Blockchains are famously open databases for anyone to inspect, but deciphering them is not always straightforward
Risk assets had a tough January, but bitcoin's performance was middle of the pack when adjusting for volatility
Counterparty risks have shifted from centralized exchanges to smart contracts as the latest hack emphasizes
Transactions Are Not Always So Simple to Decipher
Blockchains are open databases available for anyone to explore, inspect, and analyze. However, even though anyone can explore blockchain data, the pseudonymous natures of blockchains can make deciphering data less straightforward than one might think. The difficulty in measuring the number of so-called “change outputs” illustrates this point.
As a quick overview, Bitcoin’s blockchain does not create an account for individuals to maintain balances, as a bank does with customer accounts. Rather, the Bitcoin blockchain only records changes of ownership between addresses. To spend bitcoins, a user must prove ownership of addresses using a corresponding private key. Thus the “balance” of a user is just the sum of all transactions that point to an address whose private key the user knows. One thing that makes tracking the economic substance of transactions difficult is that, when a user sends bitcoins, it must consume the entire amount of bitcoins that has been sent to it in a previous transaction (what is known as the input). If a user wants to spend less than the size of the input, then he or she sends the change back to another address that he or she controls. That address may be the same as the sending address, or it can be an entirely different address. In the transaction diagrammed below, the user is sending 0.2 BTC to another user, taking the change of 0.8 in a separate address that he or she owns.
A third party perusing the blockchain has no idea that A and C are owned by the same entity and may count the whole balance of the transaction as economically substantive. That would be an overestimate. Many transactions do send bitcoins back to the same address, like in the transaction shown below. These transactions are generally easier for a third party to decipher.
Of course, this is a simplification for illustrative purposes. Real-world transactions often have multiple inputs and outputs, making data analysis much more complicated. As a result, transaction volumes are often estimated and can vary significantly based on the unique methodologies employed by each blockchain data provider. Furthermore, in addition to estimating change amounts, statistical techniques can be used to associate addresses with individual wallets (wallets can hold multiple private keys each connected to an address) or an individual entity, like an exchange. As a result, change-adjusted or entity-adjusted volume estimates differ by the data provider. The following is a comparison of transaction volume measures in bitcoins by two well-known data providers, Coin Metrics (CM) and Glassnode (GN). We point this out to educate readers about how Bitcoin transactions work and to show that there may be volume estimate differences depending on the source and measurement type.
Risk Markets Have a Difficult January
Bitcoin prices fell by -16.1% in January, the third worst January performance in the asset’s history. This aligned with poor performance across numerous asset classes. The S&P 500 saw the eighth worst January in its history. However, we are comparing the bitcoin return to about 10 years of history and we are comparing the S&P 500 return to nearly 100 years. The relative magnitude of these returns, and those of other asset classes, are also put in better perspective when adjusted for their risk. While bitcoin was the worst-performing major asset class in January while looking purely at returns, it is middle-of-the-pack when sorted by its Sharpe Ratio.
Centralized Exchange Counterparty Risk Gives Way to DeFi Counterparty Risk
This week, an unknown hacker or set of hackers were able to infiltrate a bridge between Ethereum and Solana called “Wormhole” and steal 120,000 ether worth about $325M. This bridge allows users to transfer ether value on the Solana blockchain via “wrapped ether” tokens that are backed by one-to-one by ether on the Ethereum blockchain. The hackers were able to steal the ether backing these tokens, meaning that the wrapped ether became theoretically worthless. Within 24 hours, however, the funds were fully replenished by a prop trading firm called Jump Trading. Effectively, Jump Trading made holders of wrapped ether whole. Jump Trading owns Certus One, the developer behind Wormhole, so it had an incentive to keep it running. It also may have owned some wrapped ether itself. If so, some of those funds would effectively go back to Jump.
As compared to centralized exchanges, decentralized applications have become an increasingly dangerous place to park funds. To illustrate the point, there is a popular webpage called the “Rekt” leaderboard, that displays a historical ranking of crypto hacks. The site, which does not include any data before 2020, is dominated by hacks on decentralized platforms. DeFi hacks represent nearly 90% of the stolen funds listed on the site. Crypto investors were historically wary of keeping balances on centralized crypto exchanges following high-profile hacks such as that of Mt. Gox. This custodial risk hasn’t been solved through smart contracts and decentralization alone. It took the massive losses at Mt. Gox for centralized exchanges to beef up their security practices. So far, it looks as if the DeFi protocols will have to take their lumps as well.
Market Update
Bitcoin increased by 2.2%. Equities also gained on the week, with the S&P 500 up 3.5% and the Nasdaq Composite rising by 4.0%. Gold decreased by -0.1%. Bonds were generally down on the week, with Investment Grade Corporate Bonds down -0.5%, High Yield Corporate Bonds flat, and Long-Term U.S. Treasuries falling by -1.3%. Real yields were mixed and inflation expectations decreased.
You are receiving this email because you signed up to receive our weekly research at www.nydig.com
This communication has been prepared solely for informational purposes and does not represent investment advice or provide an opinion regarding the fairness of any transaction to any and all parties nor does it constitute an offer, solicitation or a recommendation to buy or sell any particular security or instrument or to adopt any investment strategy. Charts and graphs provided herein are for illustrative purposes only. This communication does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of New York Digital Investment Group or its affiliates (collectively NYDIG).
It should not be assumed that NYDIG will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein. NYDIG may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this communication.
The information provided herein is valid only for the purpose stated herein and as of the date hereof (or such other date as may be indicated herein) and no undertaking has been made to update the information, which may be superseded by subsequent market events or for other reasons. The information in this communication may contain forward-looking statements regarding future events, targets or expectations. NYDIG neither assumes any duty to nor undertakes to update any forward-looking statements. There is no assurance that any forward-looking events or targets will be achieved, and actual outcomes may be significantly different from those shown herein. The information in this communication, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.
Information furnished by others, upon which all or portions of this communication are based, are from sources believed to be reliable. However, NYDIG makes no representation as to the accuracy, adequacy or completeness of such information and has accepted the information without further verification. No warranty is given as to the accuracy, adequacy or completeness of such information. No responsibility is taken for changes in market conditions or laws or regulations and no obligation is assumed to revise this communication to reflect changes, events or conditions that occur subsequent to the date hereof.
Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Legal advice can only be provided by legal counsel. NYDIG shall have no liability to any third party in respect of this communication or any actions taken or decisions made as a consequence of the information set forth herein. By accepting this communication in its entirety, the recipient acknowledges its understanding and acceptance of the foregoing terms.
