takes a 0% fee cut and allows for an easy integration process for crypto developers. One of the most glaring flaws in crypto today is the reliance on Web2 incumbents. A clear example of this is the Apple App Store’s recent blocking of a Coinbase wallet upgrade, claiming that Ethereum gas fees needed to be paid through their in-app purchase system so they could take a 30% cut (yes, Apple believes it is entitled to extract gas fees on Ethereum). It’s clear that crypto needs to rebuild the entire stack natively and break free of these Web2 incumbents, and Saga offers the best shot yet. The devkit is launching on Dec. 15th and submissions to the dApp store are opening in January. The phone is expected to launch to the public in Q1.

CoFi/Informal: Money is the killer app of blockchains. CoFi stands for Collaborative Finance. In our context, it’s about using blockchains to create a better form of money, but not in the ways we’ve seen so far. 

CoFi intends to create liquidity savings by identifying closed loops in how money circulates in an economy. Here is a simple example to conceptualize what we mean: If Alice owes $100 to Bob, Bob owes $100 to Charlie, and Charlie owes $100 to Alice, no one actually needs to have $100 of liquidity. They just have to understand the fact that their obligations form a closed loop so they can clear them against one another without needing liquidity. Similarly, financial obligations for businesses (i.e., invoices) form loops in the real economy, and can in theory be separated from each other to save liquidity. Indeed, this is how banks clear their obligations to each other in the banking system, and there are many examples where similar techniques are used in certain economies. 

Informal is the Cosmos project that wants to scale liquidity-saving techniques using blockchains. The leadership team, which includes Ethan (a founding figure of Tendermint/Cosmos), has conducted deep research in the field. Informal will be one of the consumer chains on the Cosmos Hub starting as early as Q1 2023.


2022 wasn’t the best year for the industry, with the negative externalities of MEV, bridge exploits, and the FTX collapse taking center stage. On the flip side, tremendous progress is being made across all the major fronts of infrastructure: UX, scalability, interoperability, privacy, and censorship resistance. Crypto infrastructure today is not yet ready to handle mass adoption, but it’s getting there, and 2023 will be a monumental year.

2020 was DeFi, 2021 was NFTs, and 2022 was a reality check. We believe 2023 will be a year to get back to our roots, with a renewed focus on the infrastructure layer. How else will we scale crypto to billions?


Gaming Year Ahead

By Piers Kicks and Joseph Lloyd


As the dust settles on a turbulent year for the industry at large, we’re provided with a great opportunity to reflect on the state of play in the Web3 gaming space. Gaming was a primary driver of the 2021 mania, yet it has given way to cold realism as we move into the trough of disillusionment. All innovations must embark on this quest through the hype cycle. Both the depth and duration of that trough remain to be seen, though this year has forced a sober mind and fresh perspective.

By now, it is clear that the earn-centricity of play-to-earn titles is not conducive to long-term sustainability and ultimately leads to speculative fervor that is harmful to the ecosystems in question. That said, these early games and models have played a vital role in bootstrapping interest from the mainstream and have driven a massive talent influx to the sector. As we addressed in our mid-year The Future of (Crypto) Gaming report, we don’t believe that the earning component of these games is fundamentally flawed, rather that there is a need for a dramatic recalibration in terms of its relative prominence in games.

By early 2022, over 50% of all deals funded in crypto were gaming-related. A total of $3.6B was deployed in 2021, a figure which was marginally eclipsed this year. Despite private and public markets appearing lackluster, we are strongly encouraged by the quality of developers moving into this sector.

We believe that the fusion of conventional game wisdom with hard-learned insights from the early cycle are laying a robust foundation for the years ahead. A key observation we believe many have still failed to grasp is that the feedback loops in game development are significantly longer than in other sectors of crypto.

In a market that moves at warp speed, it’s easy to demand too much too soon. We believe that most projects shouldn’t have live tokens in the market until the bulk of their core game loops are established, which can immunize them against speculation and inflated expectations.

This report will cover several key themes we believe deserve the spotlight, some standout events from the year, emerging models that we’re watching for the year ahead, and finally, some concluding thoughts tying all of these topics together.



Quality of content is the ultimate driver of onboarding users, but the underlying infrastructure plays a critical role in the creation of better games and experiences. For Web3 games to reach their true potential, they must deliver experiences as seamlessly as gamers have grown used to. After all, the bulk of the player growth for this sector has to be exogenous, as only a minuscule fraction of the world’s 3B gamers have even interacted with a Web3 game.

Ethereum’s scaling limitations. For years, Ethereum has been home to the largest number of developers and projects, making it the most popular ecosystem of choice. However, it was not designed for gaming applications. Since CryptoKitties caused issues for Ethereum in late 2017, teams have been looking for more scalable alternatives, which birthed several specialized infrastructure providers such as Immutable and Flow. In more recent times, we’ve seen these problems resurface with massive fee spikes at the base layer. We built a conceptual framework for thinking through a number of these trade-offs for scaling NFTs and games in an earlier report.

As a result, the demand for scalability solutions to combat the limitations brought forth by monolithic chains, such as Ethereum, continues to increase. In particular, EVM-compatible sidechains and layer 2 solutions present a way for developers to gain access to Ethereum’s robust ecosystem without the need to compete for blockspace at the base layer. While it’s possible to pull on-chain activity from existing live projects, there are very few games with significant numbers or consistent reporting. As such, we believe funding to be a better forward-looking indicator of ecosystem prevalence. It’s important to note that this data is drawn from The Block as well as various announcements, and many teams are launching on multiple ecosystems or have not yet publicly made an ecosystem choice (marked as TBD).

As we can see, the bulk of blockchain-gaming funding has skewed towards EVM-compatible ecosystems. This supports our earlier thesis of projects wanting to maintain proximity to the massive liquidity and security at the base layer. 2022 started where the preceding year left off, with “grant wars” between different platforms trying to attract great talent. As the market has cooled down broadly, much of this activity has slowed down. A particularly noteworthy event in this context was Immutable’s GameStop grant, which appeared to have no vesting conditions and was dumped instantly. Fortunately, since this occurrence, Immutable has nailed a much more milestones-based grant program as well as rolling out a $500M ecosystem fund. Polygon and Immutable are the undisputed champions of Ethereum gaming, and we hope to see less “PvP” dynamics on the grant/funding side and more collaboration moving forward.

While Polygon faced criticism in the past around the robustness of their technology, relying on a proof-of-stake sidechain that has at times frustrated developers, they have made significant progress towards becoming a true L2. In particular, they continue to advance their zkEVM and Plonky2 offerings after committing $1B to zk-rollups last year.

Monolithic vs. modular architecture. Another approach to more generalized scalability solutions is modular frameworks such as Polygon’s supernets and Avalanche’s subnets. While this technology is less mature, it offers projects the ability to more neatly roll their infrastructure stack and wield greater control over the user experience without having to build it from the ground up. One of the trade-offs inherent in the modular approach is composability, but that’s often not critical in gaming, where most of the activity occurs within its own ecosystem. We believe that this design space is still relatively unexplored in gaming, though it holds great potential as a long-term scalability candidate. We continue to monitor Celestia as an interesting project leading this space.

With the fallout from Terra and FTX affecting a number of games, we expect further ecosystem consolidation in the coming year. While we have already seen projects such as Derby Stars migrate from Terra to Polygon following the collapse, the dust still needs to settle as it relates to FTX and Solana. A number of teams were unfortunately exposed directly to FTX, providing an opportunity for ecosystems to try and engage distressed projects. It’s important to note that the Solana builder community has shown significant resilience in the face of a massive system shock, and its flourishing NFT ecosystem is still second only to Ethereum for 30-day volume. We hope this is a sign that the many talented gaming teams building there will follow suit in building a vibrant gaming ecosystem.

The First Wave of Blockchain Games

Since the start of the year, the top 10 blockchain-gaming projects by market cap have fallen by up to 95%. A common contributing factor was the inability of first-generation blockchain games to maintain a sustainable in-game economy and player base, though obviously broader market forces dragged everything down too. While a number of key learnings have been drawn relating to managing open game economies, as with all tokenomics, it is very difficult to apply changes retroactively. As such, we encourage greater reservations around releasing in-game tokens until games have progressed much further through development moving forwards.

The rise and fall of Axie Infinity. It would be remiss not to touch upon the game that drew mainstream attention to Web3 games. Axie Infinity’s daily active users (DAUs) hit all-time highs in November 2021 and have been on the decline ever since, marking the end of its reign as the most-used blockchain application in the world. Many are quick to forget just how staggering its growth was, where for a period, the game was generating more fees than both Bitcoin and Ethereum combined. It ultimately became clear that for the bulk of the player base, the profit motive was dominant. Due to the not-yet-existing requisite game loops to offset the substantial inflation happening in the economy, profits dwindled, and players followed suit.

The NFT-holder count has not seen positive growth since January, dropping 30% YTD. The number of unique daily wallets interacting with the on-chain elements of the game has fallen more than 95%, and transactions are down almost 70% from the highs seen at the start of the year.

While it has certainly been a difficult ride for Axie Infinity, the breadth of the Sky Mavis ecosystem has increased substantially. Despite suffering significant setbacks, such as the Ronin exploit that we touch on later in this report, the team has a lot going for them with the launch of Axie Origins as well as inviting third-party development into their ecosystem. Only time will tell if 2023 is the year that Axie Infinity is able to make a comeback.

The sudden surprise of STEPN. While token prices for all of the top 10 gaming coins by market cap were down 40% or more since the start of the year, the price of STEPN’s GMT token spiked. Despite releasing an open beta in late 2021, it wasn’t until March 2022 that the casual move-to-earn mobile game that encouraged users to live an active lifestyle saw significant growth.

Between March and April, GMT increased in price by over 2,600%. On Mar. 30th, its trading volume surpassed that of BTC and ETH, and the game itself had a self-reported 2.3M MAU. As overall interest in games like Axie Infinity declined, STEPN captured people’s attention and onboarded many into Web3 for the first time.

Unfortunately, this exponential increase in users quickly illuminated underlying flaws in the in-game economy. By releasing on-chain game assets into the economy before thorough testing, the team became somewhat restricted as the player base swelled and became dominated by the profit motive. As we predicted in our earlier report on the project, token emissions, in the form of in-game rewards, continued to increase and rapid token inflation incurred. Since the beginning of May, token prices have subsequently dropped as much as 94%.

The team has since gone on to develop a first-party anti-cheat system to combat bad actors, as well as introduce a number of new mechanics to limit token generation. STEPN did well to demonstrate the potential demand for Web3 games from a broader audience outside of traditional gamers. As the focus of the game moves away from earning and back to the original goal of encouraging users to live a healthy, active lifestyle, we will have to wait and see if they are able to replicate some of their earlier success.

A new approach from Sorare. A project that garnered a lot of attention in late 2021 after a colossal $680M raise was Sorare. Unfortunately, they too struggled to immunize themselves from the broader forces of the market. Floor prices for their in-game assets have dropped as much as 90% since January.

Regardless, the team has implemented many quality-of-life improvements in order to improve the user experience and partnered with the NBA and MLB to expand its offerings. The result is a reported total of 1.8M registered users as of May (up from 1.5M in March).

The combination of low barriers to entry, reduced friction, and a cohesive platform experience attracted a range of player types and, as illustrated in the chart below, users had the propensity to inject more value than was taken out.

Unfortunately, daily unique wallet transactions to the project’s L2 bridge suggest a small active Web3 user base. However, this still represents a 10x compared to third-party marketplace volume, demonstrating how Sorare has done well to take ownership of the trading of their NFT assets. In light of the recent move away from royalty enforcement on many external marketplaces, we expect other projects to implement similar strategies in order to retain secondary revenue streams.

Many critics choose to focus on dual vs. single token economies, and suggest that either can be a strong influence on the drop in price we’ve observed in some of the games mentioned. In our view, it’s not as simple or binary as that. It ultimately doesn’t matter how many on-chain or off-chain tokens a game has, but rather the dynamics between them and the players. Implementing sufficient economic levers early and allowing for a buffering period to make adjustments will result in more sustainable loops over time. We elaborated on this in our Future of (Crypto) Gaming report earlier this year.

There are less than 700 reported blockchain games as of November 2022 (143 of which have announced receiving >$1M in funding). The market downturn will undoubtedly place strain on many of these teams, and it’s unlikely that all of them will make it to launch. It is important to reiterate that game development usually happens on multi-year timelines, and diminished downstream financing prospects could place projects that failed to raise sufficient runway in the bull market at risk.

Doom and gloom aside, there are a number of well-funded projects we expect to launch sometime in 2023 that are already well into their development cycles. This next generation of blockchain games will be instructive, and monitoring the reception of these more polished titles should give us a real pulse check on the appetite from mainstream gamers.

Web3 Gaming Guilds

The rise of play-to-earn drove an explosion of activity around gaming guilds that sought to industrialize activities around these economies by equipping scholars with assets. Early entrants profited handsomely by onboarding underserved communities that benefited from supplementary income amidst a global pandemic. However, as in-game profits fell, so did the demand for NFT scholarships. As we highlighted in our in-depth update on the current state of guilds, token prices have continued to fall throughout the year, and we are witnessing a number of pivots to try to ensure their continued survival.

What’s left in the war chest. The majority of guild funding rounds were completed at the height of the P2E craze in Q4 2021-Q1 2022. The timing of these raises proved extremely important, especially for those conducting a public token sale. GuildFi, for example, was able to raise $140M in just 72 hours late last year.

As treasuries grew, so did the number of blockchain-gaming investments. The aligned incentives shared between guilds and early-stage gaming projects proved to be a popular relationship model, with most privately funded games having at least one guild on their cap table.

However, as market sentiment worsened and prices fell, the size of funds sitting in war chests shrunk considerably. Many of the early-stage investments made by guilds were for in-game assets in first-generation P2E games. As demand for these assets fell, guilds have had to reevaluate where to best allocate their remaining funds. Furthermore, it’s unclear how exactly value accrues to the guild master tokens in many cases.

The value of community. An important aspect of any guild is its community. Aside from their investment capabilities, a guild’s perceived value is heavily correlated to the size and quality of the participating members within.

While being wary of bot activity, guilds with healthy social metrics have shown how they can help to bootstrap an initial player base. As of Q3 2022, GuildFi has onboarded roughly 80,000 people into their partner communities, 15,000 of whom have actively participated in the games. Yield Guild Games states that out of their more than 20,000 scholars, 80% participate in at least one game outside of Axie Infinity.

The original purpose of guilds was to act as an invested partner that created and strengthened bridges between players and content. To this effect, we have seen guilds start to expand into esports, game testing, game curation, and discoverability, further driving value back to partners. However, there have been few standout examples of this in practice.

As we alluded to in our report earlier this year, we believe that guilds existing solely to coordinate resource extraction in games are likely to face significant struggles. As we move into the new year, the dynamics between guilds and their communities will likely change. Divergence into new business models will become a necessity, and the ability to leverage an engaged user base will provide a competitive advantage.

A forward look at the original promise: user acquisition. The market downturn has illustrated the risks involved in using a scholarship model as the sole revenue stream for Web3 guilds. Furthermore, early-stage investments and first-party infrastructure take time to yield returns, and it is often difficult to drive value to the guild token. We expect that in the near-term, guilds are going to have to revise their core value propositions and seek new ways to differentiate.

Virtual Worlds

The metaverse hype train was significant, with estimates of virtual real estate becoming a multi-trillion industry by 2030, headline-grabbing funding rounds, and Meta (formerly Facebook) committing $10B to metaverse developments. The momentum continued well into this year, with investors sinking over $120B into “metaverse-related” projects in H1 2022, more than double the amount raised in 2021.

The narrative of a Ready Player One future undoubtedly had a significant effect on Web3 markets. Investor confidence was at an all-time high, so both prices and volume began to pump. The total land market cap (excluding fungible tokens) across two of the largest projects, The Sandbox (TSB) and Decentraland (DCL), reached $1.2B in November 2021. The average land price hit $18k in January 2022, and by May, the cumulative secondary sales volume for digital land NFTs had reached almost $2B.

However, there was little substance to justify these metrics, and it wasn’t long before bloated valuations and the negative external market outlook led to some severe corrections. Comparing metrics across the top-performing NFT land projects shows that floor prices have dropped as much as 99% since January, with volume down 77%.

Despite this fall from grace being compounded by a looming economic recession and crashing crypto market, a more pressing issue is the lack of active players, which reportedly only peaked between 200k and 600k MAU across the top competitors.

It is essential to put things into perspective. As we highlighted in our September deep dive into TSB (updated in the table above), there is still an evident disconnect between valuations and active users compared to the Web2 competition.

Despite the total combined land market cap for DCL, TSB, and Otherdeed for Otherside (OTH) shrinking by 71%, the valuation per user for TSB and DCL is still 53 and 176 times higher than Roblox’s, respectively. Considered through this lens, one might argue these projects are still overvalued, although the monetization model is, of course, different.

In the short term, there is only one thing teams can do to reignite stakeholder confidence; build experiences to drive UA. TSB is well positioned in this regard. Despite still being in alpha, with the majority of experiences only available during limited-time events, they continue to work on growing the number of external partnerships. With more than 20 partner projects being announced in the second half of 2022, success will ultimately depend on how long it takes for new experiences to be developed and how fun they end up being.

If these projects can rise from the ashes and increase the active player base to a more competitive level (take Second Life’s average ~100k DAU as a benchmark), then we expect location to remain king. Those who have invested in plots adjacent to the most popular experiences will be in line to capture the most upside due to an overflow of foot traffic, leading to more exposure and higher demand.

Standout Events of the Year

Ronin Hack

In March of 2022, a hacker group was able to exploit the bridge to Sky Mavis’ sidechain Ronin. Developed initially as a scalability solution for Axie Infinity with plans to accommodate third-party titles over time, Ronin was processing 15% of all NFT volume shortly after its launch, more than all scaling solutions combined. However, Ronin quickly became a painful reminder of just how difficult building and maintaining core blockchain infrastructure can be.

Ultimately, in designing this EVM-compatible chain, the team had made certain trade-offs that exposed vulnerabilities. The hackers were able to forge a withdrawal signature after getting control over 5 of Ronin’s 9 validator nodes, a small validator set that “made it much easier to compromise the network,” the team wrote. In total, the attackers were able to obtain 173,600 ETH and 25.5M USDC, worth approximately $625M at the time, making this the largest exploit in crypto history.

Researchers from Elliptic and Chainalysis later attributed the attack to North Korea’s Lazarus group. While action was taken to halt all activity on the bridge as well as the Katana DEX, the damage was already done. Since then, Sky Mavis has expanded the validator set, conducted several security audits, and raised $150M to make affected players whole.

These events were certainly shocking, and it’s difficult to imagine anything of this scale occurring in the traditional gaming space. That said, there is a price to progress and experimentation, and the fact that the project survived this is a testament to both the team and the community. It’s not every day that a project can take such a large hit and live to tell the tale.

By now, it’s abundantly clear that trusted bridge setups are a point of vulnerability across all sectors of crypto. While there has long existed a temptation to build custom infrastructure in the blockchain-gaming space (see Dapper with Flow, Immutable with its rollup, Sky Mavis with Ronin, etc.), there are now several mature tech providers in the market. In addition, abstraction layers such as Stardust exist to make it even easier to interface with them. Developers should think very carefully about whether this is really an avenue they want to pursue. For the average developer, one of the existing options on the market may well suffice.

Looming Regulations

Unfortunately for operators in the space, guidelines on the regulatory side of blockchain gaming remain unclear. However, some standout cases in 2022 illustrate that US regulatory bodies are actively investigating areas outside of DeFi.

While not explicitly gaming-focused, one of the more prominent cases that caught our attention involves Yuga Labs, which is currently under private investigation by the US Securities and Exchange Commission (SEC). The probe aims to determine whether the NFTs and ApeCoin token, the official medium of exchange that will power Yuga’s ecosystem (and future gaming endeavors), issued by Yuga should be classified as securities.

Although the SEC has yet to release a comment or escalate this case to litigation, it does illuminate the agency’s efforts to make a start on regulating NFTs. An interesting point is that the SEC has historically pursued low-hanging fruit first. Projects blatantly advertising their assets or services as investment vehicles are easier to chase, but few would provide as much publicity as Yuga Labs. So, what would it mean for blockchain gaming if the SEC doubled down and widened its net?

The short answer is that it depends. The projects that face the most risk are those that have designed their blockchain assets around profit generation. If the assets gain in value as the company grows, these could be defined as securities and treated as such. This would mean that releasing an NFT collection would be subject to very cumbersome legal work that is not feasible for most startups.

On the other hand, games that sell NFTs as in-app purchases, or those emphasizing utility surrounding community accessibility or in-game content, may be able to sidestep scrutiny for the time being. A free mint also represents an interesting possibility to avoid regulations, provided owners are not promised any false sense of profitability over time. None of the above, however, addresses the potential issues surrounding in-game fungible tokens, especially those that provide value in the form of governance voting rights or revenue distribution.

There was a lot of fuss made over the Yuga Labs story, but the reality is that this may not amount to anything more than a publicity stunt as the SEC marks its territory. That being said, it certainly caused some rightful concern, and teams would do well to err on the side of caution with the inevitable arrival of stricter regulation.

Some general best practices for teams to avoid the gaze of the SEC and other regulatory bodies will be to avoid promises of value accrual, performance, or potential returns for on-chain assets. How this will impact the dynamics between projects and their stakeholders is yet to be determined.

Ownership and custodial empowerment are some of the core tenets of Web3, and bending the knee could very well upset many stakeholders. However, groups such as the Blockchain Game Alliance, Game7, and the Mythos Foundation are trying to bridge the gap and work with regulators to create a safe and prosperous blockchain-gaming industry for all participants. Unfortunately, as is the case with much of crypto, the playbook is not yet written.

New Rulings

The widespread adoption of blockchain gaming will be influenced significantly by the incumbent gaming giants who have significant sway over the industry. Following Valve’s move to ban the use of blockchain technology within games listed on Steam, most firms have remained neutral as they quietly observe ongoing developments. However, there have been some notable rulings from some of the most prominent players.

Minecraft and GTA follow in Steam’s footsteps. In July 2022, Mojang, the Microsoft subsidiary that developed Minecraft, picked a side when it released a statement banning the use of NFTs within its servers. In November, Rockstar followed suit by implementing similar regulations.

Mojang took the stance that the introduction of assets built upon a value proposition of scarcity goes against values relating to “creative inclusion and playing together.” They went on to note concerns that the wild west nature of Web3 and overinflated prices of some NFT collections could put their (relatively young) player base at risk of being taken advantage of.

At a high level, it appears that Microsoft wishes to protect itself in the short-term but will continue researching the potential of blockchain technology. This becomes more apparent when noting that the firm has made several investments in Web3-related companies (Consensys, Space and Time (M12), and WeMade).

Regardless, statements like these illustrate the associated risks of building a Web3 project on top of an existing Web2 ecosystem. NFT Worlds, for example, saw its NFT floor price crash 80% on the day of the news. No one can say how rulings will evolve over time, and those who are overly reliant on any one platform or piece of infrastructure will remain at the mercy of their overlords.

Epic and Apple take a different approach. After expressing skepticism around much of the practices surrounding blockchain gaming in 2021, Epic’s CEO Tim Sweeney has openly welcomed third-party blockchain developers onto the Epic Games Store (EGS). Mythos Games’ Web3 title Blankos Block Party launched on EGS earlier this year, with Grit (GALA Games) and Star Atlas, among others, joining in the coming years.

In more recent events, Apple updated its App Store guidelines and included notes on the role cryptocurrencies and NFTs will play within the ecosystem. The ruling confirms that apps can sell NFTs or services related to NFTs (minting, selling, trading, etc.) within the App Store through in-app purchases (IAPs), such that they can enforce their 30% fee.

Apple has been more explicit than Epic, stating that any features or functionality can only be unlocked via IAPs. Apps cannot provide external links or calls to action that take users to an external site to purchase content. Furthermore, externally purchased assets cannot unlock any additional content within the app.

To see the silver lining, we must first take a step back and look at the bigger picture. Although any developer looking to launch their game on the App Store will have to conform to Apple’s standards and cough up a significant portion of revenues, they can now feel confident that if they follow the rules, they will gain access to its 1B+ users.

Additionally, the industry as a whole stands to benefit from this update. The ability for users to publicly showcase their NFT collections will inevitably increase exposure. And as Apple sits back and observes, they will likely adapt these guidelines slowly. Although we cannot speculate on how this will evolve, the more people that know what an NFT is and are aware of the potential benefits of blockchain gaming, the better.

We expect the majority of incumbents to remain at a safe distance. We expect firms to implement positive blockchain-related rulings only when there is a clear competitive advantage to be had (i.e., Epic fighting Steam for market share or Apple widening its moat).

That being said, we will likely see more platforms choose to participate in 2023. Large platforms such as Facebook, Instagram, and Reddit are all incorporating NFTs in some form, further increasing adoption. As consumer sentiment towards NFTs improves, it would not be a surprise to see Google follow in Apple’s footsteps and implement similar guidelines in the near future — though sideloading already exists as a happy workaround to formal Play Store endorsement.

Furthermore, Epic is not the first gaming giant to dabble in Web3. Ubisoft is one of the more notable ones which is actively looking for the right time to try again after last year’s disappointing feedback. An increasing number of gaming studios and publishers are either investing in or experimenting with blockchain-native games (i.e., Square Enix, Homa Games, and LINE), and the testing of waters is likely to continue lest anyone be left behind.

Emerging Models

On-Chain Gaming

While this is an area of blockchain gaming whose TAM is still unclear and carries significant technical execution risk, it’s certainly one of the more fascinating areas of exploration. As with most new technologies, projects that are able to build natively to the medium, and take advantage of what it has to offer, are often the drivers of significant innovation. The on-chain gaming space is very much still in its infancy, but it is already forcing us to imagine new types of gameplay and experiences.

For now, it’s not obvious that these very technical games will have broad appeal beyond the intellectually curious, but the sector has attracted massive intellectual capital determined to bring fully autonomous worlds to life. Most people will have heard of on-chain games in the context of Dark Forest, which is a truly decentralized space exploration RTS game inspired by The Three Body Problem trilogy. As the pioneers of many of these concepts, we strongly recommend familiarizing yourself with the project.

We believe “strongly on-chain games” are very well-captured in gubsheep’s definition below:

  • The source of truth for game data is the blockchain. The blockchain is not just used as an auxiliary store of data, or a “mirror” of data stored in a proprietary server. All of the meaningful data is stored on the blockchain — not just asset ownership. This allows the game to fully utilize the benefits of programmable blockchain: a transparent data store that is permissionlessly interoperable.
  • The game logic and rules are implemented via smart contract. For example, combat in a game, and not just ownership, is all on-chain.
  • The game is developed in accordance with open ecosystem principles. The game contracts, and an accessible game client, are open-source. Third-party developers are empowered to customize or even fork their own gameplay experiences through plugins, third-party clients, interoperable smart contracts, and even total redeployment. This, in turn, allows game developers to harness the creative output of an entire (incentive-aligned) community.
  • The game is client-agnostic. This is closely related to the three above points, in that a litmus test for whether or not a game is crypto-native is: “If the core developer-provided client disappeared tomorrow, would the game still be playable?” The answer tends to be yes if (and only if) the game data is stored permissionlessly, the game logic can be executed permissionlessly, and the community can interact with the core smart contracts without relying on interfaces provided by a core team.
  • The game embraces real-world value digital assets. Blockchains provide a native API into the notion of value itself, and digital assets are by default interoperable with cryptocurrency. This allows game developers to build new, positive-sum incentive structures for their player and developer communities.

The notion of building autonomous worlds that reside fully on-chain and possess the ingredients to truly outlive their creators is very exciting, bordering on philosophical. In theory, if these models work, they can provide an unmatchable degree of assurance over the time, money, and energy that players invest into these worlds. Once again, there are significant technical hurdles to overcome, though we have been encouraged by the progress several talented teams are making already.

Some of the projects we are watching include:

Free-to-Own (F2O)

In August of this year, Gabe Leydon’s new studio, Limit Break, made headlines upon emerging from stealth by announcing a staggering $200M raise from a number of top-tier investors. The focus is on a new game launching via a model dubbed “free-to-own” that Gabe believes will replace free-to-play.

His approach involves the studio minting a genesis collection of NFTs. But rather than selling them, they are given away for free. In addition to the early community getting these assets for free, they are actually the means by which to produce more items as “factory NFTs.” This way, the assets that drive core economic activity are owned by the community.

For further alignment, a portion of these genesis NFTs is held by the studio itself, such that they are incentivized to drive enduring value to them. In Limit Break’s case, these initial factory NFTs manifested as DigiDaigakus, which are waifu characters. While details around the game are scarce, we know that each Digi periodically receives a spirit NFT which will eventually be used in the production of Heroes.

While many other blockchain-gaming projects have relied on these early mints as a source of revenue, that needn’t be the case for a company as well-funded as Limit Break. It’s important to note that other projects, such as Loot, have technically explored the free mint approach before. This time, though, it’s very much integral to the pitch, and is being used front-and-center in much of the marketing.

The reception of the game remains to be seen, though it seems that a F2O model could circumvent some of the issues we touched on earlier with the Yuga Labs case as well as the App Store rulings. If nothing is sold, it’s harder to be in violation of securities regulations or the taxing of 30% of primary sales, though only time will tell how this plays out in practice.

Critics have pointed out that much of this seems like an elaborate marketing gimmick given that there is an unavoidable degree of exclusivity that undermines how equitable the project can be. The assets were distributed to a small allowlist that some suggest included insiders. This exclusivity only further exacerbates speculation, which leaves later entrants to the community no better off than in a regular mint. Needless to say, the floor price of DigiDaigakus has risen substantially.

Clearly, this model is not applicable to all projects, as it demands more significant capital requirements that might be beyond the reach of smaller developers. It has certainly succeeded in drawing attention though. Limit Break will be a key project to watch heading into 2023, as Gabe has already suggested that the majority of their $200M will be spent on marketing — some of which is destined for a Super Bowl ad.

PlayFi and Improved Esports Monetization

One of the models we believe has great merit is PlayFi (as pioneered by NOR), which we touched on at length in our Future of (Crypto) Gaming report earlier this year. Essentially, the model looks to protect the core game loop by disallowing money to influence it whatsoever. As we have seen, if left untamed, money will usually trend towards the dominant motivator. Instead, PlayFi looks to monetize around the game through a series of metagames taking inspiration from the sports model, which has flourished across millennia.

In the gaming context, this could take the form of gambling, broadcasting/ticketing, and taking a share of tournament prize pools. While some of this may sound similar to certain modern esports, it’s our view that the Web3 infusion represents a significant step up. Ultimately, crypto is primarily going to serve as the backend accounting engine that facilitates ticketing, payments, player NFT contracts (on-chain reputation), automated tournament smart contracts, and so on.

We continue to be very excited about this model, and believe it may hold the ingredients to improve esports monetization broadly. What’s more, by doing away with crypto components entering the core game loop, platform restrictions and some of the other impediments alluded to earlier in the report can be averted. By having players themselves be represented as NFTs, we unlock a large surface area for sponsorship that was previously challenging to implement. While it’s still early, and NOR has much to prove, we anticipate these ideas having broad applicability across a number of competitive titles. Projects such as Stadium are also working on adjacent infrastructure.


This year has certainly been a challenging one for blockchain gaming, arguably more so than other sectors of Web3. With so much hype from the late bull cycle, it often feels like gaming has the most to prove. While things certainly look bleak on the surface, many of the greatest game designers in the world have succumbed to the allure of this new frontier.

Many gaming-industry participants that haven’t formally “defected” by leaving to start projects of their own are still positioning teams internally for participation. Beneath the surface, incumbents are tinkering and exploring, with many of the mobile publishers in particular assembling crypto-focused teams, having been further encouraged by the stagnation of mobile F2P. Apple’s App Tracking Transparency (ATT) policy that rolled out last year has changed the nature of the game for many, driving user acquisition costs through the roof and forcing teams to explore new monetization surface area. It’s our view that many of these companies are poised to act, equipped with deep experience and strong IP, waiting patiently to strike once consensus begins to form around the “next model.”

For the teams already building in the space, this year has rattled many of them and truly tested conviction. Unfortunately, many of this cohort of projects are likely to face stress in the coming year as concerns around downstream financing grow. Teams that had anticipated partial funding from early NFT mints, for example, might now find themselves up against a challenging retail and private funding environment.

In our view, 2023 is not destined to be the year that crypto gaming truly breaks into the mainstream. While we are eager to see how the market receives high-quality titles entering soft launches such as Sipher, EmberSword, and Illuvium, we fear that the hangover from much of the lunacy that took place in crypto this year will dampen consumer appetite in the near-term. The bulk of the AAA games that will more permanently change that are still heads down in their development cycle throughout the year ahead.

Furthermore, as we’ve alluded to, there remain significant headwinds in the form of distribution questions, regulatory uncertainty, and material UX frictions such as client-wallet interactions — although material improvements are constantly emerging. It’s certainly possible that we see another STEPN-like title explode into prominence, though we’re not certain the foundations are robust enough for enduring success yet.

There is, however, light in the dark. With ~$7B of funding in the last 24 months, and the massive talent capture that’s happened, we truly are entering the next chapter for Web3 games. While studios focus on executing their vision, most of the large game platforms are being forced to take a stance on crypto, which has by now demanded their attention. While the nitty-gritty of policy formation is worked through as incumbents position to try to capture value from this market, initiatives that are adjacent to gaming are making material headway.

As we touched on in our NFT Year Ahead report, large-scale mainstream consumer familiarity is being introduced as Meta rolls out NFTs on Instagram, Twitter deepens its crypto ties, and Reddit places a flag in the sand. It seems unlikely that this wave of interest from the titans of the web is for nothing, and we expect much more activity in the coming year from the big players. Polygon, in particular, has done tremendous work this year onboarding mainstream brands after attracting YouTube’s former Head of Gaming, Ryan Wyatt. We have long said that gaming and NFTs will be the trojan horse for global blockchain adoption, and for the first time, the tide does appear to be turning.


NFTs Year Ahead

By Teng Yan and Kevin Kelly, CFA

Current State of the NFT Market

It’s been a wild ride for NFTs.

When we map NFT trading volumes on OpenSea with Gartner’s Hype Cycle — which represents the maturity and adoption of new technologies in solving real business problems — we can infer that NFTs hit the peak of inflated expectations from late 2021 to early 2022.

Since then, transaction volume and attention have been down only. Cobie describes NFTs as just “altcoins with pictures.” We are in the trough of disillusionment. The only way forward is to build our way out, finding real-world use cases for the technology. Only then will we see mainstream adoption really take off.

I’m convinced we will get there. NFTs are inherently interesting to more people because they lie at the intersection of technology, art, culture, and entertainment. They have the power to be the trojan horse that onboards the next big wave of people into crypto.

Reality vs. Expectations

While it’s easy to get caught up in the future of what this space could look like, we must also recognize where things stand today. The reality is that NFT trading activity peaked early this year and has since succumbed to the same pressures weighing on the broader crypto market. NFT trading volumes are down across the board, but the last few months have been particularly depressed; November was the lowest month for NFT marketplace volumes since June 2021.

As NFTs took the world by storm last year, on-chain activity on Ethereum also rose considerably. More on-chain activity meant more demand for block space, and “gas wars” for popular NFT drops often resulted in sharp spikes in transaction fees. At a certain point, periods of high congestion actually pushed transaction fees above the sale price of many less-expensive NFT collections. This priced out many potential participants, some of whom were new entrants with little-to-no prior Web3 experience.

Low-cost transactions are critical for mainstream adoption. The decline in on-chain transaction activity and increased adoption of L2 solutions helped reign in average transaction fees. But even that hasn’t been enough to reverse the downtrend in NFT volumes, which means high fees weren’t the only culprit. Several months of bullish price action and “JPEG flipping” turned into buyer exhaustion as the novelty of new NFT projects started fading away.

There have been a lot of inspiring projects that have built great communities over the last 12 months. But generally speaking, we saw an acceleration in copycat projects and half-baked drops that caused supply to outpace new demand. As a result, prices for most NFT collections have trended lower, hitting holders with the double whammy of lower ETH-denominated prices as the price of ETH itself tumbled.

NFTs, like the rest of crypto, are subject to strong bouts of momentum and reflexive price action. For example, we can see that total trading volume on OpenSea peaked around the same time as floor prices for BAYC, as buyer demand started to show signs of exhaustion.

Despite the market drawdown, NFTs are still wildly popular compared to where they were 18 months ago. The average number of unique NFT buyers and sellers has declined from prior highs, but many participants are still active in the NFT market.

What’s amazing is we’ve only seen the tip of the iceberg when it comes to experimentation in this space. As more creators, brands, and communities develop their Web3 strategies, NFTs will likely capture even more mindshare.

Let’s dive into the most significant themes in the year ahead for NFTs (ex-gaming).

Five Big NFT Themes for Next Year

Theme #1: Cambrian Explosion for NFT Finance

When an NFT is minted, it gains “superpowers” — it can be bought, sold, and transferred. An economy forms around it. Like a seedling in the soil, the economy can flourish with the right tools. Greater financialization unlocks a new level of utility for NFTs. It brings new participants into the space (market markets, lenders, etc.) which are necessary for NFTs to truly become an established asset class.

We will look back at 2022 as the year the foundation was laid for NFT finance to take off. From January to November, the cumulative volume of loans taken out using NFTs as collateral more than 10x’d, hitting >$500M. The upward trajectory shows no signs of stopping, even when considering the bear market. Borrow/lend is the basic financial utility that lubricates an economy, similar to how AAVE is a core pillar of DeFi.

NFTfi and BendDAO account for 90% of NFT loan volumes. They exemplify the two different lending models today. NFTfi follows a peer-to-peer lending model with a single borrower and lender. Here, the counterparties are known and the terms are transparent. On the other hand, BendDAO is a peer-to-pool protocol where the borrower secures a loan from a liquidity pool instead of an individual lender. Peer-to-pool lending is a newer and yet-to-be-proven concept that introduces additional risks. However, it is highly alluring because of the potential efficiency gains and instant liquidity.

For a deeper dive into NFT lending, refer to our report NFT Lending: A rising Opportunity When NFTs Meet DeFi.

Expectations for 2023 and Beyond

There will be an NFT-Fi summer at some point, similar to the DeFi summer of 2020. In the coming weeks and months, many interesting financial products centered around NFTs will be launched. Several will likely use their own native token to bootstrap initial users and incentivize liquidity providers. This could draw in capital flows from DeFi players who may have little direct interest in NFTs but are lured in by potential profits and yields.

It is also worth noting that NFTs went through an entire cycle without any leverage primitives, which is quite a feat. Leverage is a “hell of a drug,” and something the NFT ecosystem has yet to truly experience. When leverage tools are made easily available to users, we could see sparks fly.

NFT derivatives (options and perpetuals) launch. Imagine having direct exposure to the Bored Ape Yacht Club without having to fork over 60 ETH to buy an NFT. This will enable many more people to participate in the economy. Conversely, the ability to hedge NFT exposure will make it less risky for investors to own NFT assets and bring large, sophisticated players in.

Derivatives introduce greater leverage into the system and can dramatically alter the price action of NFT collections. There will be greater volatility, liquidity, and more efficient markets. The main challenge is finding the right protocol design so that these derivatives have low spreads and attract actual usage. Examples:

  • NFTPerp is a decentralized exchange for NFT perpetual futures that covers 9 NFT collections, including Azuki, Doodles, and Bored Ape Yacht Club. It is currently in private beta.

  • Hook Protocol is an NFT-native options protocol that allows users to buy and sell call options on NFT collections, including Otherdeeds and CryptoPunks.

NFT AMMs gain traction. Sudoswap is the NFT equivalent of the Uniswap moment for ERC-20s. Sudoswap is an automated market maker (AMM) for NFTs that enables instant liquidity. User retention has been good (recurring users as a % of daily users) even as NFT transaction volumes fell. AMMs are well-suited for “fungible” NFTs, such as in-game items or membership passes where most items are similar. As GameFi takes off in the coming years, I expect greater volume to flow through AMMs.

In an interesting twist, Uniswap itself has launched an NFT aggregator feature that pulls marketplace listings from seven top marketplaces including OpenSea and LooksRare. This was expected after its acquisition of Genie in June. Using its new Universal Router smart contract, it claims to be more gas-efficient than other marketplace aggregators and enables complex swaps in a single transaction. Uniswap sees NFTs as another format for value in the growing digital economy and not separable from ERC-20s.

NFT lending version 2.0. Capital efficiency is the elusive beast everyone is chasing. Peer-to-pool protocols with new, experimental designs will go live. For example, Astaria, by ex-SushiSwap CTO Joseph DeLong, introduces a 3rd actor (strategist) to determine the best loan terms for an NFT. Loan aggregators like MetaStreet will also see increased usage as they make it easier for lenders to participate while managing their risk profiles.

NFT pricing gets solved. The pricing of NFTs has been opaque and unreliable. This is a critical piece of NFT finance infrastructure that is missing — we need a robust pricing feed that is difficult to manipulate while providing granular data beyond floor prices. New pricing protocols use machine learning algorithms (e.g., Upshot) to provide accurate, low-latency price feeds. These will be used more widely as we become comfortable with their accuracy.

Theme #2: The Great Unbundling of NFT Marketplaces

“The marketplace that wins is the marketplace that figures out how to make their buyers and sellers meaningfully happier than any substitute.” – Sarah Tavel

NFT marketplaces are the crown jewels of the industry. They are highly scalable cash flow businesses that are not dependent on the success of any individual NFT project. Plus, they operate in a growth market that could expand to trillions of dollars one day. Despite the bear market, OpenSea (OS) still generated >$500M in revenue this year (and over $1.8B in total fees), so it’s no wonder that many challengers have arisen.

Heading into 2021, OpenSea was one of the only NFT marketplaces available, benefiting from relatively little competition. As NFTs gained popularity, other marketplaces started to emerge, but OpenSea already had a big head start in terms of supply (NFTs listed) and demand (OpenSea was the default marketplace if you wanted to buy and sell NFTs).

In January, >90% of NFT trading volume passed through OpenSea. Today, that dominance has shrunk significantly, with several serious competitors emerging: LooksRare, X2Y2, Magic Eden, and Blur. Fee competition is real. OpenSea has the highest fees and full royalties, while its competitors have lower (or zero) marketplace fees and/or optional royalties. LooksRare and X2Y2 use native tokens to incentivize listings and trades, and Blur is launching its token soon. A steep drop in NFT trading volumes has exacerbated the hyper-competitive dynamics as marketplaces compete for a smaller pie in the short-term.

(For more on NFT marketplaces, refer to our reports LooksRare vs. X2Y2 : A Story of Incentivized NFT Marketplaces and A Primer on NFT Wash Trading)

Marketplace Business Models

Marketplaces are in the business of matching supply and demand for certain products and services. Exchanges like Coinbase and Kraken create markets for buying and selling crypto assets. Uber and Lyft created markets to connect drivers and users who need rides. Airbnb created a market for travelers (demand) to connect with homeowners (suppliers) to rent underutilized space in their homes. But not all marketplaces are created equal.

Bill Gurley is one of the top thinkers in understanding marketplace opportunities. In his seminal post, “All Markets Are Not Created Equal: 10 Factors To Consider When Evaluating Digital Marketplaces,” he outlines ten key characteristics for evaluating marketplace opportunities. Among them is the concept of high fragmentation, which many consider one of the most important factors in determining the potential success of marketplace businesses.

“High buyer and supplier fragmentation is a huge positive for an online marketplace. Likewise, a concentrated supplier (or purchaser) base greatly diminishes the likelihood of a successful online marketplace.”

Building on the work of Sarah Tavel, David Phelps also examined some of the key characteristics that help determine the success of different marketplaces models. Phelps cites several examples to illustrate his conclusion that non-fungible supply and demand are foundational ingredients for winner-takes-all marketplaces.

Content is an example of non-fungible supply. Each incremental user that joins Twitter or TikTok creates more value for existing users because users on these platforms are not interchangeable. They provide their own unique content (non-fungible supply) and sometimes content that you can’t find on other social platforms. Social media platforms also benefit from non-fungible demand; each Twitter user has unique preferences and interests because not everyone likes the same content.

Airbnb is another example Phelps cites as a marketplace that benefits from non-fungibility. Each additional unit of supply (homes) increases the value and “happiness” of its users because it provides them with more options that cater to their unique tastes. Compare that with Uber, where the value of the 10,000th driver to a user is far more negligible.

Marketplaces that cater to fungible supply and demand eventually see diminishing returns from each new user, because each incremental increase in supply is interchangeable with the last.

Exchanges, for example, compete in a market characterized by fungible supply and demand dynamics. “It doesn’t matter who you’re trading with, just that there is someone to complete the transaction.” Similarly, each new driver that joins Uber is interchangeable with all the other drivers already there.

There’s no denying that these companies have built huge businesses, but they aren’t winner-takes-all marketplaces. They operate in markets where there isn’t a ton of differentiation in the services they offer, nor is there a lot of variation in user preferences for those services.

When the supply of the service provided is fungible, and user preferences are homogeneous (i.e., users want a ride from A to B), users become more incentivized to care about price. “Homogeneity of buyer need kills the possibilities for a winner-takes-all marketplace.”

These concepts are prescient for analyzing any internet marketplace, including those for NFTs. For starters, NFT marketplaces benefit from a high degree of buyer and supplier fragmentation.

Aggregating supply can help bootstrap a new marketplace, but to build a strong moat – and true network effects – it has to aggregate demand, which is a harder challenge. OpenSea initially captured most of the market share because it aggregated both supply and demand.

OpenSea also benefited from the non-fungible supply (pun intended). Many NFT collections have a wide spectrum of characteristics between individual NFTs. While some carry similar attributes, there’s often a lot of variation within and between different collections. The demand side may be less diverse, but it includes non-fungible buyers which are arguably more unique in their individual preferences than the average trader on fungible-token exchanges.

However, we’ve seen a reduction in switching costs between NFT marketplaces because non-fungible tokens can be listed on multiple exchanges (similar to the same house being listed on Airbnb and VRBO). Going back to the Airbnb example, while it’s the dominant player in its vertical, it isn’t isolated from competition because it operates in a market where switching costs aren’t that prohibitive (another measure of fungibility). VRBO may not have as many options to choose from, but if it offers different options than those on Airbnb, users are incentivized to check both marketplaces before booking their perfect vacation.

Since non-fungible supply is becoming less of a moat, OpenSea has started to compete on price, because users are more incentivized to care about transaction costs if they can buy/sell the same NFTs on other marketplaces. One manifestation of this is the trend towards optional royalties, akin to the race to the bottom in fees for competitive marketplaces.

The rise in competition among alternative marketplaces also puts pressure on OpenSea’s ability to be the ultimate aggregator of demand for NFT buyers and sellers, further limiting its ability to operate a true winner-takes-all marketplace. Again, we revisit Sarah Tavel’s intro quote (emphasis our own):

“The marketplace that wins is the marketplace that figures out how to make their buyers and sellers meaningfully happier than any substitute.”

The key here is how to make buyers and sellers happier than any substitute. That is why, as in other industries, the race to the bottom in fees on NFT marketplaces will likely continue because it creates more happiness for buyers and sellers.

Putting aside the debate as to whether this trend is right or wrong – and more specifically, the adverse impact it has on creators – the history of marketplaces offers a lot of insight into the possible fate of their crypto counterparts.

Expectations for 2023 and Beyond

If we study the history of successful marketplaces (Craigslist, eBay, Amazon), we see a similar pattern emerge — a large incumbent with a bundled platform is challenged by startups with an unbundled product that customers prefer. Sometimes, they grow even larger than the original platform they disrupted (e.g., Zillow now generates 10x more revenue than Craigslist).

OpenSea and its main competitors are large marketplace platforms covering all NFTs. We will see the landscape for NFT marketplaces change significantly. A great unbundling is about to happen.

Vertical marketplaces will gain prominence. We’ve seen the rise of specialized marketplaces in nearly every other industry where internet marketplaces are present. We know that the rise of internet marketplaces unlocks economic value by matching those who own or produce goods with large cohorts of buyers specifically interested in those types of goods.

I am closely watching marketplaces focusing on NFT verticals such as PFPs, art, virtual land, music, and fashion. The buyer’s journey for an art collector is very different from that of a PFP trader — an art collector wants to know the history and meaning of the work and the artist’s brand and be able to admire the aesthetics in detail. In contrast, the PFP trader looks at floor price changes, rarities, and the strength of the community.

(For a deep dive into generative art, refer to our report Generative Art Takes Off – Is it the Defining Art Movement of the Century?)

Vertical marketplaces enable a better user experience and business models tailored to their specific verticals. For example, SuperRare recently sold out its inaugural membership pass (RarePass), which gives members a new 1/1 piece of artwork from its stable of top artists every month. This is difficult for platforms like OpenSea because they are pulled in many different directions and cannot please all their customers.

The gross merchandise value (GMV) of these vertical marketplaces is tiny compared to OpenSea today, so they’re easy to dismiss. But we must consider that they are still in the early stages of growth, optimizing for customer happiness over GMV. At the right time, they could reach an inflection point where the product is superior enough that the market starts tipping in their direction. Some tipping points could include:

  • Inclusion of unique features not available on OpenSea, such as sector-specific analytics and insights.

  • Curation of strong vertical communities, which remain sticky because of the social bonds formed.

More NFT teams will opt to launch project-owned, white-labeled marketplaces. The Bored Ape ecosystem collections (BAYC, MAYC, Otherdeeds) have generated over $50M in transaction fees for OpenSea. Imagine if BAYC had its own marketplace and could capture all of those fees. The fees would go back into building out their vision and bringing value to NFT holders instead of being extracted by a middleman. This is a key unlock, because NFT creators (artists, brands, talent, etc.) can capture more of the economic value they create and share that with their community of supporters (NFT holders).

In the past, it was a heavy lift for NFT teams to launch their own marketplaces. Now, providers like Rarible and Zora allow others to build on their existing infrastructure, making it much more manageable. Reservoir is another NFT infrastructure piece that we believe will be very important in the coming years. It aggregates liquidity across major marketplaces and allows others to leverage their open and on-chain orderbook via APIs.

With a private marketplace, NFT teams have better control over their economy. They can set appropriate fees and royalties, enable trading in their native currency, and provide discounts or benefits to community members. For example, ApeCoin DAO and Snag Solutions have partnered to launch a marketplace that enables APE to be used for trading, has lower fees than OpenSea, and will support the Bored Ape and Otherside economies.

Thematic marketplace aggregators will bring order to the chaos. Aggregation in Web3 is extremely powerful and scalable. The composability and on-chain provenance enabled by the blockchain reduces friction typically encountered by Web2 aggregators (legal licenses, authenticity checks). Gem and Genie have shown how aggregators can grow very quickly.

The fragmentation brought about by new vertical and private marketplaces will be mitigated by thematic marketplace aggregators, who will emerge to match buyers and sellers for specific types of NFTs. For example, a gaming marketplace aggregator that pulls listings from all the top gaming marketplaces becomes very interesting once gaming is more widely adopted and trading, lending, and borrowing in-game assets are more commonplace.

OpenSea – Fate or Fortune?

The trend towards vertical marketplaces doesn’t mean OpenSea is doomed. An incumbent can still run a successful business model despite increased competition. Craigslist is still a big player in the market for classified ads because it benefits from tremendous supply, the scale of which is difficult to replicate.

OpenSea seems to be doubling down on its own supply-side scale, which makes sense, given multi-chain support is one of its current competitive advantages (similar to other centralized exchanges that offer cross-chain compatibility).

OpenSea is also one of the most heavily searched platforms in all of crypto (averaging ~30M visitors per month, according to SimilarWeb). Many smaller creators and project teams are still incentivized to list on OpenSea because that’s where most of the demand (buyers) is. Creators or brands with large existing distribution channels may choose to launch on other vertical marketplaces or create their own marketplaces, but those with limited reach are more incentivized to leverage OpenSea’s distribution to drive awareness and discoverability.

This brand recognition is another advantage – anyone somewhat active in NFTs has used or at least knows of OpenSea. Leaning into this, if they can position themselves as the most trusted and secure platform for buying, selling, and minting NFTs, they may be able to fend off rivals who don’t have the same pedigree. Offering a secure experience will become increasingly important as more “non-crypto” users enter this space. Many will turn to a platform they can trust over one that is less established, even if the alternative offers a better user experience.

TL;DR: The trend towards vertical marketplaces doesn’t mean OpenSea is going away, but it does present opportunities for more specialized marketplaces to thrive – and possibly even surpass – the industry incumbent.

Theme #3: NFTs Go Mainstream: Big Tech and Brands

Strong tailwinds will accelerate the mainstream usage and adoption of NFTs in 2023. I want to highlight two of these trends.

Big Tech Is Embracing NFTs

Instagram enables creators to mint, buy, and sell NFTs on Polygon while also supporting NFTs on Solana, Ethereum, and Flow. Reddit launched its collectible avatars with over 3M crypto wallets created. YouTube includes NFTs in new creator tools. Apple allows in-app minting, buying, and selling of NFTs — although there is controversy over its intentions with its blocking of Coinbase Wallet’s NFT transfer feature unless 30% of gas fees were paid to it.

Web2 companies own the distribution channels that give them access to billions of users today. The top social media platforms have hundreds of millions to billions of monthly active users (MAUs). By leveraging their expertise in building great UX products and integrating with familiar payment systems like Apple Pay, these platforms can abstract away a lot of the friction in onboarding new people onto NFTs. Many are already developing their own NFT initiatives, some of which are likely to launch in 2023.

Crypto’s mainstream moment is close at hand. Never before in our history have there been hundreds of millions of potential users interfacing with blockchains. Many people’s first step into crypto and NFTs will be through these Web2 platforms — and some may not even realize they own NFTs.

Big Brands Are Embracing NFTs

Several big brands have generated meaningful revenue from NFTs, including Nike, Adidas, Gucci, D&G, Tiffany & Co., and Time. Tiffany & Co. sold $12M of NFTs in August, entitling owners to claim custom-made CryptoPunk-inspired pendants. The Web3 audience is affluent and willing to spend, and the success of these trailblazers is drawing attention.

Most large consumer companies are already thinking about opportunities in the metaverse. They’re starting to take Web3 seriously because it offers them a way to build more direct relationships with loyal patrons while creating new ways for people to engage with and experience their brands.

Customer acquisition costs for many brands have also increased dramatically in recent years. Increased regulatory scrutiny on targeted advertising practices, changes in privacy settings, and the inherent limitations in data collection for social commerce are pushing more companies to invest in DTC strategies. Social media advertising is a huge market for acquiring customers, but brands are actively trying to push customer traffic to their own sites, which allows them to collect first-party data so they can market to these customers (purchases through social media apps limit their ability to do this).

Every brand is different, but many have overlapping goals that make Web3 enticing. Some see an opportunity to sell digital items to their customers, while others are looking for ways to foster more engagement with their brand’s community (including building virtual spaces for their communities to gather). As social channels become more saturated, brands will need to find better ways to acquire and retain customers. Web3 may be the next battleground, as it’s still a green field ripe for growth.

We’re starting to see forward-thinking brands enter the fray, which will eventually bring a fresh segment of future Web3 participants with them. Not every brand will get this right, and many brands may not be able to create a sustainable Web3 strategy yet. But those that understand the power of community, and have the willingness to lean into the benefits Web3 has to offer, are the brands that have the biggest opportunity to create strong moats to thrive in this new era.

Expectations for 2023 and Beyond

More brands and big tech companies will integrate NFTs into their business models in meaningful ways, resulting in a flurry of creative use cases for NFTs. Starbucks is one example of a large multinational that has integrated NFTs with its loyalty program, allowing members to earn or purchase limited-edition stamps that unlock additional benefits.

Dynamic NFTs, which change according to real-world events or user actions, also have a lot of potential to drive brand engagement. The big question is who will be the first to achieve product-market fit? And who will write the playbook for more brands and companies to follow?

The Web3 creator playbook comes to life as new users surge. Minters of NFTs launched by big brands have mostly been Web3-natives and power users so far. This will change as more new participants enter. Talented creators can monetize through NFTs, bootstrapping an initial audience of fans. This kickstarts a virtuous cycle of content creation, audience growth, and business growth. The creator economy is going to thrive.

(An example: Aku is one of the first web3-native media companies funded via NFT sales. For more details, refer to our report Aku, The Moon God & The New Age of Web3 Media)

M&A activity will heat up. Large corporations convinced of the space’s potential will make strategic investments or acquisitions to gain a leg up against their competitors. A prime example is Nike’s acquisition of RTFKT in late 2020 — RTFKT has become its experimental Web3 playground while Nike’s core business operates as usual.

There will be consolidation within Web3, too. Yuga Labs acquired 10KTF and WENEW, adding them to their ecosystem this month. Could Web3 companies that have shown traction, like VeeFriends, Azuki, Nouns or Art Blocks, be acquired? It’s not out of the question.

(For a deep dive into the Nouns ecosystem, refer to our report Nouns — Hyperscaling a Brand & Treasury From Zero)

Theme #4: NFTs — The New Social Tokens

As a concept, social tokens are compelling. For the first time in history, we have verifiably-scarce digital assets that can be tied to an individual’s (or community’s) reputation and success. Social tokens represent and govern how influencers and creators transfer value to their communities. They have the potential to remove rent-seeking intermediaries involved in the value transfer.

The ongoing World Cup highlights an example that has received much attention. Chiliz launched over 50 sports-related fan tokens (ERC-20s), partnering up with football giants such as Inter, Rome (ltaly), and Manchester City (UK). Token holders get discounts on merchandise and can vote on club decisions such as the jersey design. However, there have been valid concerns over their tokenomics. Only a small % of the fan tokens are available to the public, and the large majority are held by Chiliz and the teams.

Increasingly, social tokens are being launched as NFTs. A few examples this year include:

  • Steve Aoki launched his A0k1 credits in February. The NFTs can be used to upgrade passports to the A0k1verse. Passports provide fans with free merch, exclusive access to Aoki concerts, and the opportunity to create a song with Steve Aoki.

  • Cristiano Ronaldo worked with Binance to launch an NFT collection just before the World Cup, allowing him to better connect with his fans. There are several rarity tiers, with perks ranging from autographed Ronaldo merchandise to a personal message from the football star himself.

  • VaynerSports is a talent representation and brand agency for professional athletes in football, baseball, combat, and gaming. Founded by AJ Vaynerchuk, it launched a membership pass NFT that allows holders to meet VaynerSports athletes and win tickets to professional sporting events.

Expectations for 2023 and Beyond

NFTs will be the preferred medium for social and fan tokens. While early social tokens started out as fungible tokens (e.g., Friends With Benefits, AC Milan, WHALE), we foresee that future social tokens will launch as NFTs rather than ERC-20s. NFTs can be tied to rich media like videos, music, and images, allowing them to accrue cultural and memetic value beyond financial value. NFTs are well-suited to be the primary assets used for social flexing and digital identity. They can also function as a membership pass for token-gated access. The design space and potential for gamification with NFTs are huge.

A huge wave of creators, celebrities, and sports brands will launch NFTs. This will be larger than anything we have seen thus far.

  • The technical infrastructure to support this is rapidly improving. No-code platforms, token-gating solutions, and tooling for dynamic NFTs are just a few things I’m excited about.

  • An increasing number of people, especially decision-makers, are being educated about the potential for NFTs to grow their brands and create new revenue streams.

Asia could be the place where social and fan tokens take off first. Fan culture in Asia is rabid, and fans are willing to financially support their favorite stars by purchasing large amounts of merchandise. K-pop is one obvious example. Merchandise and album sales are very significant revenue streams for K-pop entertainment agencies. There is a greater cultural acceptance of NFTs in Asia since property rights are often not as robust as in the US.

So far, only a tiny % of creators and influencers in the sports and entertainment industries have launched their own social tokens. This will change in the coming years.

NFT projects will launch their own fungible tokens. Fungible tokens and NFTs complement one another when building an economy around people and brands. They enable the community to expand beyond the limited set of NFT owners. The clearest example is ApeCoin, launched to support and complement the Bored Ape economy. From an initial community of 20,000+ APE holders, it has expanded to 100,000+ unique wallets today. Watch out for Azuki, Moonbirds, and Clone X tokens in the future.

Native fungible tokens are the currencies that lubricate the ecosystem — a medium of exchange for value transfers. Community members who contribute significantly with their time and effort can be rewarded with tokens. Fungible tokens can also be used to purchase merchandise, mint future NFT drops, or as a gamification tool (stake your NFTs for tokens, earn tokens for completing tasks).

Importantly, greater emphasis should be placed on thoughtful approaches toward tokenomics. Simple stake-and-earn mechanisms are not meaningful. Tokens should be channeled towards those creating value, rewarding productive contributions with additional ownership.

A cautionary note: Social tokens are still in their infancy. Value capture remains a key problem. Tying ownership and profits back to a token involves legal challenges, as these tokens could be classified as securities and subject to stringent laws. Regulatory guidance around tokens and digital assets has been vague and will continue to be for a while.

Other headwinds include discoverability issues, since the social token landscape is quite fragmented and there is no aggregated platform for consumers to find out about tokens. There is also a lack of material, demand-driving utility. We believe that these are solvable challenges in time.

Theme #5: “Phygital” Brings Physical and Digital Together

The lines between our digital and physical worlds are blurring. Objects can now exist in the metaverse and the real world, linked through technology. NFTs are the bridge, functioning as an immutable representation of authenticity and ownership in both realms. They empower physical items with new utilities, such as unlocking token-gated benefits and unique AR experiences.

This year, RTFKT released a Nike AR hoodie that can be worn on Clone X avatars and entitles owners to claim the same physical hoodie. 9dcc, a luxury fashion house by gmoney, launched a collection of t-shirts with embedded NFC chips that enable the NFT to move together with the physical item. Azuki launched its physical-based token (PBT), using an open standard that ties physical items to an NFT.

These early phygital items have already generated millions in sales, indicating the latent demand for such goods. For more on “phygital” and digital fashion, refer to our deep dive report on Why the Future of Fashion is in the Metaverse.

Expectations for 2023 and Beyond

More physical items will be sold with accompanying NFTs. The technology that enables NFTs to be tied to physical items is not complex, and it will get cheaper and more intuitive. Brands will utilize this to create delightful customer experiences that complement their physical products.

Giving free NFTs that accompany purchases of physical items also allows brands to start building out their own on-chain social graphs, which they can then query, segment, and reward based on who’s engaging with their brand and products most. This is the first step in bringing more real-world items onto the blockchain.

High demand for digital artists and designers. Phygital opens up a new world of storytelling and experiences for physical items. The use of AR filters in fashion is a growing trend among the social media-addicted crowd today. Talented digital artists and designers are essential to creating great content.

Phygital gets a better name. If there’s one thing that unites the NFT community, we hate the term “phygital.” It’s an ugly word for a powerful concept, and many have called it by different names (gmoney calls it a “networked product”). I hope someone finds a better term we can all agree to use.

What Surprised Us This Year

Surprise #1: Creator Royalties Crash and Burn — New Business Models Needed

The ability for artists to earn royalties is a core value proposition for NFTs. It brings many artists and creators into the space. Royalties are a source of income that allows them to continue their creative work without the pressure of constantly selling new works to make ends meet. Royalties typically range from 2.5-10% of the sale price.

Yet, it appears that NFT royalties are trending toward zero. The slippery downward slope began with the launch of Sudoswap in July, a new marketplace that gives fees to liquidity providers but does not include a royalty feature. X2Y2 saw this as an opportunity, and shortly after made royalties optional. Weeks later, LooksRare and Magic Eden followed.

Few people are willing to pay royalties when there’s no incentive to. We observe a steep decline in trades that includes royalties (e.g., only 10-20% on Magic Eden) once royalties are made optional.

OpenSea remains steadfast in its support of creator royalties and is fighting back. It released a code snippet for NFT smart contracts that restricts the transfer function if it falls under OpenSea’s list of operators that do not support royalties. OS stated that it would only enforce royalties for NFT projects that include this code or similar enforcement tools.

The challenge is that there is no perfect way to enforce royalties on-chain in an open, permissionless system like Ethereum. All solutions involve tradeoffs in decentralization. Do you genuinely own your NFT if OpenSea dictates which addresses you cannot transfer your NFT to? A bad actor could one day decide to blacklist all addresses except for OS. It brings us back to the centralized, permissioned systems of Web2.

We are heading into an era where new business models for creators beyond royalties will be found. This could mean a tipping service. Creators could keep a stash of NFTs to be sold later on, or create a tiered membership system where those who pay royalties are entitled to additional benefits (I like this). Human ingenuity will light the path forward.

Surprise #2: The Rise and Fall of the Solana NFT Ecosystem

Solana NFTs took on a life of their own this year. The ecosystem expanded rapidly to become the 2nd largest NFT ecosystem, with approximately 1/6th of Ethereum’s trading volume. It evolved into a vibrant sub-culture that was quite different from Ethereum. Trading, PFPs, and community tribalism were focal points, fanned by vocal influencers like ShiLLin VilLLian and Frank.

This propelled Magic Eden (ME) into the spotlight. Previously viewed as a niche marketplace, ME cemented its position as the dominant NFT marketplace on Solana by focusing on communities and its launchpad. User activity on ME grew by several multiples through the year, with over 2M transactions on some days. ME was able to rake in significant revenue from transaction fees and expand rapidly. Today, it has expanded cross-chain to compete directly with OpenSea, showing that its ambitions are not limited to Solana.

Unfortunately, meteoric rises are often accompanied by a fall. Solana faces an existential crisis with the collapse of FTX/Alameda and its founder Sam Bankman-Fried, two of its most prominent backers. The SOL price crashed by >50% in November, and much liquidity has since fled its ecosystem.

Since NFTs were denominated in SOL, this triggered panic among the Solana NFT community and team members. Several teams are considering moving their projects off Solana to another chain, including top projects such as DeGods and Solana Monkey Business. FTX/Alameda hold many SOL tokens which could be liquidated in bankruptcy, putting downward pressure on its price. This, together with the reputational hit from being associated with SBF, continues to be a significant overhang on the entire ecosystem.

Still, the Solana community remains resilient, and development announcements at the recent Breakpoint conference are promising. It remains to be seen if the Solana NFT ecosystem can pick itself back up in the coming year, but I’ll be watching.

Surprise #3: Music NFTs Remained Niche

Earlier this year, we put out our thesis on music NFTs and how they will drive new revenue streams and engagement models that allow artists to build more successful and sustainable careers. We viewed music NFTs as a potentially game-changing moment for the music industry that could enable a new wave of independent artists to circumvent incumbents and middlemen.

There was a lot of excitement and activity early this year, with platforms like Sound and Catalog seeing tremendous month-over-month growth in sales. In hindsight, this was the peak of the hype phase around music NFTs. Since then, the primary sales volume on platforms like Catalog and Sound has fallen significantly. Sound is doing much better than Catalog sales-wise, and volume is starting to pick up again. It is safe to say music NFTs are still a niche market today.

One reason for this is the collective realization that using music NFTs – which represent IP ownership and accrue royalties – will take years, not months. They challenge an entrenched system where record labels and publishers wield dominant power in an industry with little reason to innovate and change. Platforms like Royal are pushing the boundaries, and we expect similar breakthroughs to emerge despite the uphill battle ahead. Meanwhile, music NFTs can function primarily as:

  • Digital collectibles to fund artists’ creative work and establish an early fan base (indie artists).

  • Fan engagement tokens that bring fans closer to their favorite artists (more popular/mainstream artists). They could be channeled towards concerts and merchandise sales (e.g., discounted tickets, exclusive merch) and collectible digital moments for attendees or phygital NFTs fans can redeem when they purchase merchandise.

Despite the lull in music NFT adoption, our long-term thesis still holds, and it will take time to play out. The events of 2022 – with worsening macro conditions and multiple major crypto-related blowups – certainly dampened consumer adoption. But innovation and progress have not stopped. Music NFTs are still a life-changing opportunity for many artists, allowing them to earn more for their work than they’d receive through other channels like streaming platforms. TL;DR: We are still in the early innings.

For those interested, Coopahtroopa publishes a weekly newsletter highlighting the latest developments in music NFTs.

Futuristic Ideas (Longer-Term)

Everything Will Be Tokenized

NFTs allow verifiable proof-of-ownership and proof-of-authenticity while minimizing administrative overhead. These are very compelling use cases for blockchain technology. The cost of creating an NFT is negligible, so a future where NFTs represent (almost) everything we own is entirely possible.

This house was sold as an NFT on Roofstock’s marketplace.

Already, there are some examples of this.

  • In October, Roofstock sold its 1st on-chain house for $175k. Each house is owned by an LLC, and the NFT represents sole ownership of the LLC. Once the asset is on-chain, there will be many new use cases enabled by DeFi interoperability. For example, the house NFT can be fractionalized, and portions of it resold. More people can participate in its upside and earn sustainable yield, which democratizes access to high-quality, real-world assets. An on-chain loan can be taken out using the house NFT as collateral via a lending protocol like Arcade. This can be done in minutes, with no legal paperwork or middleman necessary.

  • Hoseo University in South Korea will issue diplomas and degrees as NFTs beginning this year. In the future, many academic and real-world qualifications (e.g., driver licenses, vaccination certificates) will be issued as verifiable credential NFTs or soulbound tokens. These are tamper-proof and can easily be checked for their authenticity. Such verifiable credentials are essential to a decentralized identity where the user owns their identity instead of the organization, and the identity is portable and interoperable. Decentralized identity is a core component of the Web3 technology stack and will unlock a new set of use cases in crypto.

For a deep dive into digital identities, verifiable credentials, and the reputation layer in crypto, please refer to our report Reputational Identity — 2022 Progress Update.

These are just the tip of the iceberg of possibilities. New multi-billion-dollar businesses will emerge around this; it’s only a matter of time.

Yes, it will take years to get there. We need to onboard the everyday person into NFTs intuitively and frictionlessly, making it as simple to use as WhatsApp. New legal frameworks must be developed to recognize NFTs as property. Governments and large corporations have to buy into the vision of transparency and decentralization enabled by the blockchain. New utility layers need to be built so people will want to use these NFTs.

Digital Items  >>  Physical Items

Digital items could be worth more than their physical counterparts. Here’s why:

The metaverse will inevitably be a more significant part of our lives. Technology is advancing rapidly, enabling a greater sense of presence in these virtual worlds. New, beautiful experiences can be created that were not possible before. Persistence and interoperability make our actions in the metaverse meaningful, and NFTs help enable this.

At the same time, the young generation (Gen Z and soon Gen Alpha) today is highly comfortable with technology and the ownership of digital assets. Look no further than Fortnite and Roblox, where sales of skins in these proto-metaverses are through the roof. Roblox player spending is rising, and the total market for skins is estimated to be worth $40B per year. Roblox gamers represent only a small fraction of our population, too.

The confluence of metaverse expansion and positive demographic factors will lead to digital identities becoming as important, if not more important, than our physical identities. We are willing to spend to make our digital identities unique — a new, more powerful version of social flexing. We’re already seeing early signs of this in fashion. A digital version of Gucci’s Dionysus Bag with Bee in Roblox’s virtual world was sold for $4,115, significantly more expensive than the physical bag which sells for $3,400.

NFTs Are No Longer…NFTs

It’s time for a change. “Non-fungible token” is a technical description. It has little meaning to most people, especially mainstream audiences interacting with NFTs in the future. It still functions adequately as a catch-all term today. But as the various NFT verticals mature, it no longer makes sense to use “NFT” to describe generative art, virtual lands, and that sword in your favorite Web3 game — all very different things.

Reddit used the term “digital collectible” to refer to its NFT avatars with great success. It has resonated well with its audience. Similarly, we will reach a consensus over new terms to better represent each use case.

The technology could become so pervasive that it becomes an integral part of everything we do. No one uses “TCP/IP” to describe the internet today. Either way, I give it 50% odds that the term “NFTs” will no longer be widely used in 5 years, even as the industry grows 10-100x larger.

Final Thoughts

Like most markets in crypto, NFTs have taken it on the chin this year. The price of a Bored Ape was once north of $400,000. Today, you can buy one for less than 20% of that cost. Focusing on prices, however, often leads us to miss the forest for the trees. The amount of development and creative energy in the NFT space is staggering, and shows no signs of stopping. Every day, more people are being educated about the power of Web3 and the benefits NFTs can provide. Some of the world’s largest companies and brands are getting involved in meaningful ways. The genie is out of the bottle, and there’s no going back.

NFTs are crypto’s first major mainstream opportunity. The tiny market cap of NFTs relative to the entire crypto market shows how early we are. NFTs have the potential to grow into a multi-trillion-dollar industry, and that future may not be as far away as many believe.

NFTs: The Gateway to Web3

The following excerpt was written by our Head of Research, Kevin Kelly:

As this year’s bear market drags on, it’s given us time to reevaluate our core theses and why we still have so much conviction in this space. One question I’ve been grappling with is what will be the catalyst that attracts more users – and capital – to the crypto economy sooner?

One way is to build new use cases beyond decentralized finance applications. Real-world assets (RWAs) are one example of a huge market opportunity. But another big one – and the one I’m personally most excited about – is the expansion of NFTs and Web3-enabled assets. In my view, they have the power to onboard a majority of new entrants over the next few years.

As the dust settles on this latest hype cycle, it’s becoming clearer to me that NFTs will serve as a primary gateway to onboard the next generation of Web3 participants. 

We’ve already seen the power of this sector. At their peak, NFT transactions made up over 50% of Ethereum gas usage, flipping their ERC-20 and DeFi counterparts.

Of course, we’re still a ways away from mainstream adoption, but this space isn’t just theoretical anymore. We’re seeing real engagement and creative experimentation to build new use cases for a growing list of digital asset types – and that’s incredibly exciting if you ask me.

If we took anything away from last year’s NFT craze, it’s that crypto applications go way beyond just decentralized money and DeFi. Like all novel innovations, the NFT boom-bust cycle was a classic example of markets getting overextended on overly hyped expectations of what this new technology would enable in the short run. This attracted a ton of speculators taking advantage of an inefficient market that no one knew how to price.

Each wave of adoption follows a similar trend where hype starts to build, new entrants pile in, prices rise which brings in even more people, speculation takes over (driving prices even higher), new entrants start to get priced out, demand wanes, and assets finally reprice to more justifiable valuations given the market’s current state. We saw this during the 2017-18 ICO mania. We saw this during “DeFi Summer” in 2020. We saw it in the NFT market in 2021. And we’ll see it again in the future because that’s how innovation cycles work.

What’s important is that not everyone leaves after the excitement fades. Each hype cycle carries forward a larger number of active participants who intend to contribute, invest, and build the next generation of new “things,” whether that be protocols, applications, or complementary products and services that push the industry forward.

Interactive Digital Assets (IDAs): Increasing the Surface Area

When I try to explain NFTs to my non-crypto friends, I often refer to them as interactive digital assets because, in my view, that’s what they are. And these types of assets have massive potential — I believe most of us are still underestimating how big their impact will be (myself included).

The creation of new asset types will also benefit the entire crypto economy by increasing the total surface area for new participants to engage with digital assets and the networks they’re built around. The customization and relatability of NFTs makes them uniquely positioned to attract a wider audience, bringing in new sources of demand and buying power.

NFTs are often placed in the same generic bucket, when in reality there are stark differences between collections. This versatility is already enabling a ton of creative use cases, creating more opportunities for NFTs to find product-market fit (or “community-market fit”). Eventually, we’ll see the term “NFT” retired in favor of more specific terminology that better represents the differences between asset types and their core attributes.

If we look at the adoption curve of the internet, there was a certain inflection point where the growth rate of adoption accelerated. This partly stemmed from better infrastructure that made accessing the internet cheaper and more accessible. As more and more people started actually using it, eventually, network effects started to take hold.

What we need now is another creative renaissance that prioritizes novelty and utility over hype and speculation. If the first NFT wave was driven by collectability and novelty, the next wave has to build on these core pillars by introducing new layers of utility that excite both Web3 enthusiasts and non-crypto folks alike. Simply put, what we really need is to create more things that more people care about, and more things that people actually want to use and engage with.

I have a lot of thoughts on this topic that I’m going to air out in another context, but I wanted to share a snippet of what’s got me excited because I really believe this is just the tip of the iceberg. This movement’s best days still lie ahead.

Markets Year Ahead

By Kevin Kelly, CFA, Jason Pagoulatos, Andrew Krohn, and Christian Cioce, Ph.D.

The Year Ahead for Markets is the final report of our Year Ahead series. It provides our top-down view of the biggest macro and market trends we’re focused on as we close the book on 2022 and look to the new year. We highly recommend reading all of the other sector Year Ahead reports to get a much deeper understanding of the most critical trends impacting individual sectors and the teams and protocols building the future of this industry.

The Year Ahead for NFTs | Gaming | DeFi | Infrastructure

A Tale of Two Halves – The Great Reset

2022 was The Great Reset for crypto. Overly hyped trends and mass speculation pushed the crypto market far out over its skis by the end of 2021, so this year’s washout was a necessary reset. Sizable corrections are healthy for long-term secular uptrends.

The last three years have been a tale of two halves.

The plot of act I was the culmination of policy responses to the post-COVID flash recession — massive stimulus programs were the stars of the show.

“The giant backstops put in place by such policies turned markets around almost on a dime, and were a key catalyst in propelling asset prices to new all-time highs. Financial conditions eased, risk appetite returned, and BTC and crypto assets were huge beneficiaries of this environment, which saw global liquidity expand at one of the fastest rates on record.”             

Why Bitcoin is Behaving Like It Should (January 2022)

Act II was the fall of the market’s shining white knight as our story’s hero turned into its biggest villain. All the tailwinds that propelled asset prices to new highs reversed course, and 2022 was the polar opposite of the previous 12 months — something we warned of a year ago:

“Several macro tailwinds that helped propel BTC and crypto assets to new highs over the last 12-18 months have reversed course; the shift away from excess liquidity and accommodative monetary conditions is a structural headwind we’ve highlighted in recent months, which now appears to be coming to a head.”

This leads us to an important theme we’ve been harping on since our earliest days — crypto is macro.

What’s happening in macro has a direct impact on the crypto market, as we’ve seen not just over the last two years, but arguably the better part of the last few price cycles. We’ll get into that shortly, but first let’s get a quick sense of the current state of the crypto market.

State of the Crypto Market

The sharp drawdown in crypto asset prices this year has many wondering when the pain will subside. General interest in many of the most prominent crypto themes of the last few years has died down considerably over the last 6-9 months.

Unsurprisingly, interest tends to pick up during bull markets and wane in bear markets.

BTC is trading right in the range of its previous 2017 peak and its summer 2019 retest, an area many consider to be a pocket of vulnerability as we head into 2023.

BTC is down ~76% from its prior all-time high. For context, the price of BTC fell ~85% from peak-to-trough in each of the last two major bear markets. History never repeats itself, but this year’s drawdown mirrors that of 2017-2018 in many ways.

ETH saw an even larger drawdown during the 2017-2018 cycle, falling 93% from peak-to-trough. ETH’s peak drawdown this year was 82% back in June — it’s currently trading ~76% off its prior ATH as well.

Interestingly, BTC and ETH peaked in November 2021, unlike the rest of the crypto market which peaked earlier in the year back in May 2021, as measured by the S&P Crypto BDM Ex-MegaCap Index. The broader crypto market has experienced an even sharper ~82% price drawdown from its all-time high.

If the market were to mimic the same peak-to-trough drawdown of last cycle (~93%), the total market cap for the broader market would have to fall another ~60% from here (though that’s not our base case).

Correlations between crypto and traditional asset classes have been very tight over the last 12 months, and for good reason. Intramarket correlations within crypto have also remained elevated this year, which has led to widespread weakness across every major sector.

Bitcoin is now trading roughly two standard deviations below its long-term trend.

Prior cycle bottoms were marked by a sizable selloff that pushed BTC into oversold territory on its 14-month RSI and a test of its 200-week MA, which historically served as strong support for price to find a floor. We saw these same conditions play out this past summer, and BTC has been largely rangebound since.

Past performance is not indicative of future results. But if this cycle follows the general path of those before it, one would expect to see markets consolidate into Q1 2023 before forming a clear bottoming pattern. This accumulation period in H1 2023 would be a welcoming setup for the crypto market to move into its next bull cycle. We would add that this is dependent on a reversal in the key macro headwinds that have weighed on risk assets throughout 2022.

Key Theme #1: Liquidity Still Runs the World

For those who haven’t read our “Liquidity Runs the World” report, we highly recommend it as a precursor for the topics discussed below.

We noted at the turn of last year that a sustained downtrend in global liquidity was the biggest risk to crypto markets heading into 2022.

“Bitcoin is one of the purest plays on fiat currency debasement. It also happens to be one of the most leveraged bets on global liquidity; when liquidity is abundant and expanding, BTC and crypto assets tend to outperform; when liquidity tightens, they struggle.”

Global liquidity is the most powerful force in macro, which is why it’s our first key theme and one which we believe will have a significant market impact in 2023.

Global liquidity cycles have a strong correlation with changes in the business cycle.

And the business cycle drives changes in asset prices.

Therefore, trends in global liquidity influence the direction of markets. They drive fluctuations in global equities…

And have a strong impact on the largest equity market in the world.

They even influence the direction of the crypto market.

And not just mega caps like BTC and ETH…

Global liquidity’s influence on crypto asset prices also affects capital flows into (and out of) crypto funds.

One caveat is that M2 is not an all-encompassing measure of global liquidity (see our prior report Liquidity Runs The World for a more in-depth discussion on these points), but it serves as a decent proxy. It tracks trends in major central bank balance sheets…

and the relationship with markets, including crypto, is striking.

Liquidity cycles aren’t new — we’ve seen their power before. Global liquidity growth slowed considerably back in 2018 as financial conditions became more restrictive. The result was a sizable correction in risk assets and a prolonged bear market for the most speculative long-duration assets (like crypto). We saw a similar dynamic play out over the last 12 months, though on an even greater scale.

Global liquidity cycles drive changes in asset prices. They influence the direction of global equity markets. They drive fluctuations in bond yields and credit spreads. They even have a substantial impact on the crypto market, which is why a reversal in global liquidity is one of — if not the most — important catalysts for a renewed bull market.

It also looks like this liquidity cycle is approaching another inflection point.

Global Liquidity – The Reversal We Need

There are early signs that a reversal in global liquidity is upon us. Here’s an updated chart from CrossBorder Capital that shows the early signs of a potential bottom in this current cycle:

“The cycle moves in 5-6 year waves and is currently just starting to turn higher from its mid-2022 lows. Global liquidity leads financial markets by some 6-12 months and economies by around 12-18 months…it shows that we are at ‘maximum tightness’” CrossBorder Capital

Our good friend Raoul Pal also has a great chart showing how the business cycle tends to lead liquidity reversals as well.

“…but the business cycle leads liquidity, and the ISM (shown inverted here) is forecasting significant economic weakness ahead, and thus liquidity is on the cusp of turning to offset falling growth…” – Raoul Pal, GMI

The two biggest contributors to global liquidity are the US and China. The world’s second largest economy has grown to be a liquidity powerhouse over the last 15 years.

Households in the US and China also make up nearly half of the world’s personal wealth.

After months of stern rhetoric, pressure is starting to mount on China as its economy sputters. Policymakers are warming up to the idea of supportive initiatives aimed at promoting growth as the country continues to grapple with significant headwinds (some of which are self-induced, e.g., zero-COVID).

The focus in China is shifting, and reopening its economy is now top of mind to combat its weakening growth outlook. The PBOC has already asked banks to “stabilize” lending to property developers, a critical sector for China’s economy, who’ve struggled to claw their way out of a year-long slump that’s left many companies cash-strapped and facing greater insolvency risk. The PBOC recently cut required reserves for banks for the second time this year — the latest of which is estimated to free up ~$70B of liquidity — and will likely take further action to prop up growth (especially as the rapid spread of COVID infections impact a growing percentage of its workforce).

China’s credit impulse has turned higher in recent months too.

Positive net changes in China’s credit impulse tend to lead to reversals in global M2 growth.

In recent years, they’ve also led trend reversals for the US dollar (which would be a very welcoming sign for markets).

Global liquidity cycles have an inverse relationship with the dollar, making them a key trend to monitor given our past warnings that a strong USD remains one of the biggest headwinds facing risk markets (including crypto).

We saw the year-over-year change in China’s credit impulse bottom ahead of the crypto market back in 2018, which may support a more optimistic outlook as we get deeper into next year.

The crypto market’s outperformance really started to accelerate after the net change in the China credit impulse turned positive, which is something we’ve already started to see over the last few months.

The Fabled “Fed Pivot”

The US is a bit of a different story, at least for now. Much to the dismay of investors, the Fed has aggressively targeted tighter financial conditions in its battle against inflation.

Tighter financial conditions are no friend of markets, especially risk assets whose valuations are grounded in potential growth further out in the future.

The US has yet to show signs of a liquidity reversal. Liquidity conditions have improved somewhat over the last several weeks, but more improvement is needed to see a sustainable move higher in markets.

The problem is that an expansion in global liquidity tends to loosen financial conditions, which is the opposite of what the Fed wants right now (at least until they have more confidence that persistently high inflation is officially behind them).

Many pundits are trying to predict when we’ll see a “Fed pivot,” but most are focused on when the Fed will pause rate hikes and if/when they’ll start signaling a new wave of rate cuts.

Rather, we’d argue that what really matters is when we see a reversal in liquidity conditions — that’s what will continue to have an outsized influence on markets and asset prices going forward. We saw this dynamic during the 2017-2018 cycle, which we highlighted at the start of the year:

“…the crypto market had one of its best bull runs on record [during 2017], even as the Fed (and other major central banks) started to raise rates…it wasn’t until liquidity conditions started to deteriorate that BTC topped out [as we saw in early 2018].”

TL;DR: We have to keep our eyes on changes in liquidity.

If the US and China move towards a more expansionary liquidity environment, that would give us stronger conviction that a bottom is truly in the rearview. Longer-duration risk assets will likely lead the way when the market realizes that the liquidity trend reversal has legs.

Liquidity Impacts Crypto Markets Too

This liquidity phenomenon isn’t just present in traditional markets, it’s also prevalent in crypto.

When prices are high, the crypto economy has a bigger balance sheet that can be borrowed against. During the 2020-2021 bull market, we saw the total amount of loans outstanding balloon alongside asset prices.

This year, we’ve seen a significant decline in demand for borrowing alongside the value of crypto assets.

This pullback in borrowing demand has led to a decline in utilization rates for the most prominent collateral types like USDC.

Centralized lenders have historically served as a notable source of liquidity. That’s why headlines about large prime brokers and lenders (like Genesis) needing emergency funding are so impactful. If we see further contraction in credit growth, that means less liquidity for the crypto economy.

Market makers also got caught up in the FTX collapse. Higher volatility forces MMs to reduce their risk, leading to worsening market liquidity conditions, as seen over the last several weeks. In the immediate aftermath of the FTX collapse, market liquidity for BTC-USD pairs dropped to its lowest level since early June, according to data from Kaiko.

The sizable drop in total stablecoin market cap after the LUNA/UST implosion is another example of a negative liquidity shock this year.

The transition to a risk-off environment has pushed many market participants to stack stables, which has drastically increased their percentage of the total market cap. This represents capital that hasn’t left the crypto economy. Once the market turns, we’d expect to see some of this dry powder re-enter the market.

Capital flows have a big impact on asset prices throughout global markets and economies. As we’ve seen, the decline in funding liquidity can have an adverse impact on market liquidity too.

Access to liquidity is one of the biggest risks to the crypto industry over the next 3-6 months. Venture capital funding has fallen considerably year-over-year, which is forcing companies big and small to cut costs and headcounts in an effort to ensure their survival. The back half of the year has been challenging for many teams looking to raise capital for new projects or series funding for existing ventures, and conditions will likely get worse before they get better.

Key Theme #2: The Almighty US Dollar

The strong dollar narrative has been a cornerstone theme of ours throughout 2022. In our January report, Why Bitcoin Is Behaving Like It Should, we cited the likelihood of a strong dollar as a key risk to the crypto market. More specifically, we cautioned that:

  • Growing expectations for higher rates, coupled with a relatively strong economic outlook in the US — at least compared to other regions — have helped breathe new life into the US dollar

  • A stronger greenback implies tighter monetary conditions, which does little favor to assets like BTC that tend to move inversely with the USD

  • The US dollar is extremely important in determining the direction of global markets, especially assets tethered to a currency debasement narrative

Fast forward a year and we’ve seen the USD strengthen against just about every major currency to the detriment of risk assets like crypto. The 15 months leading up to its late-September peak saw the strongest dollar move we’d seen in decades, so we expected some consolidation after such a rapid rise.

Aggressive monetary tightening, demand for dollars and US safe havens, and the contraction in global liquidity helped propel the dollar to 20-year highs.

Historically, dollar momentum can continue after a healthy consolidation period.

We saw the DXY’s 14-month RSI break above 70 at the end of April for the first time since its 2014-2016 run-up. Shortly after, we cited the importance of USD momentum, specifically how “Similar overbought readings over the last four decades led to a stronger dollar ~78% of the time over the following 12 months [with average gains of ~5.7%]…which would put the DXY index just shy of 111…”

The DXY went on to gain another +10% through late September (peaking at 114), but has since fallen back to the same levels we saw in May.

The worldwide fight against surging inflation has prompted a synchronized tightening of global rates and financial conditions, and the strong dollar continues to be a big part of that story.

October marked the recent turning point, as peak “tightness” led to somewhat easier financial conditions and the market started repricing future rate hikes as fears shifted from inflation to rising recession risk.

The US led the pack in tightening financial conditions over the last 12 months, but that’s starting to change as inflation and energy pressures inflict hardship on Europe while the Fed gets closer to its expected terminal rate.

The destructive strength of the US dollar has also forced other countries (both advanced and developing) to take action, defending their own currencies in the face of major economic headwinds. Foreign CBs have started selling dollar reserves at an accelerated pace, similar to what we saw after the last strong USD run-up (2015-2017).

This trend has been led by China and, more recently, Japan (more on this later).

Long dollar is also one of the most overcrowded trades at the moment.

We know global liquidity cycles have an inverse relationship with the dollar. We also noted how the business cycle tends to lead changes in liquidity trends, and the US ISM has been warning of a significant slowdown for months now.

Therefore, if we expect the liquidity cycle to turn (as we’re already seeing early evidence of) to combat this weakening growth outlook, then we’d expect to see a reversal in the USD too.

So, are we out of the woods? Not necessarily. Another wave of dollar strength is still a key risk as we move into 2023. It is important to acknowledge that the Fed remains steadfast in their fight against inflation, and we know through historical precedent that the latter stages of inflation can be sticky, especially if wage growth remains strong.

The dollar’s run-up has already caused a lot of destruction, but the US still looks like the “cleanest shirt in the laundry” to many. If capital flows to the US in search of safety against weakening growth prospects elsewhere — like the eurozone — we could see another dollar rally. Demand for dollars remains high, and dollar liquidity constraints only add more fuel to the fire.

If we get another period of dollar strength, it’d likely mark the end of the latest relief rally. The size and speed of USD fluctuations is critical too. If the USD appreciates too much too fast, the potential for major currency depreciation and debt issues becomes increasingly high — with cracks already emerging in both. Dollar-denominated debt outside the US has grown considerably over the last 15 years, and another leg higher would tighten global financial conditions even further.

Periods of extreme stress often lead to unforeseen breakdowns in financial markets, something crypto participants know all too well at this point.

A couple of interesting examples where this stress could manifest are the Hong Kong dollar peg (HKD, above left) and the Japanese yen/JGB market (above right). The above charts are prominent examples of potential cracks in global currency and sovereign debt markets, and ones that could be strained if we see another period of consistent USD strength. The debacle in the UK gilt market is another example that’s lingering in the minds of US officials.

It’s important to note that betting on an HKD depeg has been an infamous “widowmaker” trade over the last 15 years. Also, as this was going to print, the BOJ announced an increase in the yield cap on 10yr JGBs. This sparked a jump in the yen and a new wave of hawkish concerns, as many believe this opens the door for a tighter monetary regime after Japan’s seemingly steadfast dovish stance.

Once again, global liquidity trends have a lot of influence on where we go from here. The fragility of sovereign bond markets may inhibit the Fed’s QT plans, bringing with it a weaker dollar and some much needed relief to markets that have lost their luster this year. If policymakers can avoid an outcome in which the dollar remains a strong, consistent threat, then risk assets stand to benefit considerably.

Key Theme #3: The Narrative Shift From Inflation Risk → Recession Risk

Our third key theme for 2023 is the narrative shift from inflationary risks to recession risks. The Fed remains focused on its top priority to curb inflation, and Fed Chair Powell has stated numerous times that a period of sustained, below-trend growth is likely necessary in order to achieve this end.

Obviously, the Fed isn’t in the business of destroying wealth and forcing recessions. While there’s much debate over their effectiveness, Jay Powell & Co. aren’t sitting behind closed doors scheming up ways to inflict as much pain as possible. They’re implementing the policies that they believe have the best chance of combating the highest inflationary pressures seen in decades. Unfortunately, the best antidote for stubbornly high inflation is a recession, and the Fed knows that.

In recent weeks, there have been signs that peak inflation may be behind us, leading to a less aggressive 50bps hike at the December FOMC meeting. However, we believe the Fed will aim to keep financial conditions tight for a prolonged period in order to avoid the perceived mistakes of the 1970s, even if it means an increased risk of recession. The transition from inflation concerns to recession risks is a narrative we believe will dominate the headlines throughout 2023.

Policy Paths Forward

It appears the market is preparing for its next boss to fight.

Leading indicators continue pointing to an economic slowdown.

The rapid decline in global liquidity growth and the aggressive tightening of financial conditions this year led to one of the largest wipeouts of net worth we’ve ever seen. The degree of such a negative wealth effect can also hinder personal consumption, but it may not be as effective given the high concentration of wealth in the US (where the top 20% of earners own ~70% of household wealth).

Consumer spending is holding up better than many expected, but inflation continues to eat into purchasing power and real wage growth.

Buying conditions for large expenditures (houses, vehicles, household durable goods) are still near the worst levels we’ve seen in decades.

We’ve also seen the fastest decline in homebuying conditions and housing affordability as average rates on a 30-year mortgage still top 6.5%.

As a result, consumer sentiment has taken a big hit this year. Historically, lower sentiment readings of a similar magnitude have preceded material increases in unemployment (UE rate is lagged 18 months in the below chart).

Forward-looking indicators also imply a less optimistic outlook for the labor market, especially if we’re knocking on recession’s door.

The latest FOMC forecasts show that more Fed members see upside risks to unemployment, but the reported unemployment rate is still hovering near record lows.

Typically, we see the unemployment rate start to tick up and cross over its 12-month moving average heading into recessions. The current 12-month moving average is right in line with the latest unemployment rate print, but the Fed’s latest forecast shows unemployment rising to 4.6% next year, which would put us on a similar track to prior recession examples.

Financial conditions have tightened at a record pace, which typically doesn’t bode well for future unemployment either (UE rate is lagged 9 months in the below chart).

The Fed has cited the resilience in nonfarm payrolls and wage growth as key pressure points that may keep inflation elevated. However, alternative data and dissections of the US labor market are telling a different story.

“A good gauge for the current state of the US labor market is the pace of full-time hirings (excluding multiple jobholders). On a rolling 6-month % change basis, the momentum in US full-time hiring is basically flat and in line with the weakest prints (ex-pandemic) of the last 10 years.” – The Macro Compass

Alf Peccatiello, founder of The Macro Compass, also shows how rapid changes in US financial conditions tend to “lead job creation trends by 9 months.”

The question now is whether policymakers will wait for unemployment to signal a weakening labor market in order to justify a transition away from tighter policy, or if they’ll lean on forward-looking indicators to get ahead of what’s expected to come. Rising recession risks mean peak labor market tightness may be in the rearview, as wage growth tends to fall alongside rising unemployment (both of which are lagging indicators).

The Fed’s credibility rests on its ability to rein in inflation, no matter the cost. Several forward-looking indicators imply economic weakness ahead, setting up 2023 as a year where recession worries take center stage.

Until Something Breaks

If we avoid a serious recession and policymakers somehow manage to engineer a “soft landing,” it’s less likely the Fed will make any drastic pivot — that is unless something breaks and their hand is forced.

Liquidity conditions have been deteriorating in the world’s most important securities market (US Treasuries), the proper functioning of which is critical for the entire global financial system. We’ve been talking about the growing fragility of the US Treasury market for months, and it’s a situation we continue to monitor closely.

Historically, these types of conditions tend to be a bullish setup for bonds. But so far, Treasury yields have deviated from their historical trend, even as the business cycle continues to show signs of weakening.

US Treasuries are the world’s risk-free asset. They’re the pillar of global FX reserves, they underpin global risk portfolios, and they’re one of the most prominent forms of accepted collateral. There is no comparable alternative, which is why an illiquid Treasury market is a real systemic risk. If the market loses faith in the ability to accurately price — and importantly sell — the global risk-free asset, the whole system starts to break down.

Bond losses also reduce the value of pledged collateral, which increases margin calls and reduces leverage in the financial system. This can have adverse consequences for market liquidity and can further dampen growth when credit becomes more scarce.

“The tide of the last bull market is rapidly going out and leaving many leveraged investors dangerously exposed. The irony is that, on this occasion, much of this leverage is concentrated in conventional ‘safe’ asset markets, like government bonds, rather than traditionally in the speculative ones.” – CrossBorder Capital

Illiquidity leads to volatility, which leads to even less liquidity and more volatility. This is a real risk and has the potential to break the Fed’s hawkish spirit. If this were to materialize, the infamous “Fed pivot” would not be caused by a victory over inflation, but rather because policymakers have no choice but to step in and provide liquidity as the backstop-of-last-resort. The consequences of sitting on the sidelines would be too dire at that point.

In our view, this has become a higher probability scenario as we move into 2023. Financial stresses have largely been isolated incidents thus far, but history tells us that spillover risk and contagion can become very real, very quick.

Markets = Supply and Demand

All markets are a function of supply and demand. Fortunately for the US, the demand for US Treasuries (USTs) is quite massive. Foreign buyers (public and private), the Fed, retirement funds, banks, and money market funds are all large holders of Treasuries. But several big buyers are turning into net sellers just as the Fed has started to remove itself from the equation.

Foreign central banks have been net sellers of USTs since 2014, which many have cited as a big risk to UST demand (especially since foreign CBs are large holders of longer-duration UST notes + bonds). The foreign private sector more than offset that reduction, but foreign official holders have accelerated their selling this year as private sector holdings have plateaued (we noted Japan is a key example of this).

The BOJ’s move to increase the yield cap on 10yr JGBs is the latest wrench in the UST demand story.

Banks are another source of UST demand, but their dynamics are changing too. Banks saw a significant increase in deposits in 2020-2021, and in order to earn a return on that cash, banks could deposit it with the Fed, buy securities, or lend it out. But the risk/reward tradeoff for each has evolved over the last 12-18 months.

Initially, deposit growth was offset by a spike in demand for borrowing. But massive spending programs and a recovering economy helped pad the pockets of consumers and businesses alike, causing a decline in loan demand. This pushed banks to buy securities to generate yield on their deposits.

Over the last 12 months, we’ve seen a steep decline in bank reserves (to the tune of $1.1T) while bank lending has been on the rise, ultimately leaving less liquidity chasing alternatives (like USTs). Bank security holdings peaked in February and have declined ~$300B since August as loan growth picked up (offering the prospect of higher returns).

We could see an acceleration in this trend should demand for borrowing remain strong and bank reserves fall further. The Fed has yet to fully remove itself though, and may try to thread the needle of QT optics (UST runoffs) with liquidity provisions to shore up financial stability.

Deposits have also fallen by ~$500B since their April peak as assets in money market funds (MMFs) continue to swell. But MMFs have been net sellers of USTs in favor of parking funds in the RRP where they can earn a higher risk-free return on cash.

We’ve left the era of “free money” where cash was plentiful and accessible. Demand for cash is on the rise, and so is the competition for it.

The RRP has been popularized because it offers access to the most liquid income-generating USD assets. It is important to note that funds held in the RRP represent liquidity being taken out of the financial system. In other words, they are funds not being used or invested elsewhere (like in financial/productive assets). We’ve seen how the contraction in liquidity has already had a significant impact on financial assets.

Major buyers of USTs appear to be pulling back just as new UST issuance is expected to ramp up over the next 12-24 months. This new supply will have to be absorbed by other participants if the Fed remains on the sidelines (or doesn’t act to source liquidity elsewhere).

Policymakers do have other ways to improve liquidity conditions. They could reinstate the “temporary” changes to SLR, which currently includes bank reserves and Treasuries in bank capital ratios, thus freeing up primary dealers to absorb new Treasury supply coming to market.

The March 2020 market selloff was a prime example of the impact liquidity drying up can have. Everyone rushed to sell assets for cash, but even one of the most liquid markets (Treasuries) couldn’t handle the panic — which sent borrowing costs skyrocketing. Banks saw a huge influx of deposits, but due to balance sheet constraints they were hamstrung from stepping in. This pushed the Fed to instate a temporary exclusion of Treasuries and bank reserves from SLR calculations, which gave banks more capacity to absorb deposits, buy more bonds, and extend credit to households and businesses in need.

After the Treasury market stabilized, the Fed lifted the temporary exclusion in March 2021, much to the dismay of some pundits who argued it would lead to further disruptions in the Treasury market.

Treasury buybacks are being floated, which could alleviate liquidity pressures by issuing new T-bills (which trade more easily) to buy longer-dated coupons and off-the-run bonds (which are less liquid). The increased supply of bills would likely be gobbled up by MMFs and other investors/institutions seeking safe, high-quality assets to hold.

We’ve seen a shortage of “safe assets,” including the supply of T-bills. There’s been a substantial decline in net issuance of T-bills over the last 12-18 months with the US Treasury instead ramping up net issuance of longer-dated notes and bonds.

The Fed’s standing repo facility is another potential backstop if liquidity conditions worsen. The Fed could also reduce the cap on funds that counterparties can submit for the RRP, incentivizing excess cash to flow elsewhere (like newly issued T-bills) and thus increasing liquidity in the financial system.

All of these things could improve liquidity conditions without major Fed intervention. But if these measures prove inadequate, the Fed may be forced back to the table. Providing liquidity as a backstop to keep the financial system humming is a tradeoff the Fed is quite familiar with, especially if its active intervention would calm the market’s concerns of a potential liquidity crunch.

The pullback in global liquidity is starting to expose vulnerabilities in pockets of the financial system. Fed intervention may be spontaneous at first, acting only as needed. In time, though, we believe the need for QE will become increasingly apparent as UST supply outpaces demand and global liquidity constraints threaten to keep a lid on tighter financial conditions that hinder a sustainable economic recovery. The Fed may be faced with a pivotal decision (poor pun intended) as 2023 gets underway.

As a side note, massive government spending in the aftermath of COVID likely created some recency bias in the general population, who may push for another wave of stimulus if their financial situations get bad enough. However unpopular, it wouldn’t be all that surprising to see fiscal policymakers intervene again, which would only add more strain on UST supply-demand dynamics. This isn’t the highest probability outcome right now in our view, though.

Key Theme #4: The Great “Recoupling”

As we know, crypto isn’t the only market struggling this year. For better or worse, everything has been distilled down to one big macro trade with the consistently high correlation between crypto and traditional risk assets. This begs the question — can crypto finally decouple from legacy markets?

Bitcoin has struggled against this backdrop, but it is not alone. ETH has suffered at the hands of the same macro headwinds that BTC has (tighter financial conditions, liquidity contractions, stronger dollar), even despite the most bullish narrative any crypto asset has ever had at its back.

In order for us to have any strong conviction in the idea of a break in the crypto <> macro relationship, we would need to see more sustained evidence of divergences in these markets, and that hasn’t really materialized yet. If anything, crypto has been left behind over the last several weeks in the aftermath of the FTX collapse.

The correlation between many crypto assets and higher beta stocks remains high.

We expect this trend will persist, at least directionally, given the material overlap in current headwinds and potential tailwinds for both equities and crypto.

Bear Markets and Recessions

We know that BTC is more reflexive during periods of high volatility, and we’ve seen it latch on to momentum in equity markets. Assuming the two remain positively correlated, the next question is what’s next for equities?

Looking at prior recessions, the SPX experienced a ~48% and ~56% peak-to-trough drawdown after the dotcom bubble and the GFC, respectively. If we include March 2020, the average drawdown of the last three recessions equates to a 45% decline from prior highs.

  • At its depths in mid-October, the SPX marked a 25% drawdown from its peak at the start of the year. If the index were to see a 45% peak-to-trough drawdown, it would need to fall to ~2,650 (from its current level of ~4,000).

The SPX also broke below its 200-week SMA in each of the last three recessions (including 2020). After breaking this level in 2001, the index fell another 37%. We saw a 48% decline after it lost the 200-week SMA in 2008, and another 17% decline in March 2020 (though this dip was short-lived).

  • In October, the SPX tested its 200-week SMA before rebounding >10%. If the SPX were to follow the recession playbook of the last 25 years, a 30% drop below its 200-week SMA would put the index around 2,550-2,600.

Moreover, the duration of the last two major recession drawdowns (ex-2020) lasted 109 weeks and 73 weeks (the duration of the March 2020 drawdown was a mere five weeks before policymakers jumped in as a backstop). For comparison, the current bear market cycle has lasted 50 weeks so far.

  • If we were to take the average duration, % peak-to-trough drawdowns, and the average % decline below the 200-week SMA of these more recent recessions, it would imply an SPX bottom in October 2023 with an index value in the range of ~2,550-2,650.

  • If, however, the SPX sees a peak-to-trough drawdown in line with its long-term average around historical recessions (-32%), its implied bottom would be closer to 3,260 (~18% lower than current levels) and it would occur in Q1 2023.

Rising Recession Risk

Stock prices are a function of 1) expectations for future earnings (and cash flows), and 2) the price investors are willing to pay for those expected earnings and cash flows (measured by price multiples like P/E, P/CF, etc.).

The vast majority of this year’s decline in equity markets can be attributed to multiple compression rather than lower earnings estimates, which haven’t fallen as much as one would expect in an environment where recession risks are climbing. So far, NTM EPS estimates for the S&P 500 have declined ~4% from their peak in June (its current NTM P/E is 17.5x after suffering a ~19% decline YTD).

Worsening fundamentals caused by a weaker economy, and the spillover effects of persistently high inflation (lower consumer spending + higher cost pressures), could drag on margins and corporate earnings next year — especially if wage growth remains sticky. Margins tend to roll over heading into recessions, but typically bottom after.

The resilience of Q3 earnings may be masking the challenges ahead.

Peak-to-trough EPS declines for the S&P 500 varied greatly during past recessions. The minimum decline in trailing 12-month earnings over the last 40 years was ~20%.

If we zoom in on more recent recessions (2000, 2008, 2020), we find the average peak-to-trough decline in NTM EPS estimates was ~26% (2000-2001 and 2020 saw ~20% declines, with 2008 doubling that).

Earnings expectations for 2023 have started to come down, but history suggests we still have more room to fall before we see a bottom in earnings forecasts. If we are headed for a recession next year, one would expect to see earnings estimates contract as they have in prior instances. The bottom panel on the chart below shows the year-over-year change in NTM EPS estimates for the S&P 500.

An earnings recession and a further contraction in price multiples would be a double whammy for stocks. Price multiples tend to compress when liquidity contracts and financial conditions tighten.

Price multiples also tend to take an even bigger hit around recessions. The S&P 500’s forward P/E fell to ~14x when the index bottomed in late 2002. It touched the same level briefly again in March 2020, and it dropped as low as 9.5x in the depths of Q4 2008.

The question now is what flavor of recession, if any, will we see and what implications it would have for equities next year.

The worst case scenario in our view is if we get a recession next year and global liquidity conditions remain tight. If the SPX’s NTM P/E were to fall to ~14x and we get a 20% peak-to-trough decline in NTM EPS (in line with prior recessions), the index’s implied price would be ~2,675, indicating another 33% drawdown from current levels (and a total peak-to-trough drawdown of ~45%).

So far, the S&P 500 is tracking its 2008 trend pretty closely.

We see a similar picture if we compare the SPX price action to its 2000 peak (using the September 2000 peak after the SPX retested its prior high).

We did just go through one of the fastest rate-hike cycles in several decades. Prior hiking cycles led to yield curve inversions, which are one of the most widely tracked recession signals.

But equities tend to suffer painful drawdowns when the yield curve starts to re-steepen, as that’s when the market starts pricing in lower rates in response to weakening economic conditions. History shows that equities can perform quite poorly in the immediate aftermath of a Fed pivot.

Interestingly, a recent BofA note argued that the current selloff “has been more linked to higher rate volatility than higher rates.” That’s true, because the rate of change in interest rates matters more than the level of rates.

The longer that higher rates and tighter financial conditions persist, the greater the chances of recession. 2023 is already shaping up to be a real balancing act for policymakers.

If we get a more shallow earnings recession and price multiples fail to retest prior lows, equities could see another leg lower but avoid the type of steep drawdowns that historically coincide with deep or prolonged recessions.

Further downside in risk assets could also be mitigated by an expansion in global liquidity. Price multiples for equities expanded rapidly after massive stimulus in 2020, so an expansionary environment could bolster prices even if the outlook for corporate earnings remains tepid.

Crypto Is the Canary

The crypto market is one of the purest bets on global liquidity expansion and currency debasement. Not only is it influenced by macro factors, but when market conditions change, it’s often the first to react. Over the past five years, all major price reversals in BTC have preceded those in major equity indices. This is notable because we expect longer-duration risk assets to bottom as the turn in the liquidity cycle becomes more clear.

History shows that, on average, BTC has topped ~48 days and bottomed ~10 days before the SPX:

  • BTC topped 42 days before the SPX in 2017 (12/16/2017 vs. 1/26/2018)

  • BTC bottomed 8 days before the SPX in 2018 (12/15/2018 vs. 12/24/2018)

  • BTC bottomed 11 days before the SPX in 2020 (3/13/2020 vs. 3/23/20)

  • BTC topped 55 days before the SPX in 2021 (11/9/2021 vs. 1/3/2022)

Decoupling May Have to Wait

Considering the occurrence of several unforeseen crypto events in 2022, it’s possible the large majority of downside has already taken place. However, given how correlated crypto assets have been with global liquidity trends (and other factors like the US dollar), the possibility of a true decoupling seems unlikely in the near-term.

If liquidity conditions improve but the outlook for corporate earnings worsens, we could get a situation where equities remain weak/flat (because price multiple expansion is offset by weaker earnings) and crypto assets move higher. This is the most likely scenario in our view to see a true decoupling, if it were to happen.

If these conditions present themselves, or if equities do see another sizable selloff, the decoupling narrative will be stress tested. If the crypto market holds up, it could mark an inflection point for crypto to break its ties with traditional markets.

Sentiment would improve. Funding conditions would be more favorable, opening the door for even more investment in this space. Better financial conditions for project teams and protocols would attract more talent, some of which has been hesitant to take the plunge into crypto full-time because of this year’s events. Brands, talent, creators, and companies would be more enticed to explore Web3 strategies, especially those in need of a game changer to improve their current business models or foster new revenue streams.

Reflexivity and market feedback loops would begin to take over. Institutions would be back at the table as the argument for crypto as an uncorrelated asset class would have new life.

If, however, macro conditions worsen or fail to meaningfully improve, the crypto market will likely remain under pressure. We do expect to see crypto assets turn higher once the market realizes liquidity conditions are making a meaningful turn — and they may be the canary in the coal mine for traditional risk markets if history serves as a reliable guide.

Key Theme #5: Narratives Matter More in Bull Markets

When we do see a trend reversal, we believe that crypto narratives will begin to matter more and have a more meaningful impact on asset prices. This is not to say that narratives haven’t mattered at all this year. But during major bear markets, macro headwinds overpower sector or asset-specific catalysts and narratives often struggle to create sustained, positive price impact on individual names or sectors. Catalysts and narratives are often a bigger driver of asset outperformance during bull markets, and can even eclipse the most fundamentally-sound projects in the process. Narratives matter more in bull markets, especially within industries that are built on future growth prospects like tech and crypto.

We believe the key example of this theme will be the revival of the ETH Merge narrative, which has been the most impactful milestone from the original ETH roadmap. With the Merge behind us, there have been dramatic changes to Ethereum’s consensus, issuance, and energy efficiency (which helps with the ESG narrative). Perhaps most importantly, ETH’s supply will turn net deflationary as economic activity picks up.

Even with the most compelling fundamental crypto catalyst and narrative to date, there has been little impact on crypto asset prices. In fact, ETH has slumped nearly 35% since the Merge completed on Sep. 6th, 2022. We attribute this to the macro bear market that has been the ultimate driver in the collapse of risk-asset prices across the board. When these macro headwinds begin to abate, risk assets will begin to make a comeback, and we know that bull markets give rise to some of the strongest narrative-driven asset price moves.

We saw this in traditional markets in the wake of COVID with the meme stonk mania between the GME and AMC crowds.

We also saw this within the crypto markets with the start of DeFi summer with ETH trading at ~$240.

We also saw this with the meteoric rise of NFTs in January 2021. We believe this will be the case when the macro tides begin to turn, with the ultrasound money ETH narrative leading the charge (more on this in our Futuristic Ideas section at the end of this report).

Putting It All Together

This is arguably one of the toughest environments investors have faced in decades. We’ve seen a record level of wealth destruction this year, and we’re still in the midst of a challenging macro backdrop as there’s still a ton of uncertainty about the road ahead. If you ask 10 different experts where they see inflation (or the DXY, or financial conditions, or global central bank balance sheets) in 1-2 years, you’ll likely get 10 different answers. And each of them could probably provide strong evidence to support their view, which is a testament to just how much uncertainty still plagues markets right now.

There’s a lot to digest, so here are our biggest takeaways as we close the books on 2022 and look to the new year:

  • 2022 was The Great Reset for crypto. Overly hyped trends and mass speculation pushed the crypto market far out over its skis by the end of 2021, so this year’s washout was a necessary reset. Sizable corrections are healthy for long-term secular uptrends.

  • We believe 2023 will be a period of accumulation, setting the stage for the next bull cycle. If this cycle follows the general path of those before it, one would expect to see markets consolidate into Q1 2023 before forming a clear bottoming pattern. We could see a renewed uptrend as early as mid-2023, but our base case is that the bulk of the move will occur in 2024-2025 as risk appetite and speculation return in full force.

  • This aligns with our assumption that global liquidity will transition back to an expansionary environment after the significant contraction we’ve seen over the last 12 months.

  • Liquidity trends tend to follow leading indicators of the business cycle, which means liquidity conditions should start to improve materially in Q1-Q2 next year. If we expect the liquidity cycle to turn in response to a weakening growth outlook, we’d also expect to see a weaker USD.

  • We’re already seeing early signs of this (PBOC easing + China credit expansion, Fed net liquidity stabilizing, a weaker USD, recent easing in financial conditions, etc.). If this recent uptick proves to be the start of a renewed uptrend, it would bring much-needed relief to many markets that’ve been thrashed by tighter conditions this year.

  • Similarly, many are trying to predict when we’ll see a “Fed pivot,” but most are focused on when the US central bank will pause rate hikes and/or when they’ll start signaling a wave of rate cuts. Rather, we argue that what really matters is when we see a reversal in liquidity conditions, since that’s what will continue to have an outsized influence on market conditions and asset prices going forward. We saw this dynamic during the 2017-2018 cycle, and again more recently.

  • Looking further out, higher rates may not be as big of an issue now, but they will be when it comes time to roll over the enormous amount of debts outstanding. As we noted in a previous report, credit growth — and credit availability — are influenced by market conditions like changes in risk appetite and the availability (and stability) of collateral. As the aggregate amount of debt grows, more balance sheet capacity is required to refinance existing debt obligations, which is where the real vulnerabilities lie (and another reason why QE will have to return).
  • We believe crypto and equities will remain positively correlated, largely because both are facing similar macro headwinds and potential tailwinds which will continue to have a strong influence on asset prices. If we were to see a true decoupling, it would likely come if liquidity conditions improve but the outlook for corporate earnings worsens, where equities remain weak/flat but crypto assets get a lift.

  • This liquidity phenomenon isn’t just an exogenous influence on crypto, either. We see similar liquidity dynamics take hold within the crypto market as well. Liquidity truly is the lifeblood of financial markets.

  • When prices increase, the crypto industry as a whole experiences a wealth effect as the perceived size of balance sheets balloons (usually to be borrowed against). For example, during the 2020-2021 bull market, we saw the total amount of loans outstanding increase rapidly alongside asset prices, which in turn allowed active participants to take on even more leverage. This expansion in liquidity made its way into every corner of the market as capital flows fed higher asset prices (which fed more leverage and so on).

  • The Great Reset of 2022 saw a painful reversal in this trend, creating an environment defined by contractionary liquidity conditions rather than expansionary ones. Access to liquidity is one of the biggest risks to the crypto industry over the next 3-6 months.

  • When we do see a trend reversal, we believe crypto narratives will begin to matter more and have a more meaningful impact on asset prices. This is not to say that narratives haven’t mattered at all this year. But during major bear markets, macro headwinds often overpower sector or asset-specific catalysts. During bear markets, even the best narratives often dissipate as they struggle to create a sustained, positive price impact.

  • Market conditions will likely remain challenging over the next few months, but the light at the end of the tunnel appears to be getting brighter.

What Surprised Us This Year

Jason: 2022 was a year of many surprises, to say the least. The most surprising event for me was the magnitude of, and contagion caused by the 3AC collapse in June. Those of us who have been in the crypto markets for several years have seen a lot. Seeing protocols like Luna/Terra fail isn’t unheard of (while being terribly unfortunate and costly). Seeing exchanges collapse and/or commit fraud, while also terrible, isn’t unheard of either. The 3AC event was different in that it was the one of the first big institutional players to really “blow up,” taking many industry players out in the process. While these types of blowups have occurred in the traditional finance world, this was the first real one to occur within the crypto industry. In essence, it was our very own LTCM moment.

Andrew: Considering everything that has transpired in this year alone (the countless hacks, protocol collapses, NFT rug pulls, and underlying contagion, all while being overshadowed by the poor macroeconomic landscape), it’s not illogical that the prices of BTC and ETH are where they are today.

With that being said, if you told me at the beginning of 2022 that both BTC and ETH would fall beneath their previous cycle all-time highs (for an extensive duration), I probably wouldn’t have given you the time of day. Before this year, BTC and ETH had never closed below a previous cycle high, and BTC had never failed to maintain its 200-week moving average, which has historically been a key support level for cyclical bottoms.

However, both of these levels were lost earlier this year. Although current sentiment and volatility may be difficult to stomach, the silver lining is the opportunity lower prices present. With time, the industry will heal. And in the future, when we look back on 2022, it may prove to be a generational entry point.

Futuristic Ideas for 2023 and Beyond

The ETH “Flippening”

For years, Ethereum advocates have popularized the notion that ETH would eventually take Bitcoin’s top spot on the crypto leaderboard, an inflection point known as “the flippening.” As of today, ETH’s market cap is ~45% of BTC’s. But at its peak in June 2017, ETH reached over 80% of the total valuation of BTC. However, when you compare all of the potential use cases, revenue projections, development/user activity, and sustainability aspects of BTC and ETH, it becomes clear which one has the higher likelihood of making a larger splash on a global scale.

Ethereum also has the most trusted brand and benefits from its first-mover advantage among L1 networks and smart contract platforms, which has attracted a diverse ecosystem with over 2,000 live applications and over 4,000 active developers. But we’ve only seen the tip of the iceberg when it comes to Ethereum’s applications and use cases.

ETH presents one of the best risk-reward opportunities if you believe crypto has a real future, especially given the structural changes to its economics in a post-Merge world. The Merge was the most highly anticipated narrative of 2022, but so far has been overshadowed by the perfect storm of macro headwinds we’ve discussed. Many believed that the new supply dynamics of ETH would trigger an immediate appreciation in price, but the opposite transpired in classic sell-the-news fashion. Since the Merge, ETHUSD is down 28% and ETHBTC is down ~9%.

But the fundamental changes implemented through EIP-1559 and the Merge mean Ethereum now has real, measurable cash flows that directly increase value accrual to ETH. Unlike Bitcoin, which uses 100% of protocol fees to pay miners (with 0% distributed to holders), Ethereum now allocates 100% of its fees to reduce the total ETH supply (akin to a stock buyback) and reward validators on its network (akin to dividends). This allows us to use more traditional valuation techniques to come up with rough estimates for ETH’s potential value (and implied price).

Like other L1 networks, Ethereum has one main product — block space. The demand for block space has grown considerably over the last 5-6 years. Since 2017, the annual transaction count on the network has averaged a growth rate of 143% per year.

If we remove the outlier year of growth (from 2016-2017), transaction volume has grown 41% annually, which would be impressive for any company, even a high-growth startup.

Higher transaction volumes lead to higher gas prices, which lead to higher fees for the network. Ethereum’s total fees (in ETH) have grown at an average rate of 177% annually over the same period. If we convert those to USD amounts, annual fees in USD have grown at a rate of 658% per year.

More Use Cases → More Users → More Economic Activity → More Network Growth

There are several methodologies one can use to try and value decentralized networks. We highlighted some of the key factors and differences to consider when evaluating L1s in previous reports, and there are multiple frameworks one can pull from or combine to get a clearer picture of their potential.

”Staking rewards are composed of three sources: inflation block rewards, MEV, and transaction fees…Real staking yields capture fees and MEV accruing to validators (only in proof of stake), as well as token burning which also benefits all holders (beneficial in both PoS and PoW).” – Valuing Layer 1s – Memes, Money, or More?

How do you create a sustainable source of real yield? Increased network activity. That is why Ethereum is primed to benefit from the next wave of adoption, because it already captures meaningful revenue (network fees, MEV), which directly feeds into attractive real yields for its native asset, ETH.

That’s one of the reasons why the amount of fees Ethereum generates is important for its long-term health and sustainability. So far, it appears to be headed in the right direction, as total fees on Ethereum have increased each cycle as the network attracts more active users and transaction activity.

Ethereum has already demonstrated its ability to serve as a more robust alternative for services such as remittances, trading exchanges (settlement and clearing), and transparent collateralized lending. It’s also shown value as a system to record, verify, and settle value transfers of digital assets and tokenized IP like art, collectibles, or even music.

One of its biggest opportunities, though, is capturing market share from legacy financial services. There’s a strong argument that many financial services can be reproduced, and even improved upon, by leveraging DeFi primitives.

As with any forecasting tool, the conclusions are only as good as the assumptions behind its inputs. For example, there are several differences between traditional DCFs and ones that are appropriate for valuing a crypto asset as dynamic as ETH. Unlike a company, there are no payrolls, lease or rent payments, interest, taxes, or typical operating expenses that eat into expected profits. All costs are borne by network validators, so “fees” and “profits” are more synonymous than standalone line items.

Taking a page out of Arthur Hayes’ post, Yes…I Read the Whitepaper, we can get a quick sense of ETH’s potential value using example target markets. Take financial services, for example. Global commercial banks are on track to report $2.71T in revenue this year, according to estimates from industry research provider IBISWorld. Hypothetically, if Ethereum were to capture just 2% of global banking revenue, ETH would be worth >4x its current valuation even if it traded at a conservative 11x earnings (roughly in line with industry averages). And that’s just one example of a market ETH can penetrate (albeit a very large one).

Admittedly, ETH trades at a significant premium compared to the amount of fees it generates today. But using the above example — which again is still just hypothetical — its implied price multiple would be 3-4x expected earnings (vs. today’s 80-90x).

In a world where Ethereum becomes a trusted settlement layer for a larger percentage of financial transactions, the “flippening” doesn’t seem that outlandish. If anything, it’s starting to look more inevitable. It’s still a big if, but if ETH were to capture just a small percentage of legacy financial services, its valuation would likely far exceed that of BTC. As of now, it looks increasingly likely that the potential ceiling for ETH is higher than that of its OG counterpart.

Like all emerging tech plays, this one doesn’t come without its own share of risks. For starters, competing L1s and L2 scaling solutions could pose risks to Ethereum’s stronghold on the fee market. Networks that offer low costs and faster block times have the potential to steal transactional market share from Ethereum, thus hurting its future fee prospects.

But even with the rise in competition, Ethereum continues to showcase why it remains the top protocol in terms of block space demand and total fee generation. Over the last 12 months, ETH has captured 78% of all fees generated by the top 10 fee-producing protocols.

Drilling in a bit further, the disparity in fees is even more eye-catching. ETH has generated over $5.5B worth of fees over the past year. The next closest competitors are Binance Chain ($550M) followed by Bitcoin ($152M). Given its first-mover advantage and widespread popularity (both for users and developers), we believe ETH will continue to maintain its fee dominance over competitors in the coming years.

The concentration of ETH staking has also drawn attention. Four major platforms/staking providers account for more than 57% of all current ETH staked, with Lido alone representing 30% of the total.

Furthermore, the top 10 holders of Lido’s governance token (LDO) make up over 52% of the LDO supply, resulting in potential decentralization and censorship issues. Although this topic is heavily debated across the industry, reducing the concentration of staked ETH wouldn’t hurt, especially if one of its stronger narratives lies in its decentralization benefits.

Be sure to read Delphi’s Infrastructure Year Ahead report for a deep dive on all the important trends our team is tracking in that sector.

DEX User Experience Will Trump CEX

The DEX user experience will match and exceed the CEX experience we are all accustomed to. Unfortunately, the time for this is not the present, which is why we find it in the “Futuristic Ideas” section of this report. As crypto continues to move from cycle to cycle, one theme continually re-emerges — self custody and the famous motto, “not your keys, not your coins.” In the aftermath of what has been a horrendous year, this lesson has never been more important. Surprisingly, it is precisely the horrific nature of these events that has given rise to perhaps the greatest opportunity for DEXs to challenge the incumbency of the CEX experience.

There are several challenges and hurdles that DEXs must overcome in order to compete with CEXs. A few of these include:

  • User experience and integrations: A big hurdle for DEXs is that they are often more challenging to use than CEXs for most users. Most DEXs require self custody; users must have their own wallet and must manage their own private keys. This is often intimidating, and a turnoff for most market participants. DEXs have the added challenge of requiring users to have a minimum level of technical knowledge in order to use them effectively, such as knowledge of smart contracts or other protocols. Within the traditional finance realm, there have been decades of third-party software integrations with CEXs. This has carried over to crypto, as many of the largest CEXs have similar third-party integration abilities as their TradFi counterparts. Integrations for DEXs do not yet exist in any meaningful way.

  • Liquidity: Another major challenge for DEXs is that they often have lower liquidity than CEXs. This can make it more difficult for users to execute trades on the exchange. This can also lead to higher volatility and wider spreads in various markets. In order to compete with CEXs, DEXs must find ways to increase their liquidity and make it easier for users to trade on their platforms.

  • Ironically, regulation: CEXs are often more heavily regulated than DEXs. This gives users MORE confidence in the legitimacy, security, and reliability of the exchange. This is ironic, as the aftermath of the FTX collapse is still playing out. DEXs, on the other hand, may not be subject to the same level of regulation, which can be a concern for some users. In order to compete with CEXs, DEXs will need to address user concerns.

DeFi applications have massive potential to disrupt and improve traditional financial services as well. Bringing more real world assets (RWAs) on-chain would increase transaction volumes and fees, especially for protocols that attract the most liquidity (as liquidity has its own network efforts). RWAs are more familiar instruments for TradFi investors too, which naturally should attract more institutional activity and capital.

The size of the global investable securities market is massive — even if DeFi facilitated a fraction of that total transaction volume, it would drastically increase its TAM by several magnitudes. For context, US equity exchanges regularly facilitate more than $80-100B of daily trading volume alone. Uniswap, the largest decentralized AMM, typically does 0.5-2% of that volume (but interestingly enough, it generated nearly 25% of the total annual revenue of Nasdaq over the last 12 months).

Special thanks to Cheryl Ho for designing the cover image and countless graphics within this report, to Abe Weiskorn for design management, planning, and direction, and to Brian McRae for editing.


Below is a list of all Delphi Digital reports referenced in The Great Reset: Navigating Crypto in 2023.

0x Protocol: A DeFi Pioneer Making Waves

The State of Undercollateralized DeFi Lending

The Race to Build A “Sticky” DeFi Debt Market

TrueFi Leads Liquidity for Unsecured Loans

Lyra: A Next Generation Options AMM

Synthetix Paves an Optimistic Path

Aave V3: A Multi-Chain Liquidity Protocol

Gearbox Protocol: Shifting DeFi Into the Next GEAR

Uniswap vs Curve: Which Is the Best DEX?

The Inner Workings of DeFi Option Vaults (DOVs)

Re-Evaluating The Decentralized Derivatives Landscape

Do Fundamentals Matter in Crypto Markets?

Is Fuel The Best Modular Execution Layer?

Finding a Home for Labs

Sei Network: DeFi-Optimized Cosmos Chain

Cosmos: The Evolution of IBC

Pay Attention To Celestia

MEV Manifesto

The Race To Become Solana’s Liquid Staking Winner

ATOM 2.0: Building The Hub’s Economy

The Resurrection of THORChain

ZK (Validity) Rollups: Entering the General Purpose Era

Arbitrum Nitro: Building on Year 1

The Complete Guide to Rollups

Osmosis: Diffusion Across the Cosmos Ecosystem

The Hitchhiker’s Guide to Ethereum

The Future of (Crypto) Gaming

Ranking NFT Platforms: A Guide For Brands

NFT Game Platforms: Through the Eyes of Founders

Gaming Guilds Update

The Tide Rolls Out for The Sandbox

STEPN Sprinting Away

NFT Lending: A Rising Opportunity When NFTs Meet DeFi

Sudoswap: Where DeFi Innovations Meets NFT Markets

A Bull Case for Music NFTs: Everything You Need To Know About The Next .WAV Of On-Chain Art

Reputational Identity — 2022 Progress Update

Why the Future of Fashion is in the Metaverse

LooksRare vs. X2Y2 : A Story of Incentivized NFT Marketplaces

NFT Lending: A Rising Opportunity When NFTs Meet DeFi

Generative Art Takes Off – Is it the Defining Art Movement of the Century?

A Primer on NFT Wash Trading

Aku, The Moon God & The New Age of Web3 Media

Nouns — Hyperscaling a Brand & Treasury from Zero

Why Bitcoin Is Behaving Like It Should

Liquidity Runs The World

Crypto’s Make or Break Moment

Crypto Hell Week

Managing Expectations Heading Into “The Merge”

ETH Supply Turns Net Deflationary Since The Merge

Valuing Layer 1s: Memes, Money or More?

Searching for Market Bottoms

Reflexivity & The Fall of the Efficient Market Hypothesis

Liquidity Cascades & The Evolution of Financial Markets

Volatility, Order Flow, & The Inelastic Market Hypothesis

The Great Decoupling: Perception vs. Reality

The Aftermath of FTX’s Downfall

November 2022 Chartbook: Uncertainty Reigns Supreme Post-FTX Collapse

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