Over the course of February, one could not scroll crypto Twitter without encountering the Bitcoin Odinals debate. Ordinals enable the creation of Bitcoin-native non-fungible tokens (NFTs). Ordinals, developed by Casey Rodarmor, use the input field in Taproot transactions to embed image-related data into the Bitcoin blockchain. The Taproot upgrade, which was activated in November 2021, allows for the cheaper storage of arbitrary data and permits users to store as much data as they want in a single transaction, provided they pay for it and the total block size remains under 4MB. Prior to Taproot, users needed to use multiple transactions or inputs to store large amounts of data.
A side effect of Ordinals and Inscriptions is the growing adoption of Taproot, which surpassed 5% on February 1 and reached ~18% on February 9th (image below). The introduction of NFTs on Bitcoin has also resulted in an increase in fees, which can be a positive for the long-term security of the network.
Ethereum and the Shanghai Upgrade
On February 7th, Ethereum’s Zhejiang testnet successfully conducted a simulation of staked ETH withdrawals, marking an important first milestone in the testnet sequence for the Shanghai/Capella upgrade. Zhejiang was the first of three testnets in this sequence before the actual mainnet upgrade can be confidently scheduled. On February 28th, Ethereum’s Sepolia testnet went live on and finalized, marking the successful implementation of the second testnet. Following Sepolia, Goerli, which is considered the most critical public Ethereum testnet, will be the final step before staked ETH withdrawals can be enabled on the Ethereum mainnet. The Shanghai upgrade, which contains multiple features, is most eagerly awaited for its ability to enable withdrawals. "Exited" validators will have access to full withdrawals, while active validator balances above 32 ETH will have access to partial withdrawals. As of today, core developers anticipate that Shanghai will take place in late March/early April.
Coinbase and L2s
Beginning in February, COINBASE integrated with Ethereum rollup, , allowing users to deposit and withdraw straight to the L2. However, Coinbase’s biggest announcement last month had to do with Arbitrum competitor,
Coinbase made a significant announcement about their new Layer 2 project, named Base. It will use Optimism's OP Stack and collaborate with Optimism as a Core Developer. ETH will be used as the gas token for security purposes, and it will have full EVM equivalence, enabling large applications built on the EVM to move to the chain. Coinbase will use a single sequencer to operate the platform, and a percentage of transaction fees on Base will be sent to the Optimism collective, governed by OP. This news caused an 8% increase in the price of OP tokens in a few minutes, as it provides more credibility to the OP Stack and encourages more projects to build on it. For Coinbase, this presents an opportunity to use the sequencer to extract MEV and leverage their brand recognition while also contributing to the decentralized and open-source ethos of crypto. Furthermore, this development helps to grow the USDC supply, which provides benefits to Coinbase.
One of the Federal Reserve's favored inflation metrics, Core PCE, showed a slight increase in both monthly and yearly time frames in its latest reading. Annualized, core inflation has risen by 4.7% compared to the previous year. This is significant because it was expected to decelerate to 4.3%, making it an unexpected increase. While the primary trend is still downward, it's possible that 4.5% could be the lowest inflation will get over the next year or two. There are growing beliefs that inflation will be structurally higher as monthly core PCE prints remain around 4.75%. While it's unlikely to challenge 6% again, if it continues to stay close to 5% and doesn't trend below 4% or toward 3%, the Fed will likely continue hiking rates. The market also recognizes this dynamic, as seen in the change in forward expectations for the Fed Fund's terminal rate. Currently, the futures market has fully priced in hikes for March, May, and June. The author believes that the Fed will raise rates by at least 50 bps more, with 25 bps increments in March and May.
During the meeting, there was a discussion among participants about raising interest rates by 50 basis points. Unemployment rates were stable at 3.5% in December, but inflation was still high at 5%. The committee agreed that restrictive monetary policy should remain in place until there is evidence of a sustained decrease in inflation. Investors are keeping an eye on jobless claims and inflation readings. The futures market has priced in a 76% chance of a 25 basis point increase on March 22. This is significant because the market had been certain that the Fed would eventually have to pivot and crypto would continue to rise. However, the Fed's language is pushing back on that idea, and they do not seem to be slowing down their plans to control inflation anytime soon. As a result, the rest of this year may be uncertain, with ongoing efforts to combat inflation in the background. This does not necessarily mean that there will be a market crash, but it may limit potential growth and lead to more sideways action.
Regulatory Crackdowns
U.S. regulators and the SEC were busy in February, doling out headlines and enforcement actions seemingly every couple of days. This includes
- A joint statement by the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and the Treasury’s Office of the Comptroller of the Currency (OCC) that strongly discourages banks from engaging with cryptocurrencies. The statement recognized that banks are not prohibited from offering services to any type of customer, including those involved in the crypto industry. However, the regulators also highlighted the particular risks associated with crypto-related companies and assets, cautioning banks against holding or issuing cryptocurrencies as principal. They also pledged to closely monitor exposure to crypto assets.
- The Board of Governors of the Federal Reserve System recently released a policy statement on crypto activities and state-chartered banks, following a joint statement by banking regulators about the risks associated with crypto assets for the banking system. The policy statement aims to create a level playing field for state-chartered and federally-chartered banks, and it denied Custodia Bank's application to join the Federal Reserve System. The statement clarifies that neither national nor state-regulated banks have the authority to hold crypto assets as principal, which means they cannot hold crypto as an investment asset on their balance sheets. While issuing stablecoins is "presumptively unlikely" to align with safe banking practices, the Board did not entirely rule it out. The Board also highlighted the importance of verifying parties transacting with banks, including unhosted wallets, and noted that banks can custody digital assets in a regulated, safe, and sound manner.
- The SEC ordered Paxos to stop issuing BUSD. The New York Department of Financial Services (NYDFS) has ordered Paxos Trust Company, the issuer of the BINANCE USD (BUSD) stablecoin, to cease the creation or minting of new tokens. This move comes amid the controversy surrounding the BUSD stablecoin, also known as the Binance USD, and Paxos' announcement of its intention to end its relationship with Binance. The reason for the halt is unclear, but it may be related to the issuance of BUSD on other blockchains, known as Binance pegged BUSD, which was not approved by the NYDFS. Concerns have been raised about BUSD, including allegations of insufficient backing for pegged assets, comingling of client funds, and attempts to create an interest-paying stablecoin.
- Additionally, the SEC sent a Wells notice to Paxos, suggesting that the agency may take action against Paxos, the issuer of the stablecoin BUSD. Although the notice is not public, Paxos confirmed that the SEC considers BUSD to be a security, and that its offering was not registered under federal securities law. However, Paxos has publicly disagreed with the securities classification. Additionally, the NY DFS ordered Paxos to halt the creation of new BUSD tokens, and Paxos announced its decision to sever its ties with Binance. It is unclear why the DFS halted the issuance of BUSD, but it may be due to the issuance of Binance pegged BUSD on other blockchains, which was not authorized by the DFS. Paxos's competitor, Circle, has not received a Wells notice from the SEC and issues the second largest stablecoin, USD Coin (USDC).
- The SEC recently filed a complaint and settled with Kraken over its staking-as-a-service offering, with Kraken agreeing to pay a $30M fine and end the service. This marks the first enforcement action against staking services triggering securities regulation, although the underlying assets used to stake are not considered securities. SEC Chairman Gary Gensler has previously expressed concern about staking services, and Coinbase has now published a blog post stating that its staking services are not securities. While Ethereum has transitioned to proof of stake, many newer cryptocurrencies also allow owners to generate returns by participating in the block-building process.
- The SEC has filed charges against Genesis and Gemini Earn for their involvement in the unregistered sale of securities to retail investors in the aftermath of the bankruptcy of Genesis' lending arm, which impacted users' balances in the Gemini Earn program. According to the complaint, the Gemini Earn program, in conjunction with Genesis, constituted an offer and sale of securities that should have been registered. In addition, the SEC has charged Terraform Labs and its CEO with fraud in relation to the sale of crypto asset securities Mirror (MIR), Terra (LUNA), and Terra USD (UST). The SEC alleges that MIR, marketed as a "governance token" for the Mirror Protocol, and UST, an algorithmic stablecoin, are both securities.
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