2022 may be remembered as the year of the Black Swans and the fraudulent architects responsible (from Terra/Luna to 3ac, Celsius and FTX’s grand finale) – and rightly so – but it was also a year of remarkable innovation and world class talent inflows.
That said, it was 2020/2021’s macro set up that fueled last year’s events, and it’ll predominantly be macro forces that dictate the speed of crypto’s recovery in 2023 by driving capital and talent inflows.
MACRO & A CHANGING WORLD:
Covid-19 lockdowns, followed by monetary tightening, a collapse in energy supplies as Russia invaded Ukraine, and China’s unwavering commitment to Zero Covid, exposed an uncomfortable reality concerning the prevailing economic order.
- Intricate global supply chains built on decades of stable diplomacy have resulted in an extreme overreliance on cross-border human capital, logistics, and raw inputs.
- As international relations deteriorated and supply chains fractured (made worse by a post-lockdown shift in consumer spending from services to goods), immense stress has been exerted on the global economy, demonstrating a vulnerability to a changing macro landscape.
- While some of these drivers are transitory, others will prove permanent – namely, tighter flows of talent and goods, as well as weaker international collaboration on technological development.
- Another major headwind facing many countries: aging populations. In the U.S., the fertility rate sits well below the replacement rate, and at record lows. Given international tensions, skilled immigration isn’t likely to be a solution here anytime soon.
- An aging population means a falling labor supply, a decline in productive output, and upward inflationary pressure as governments spend more on care while the elderly become net spenders on healthcare.
2023 will therefore force major countries – in particular, the U.S. – to confront an existential crisis on their ability to power the future of economic and technological progress.
Aggressive fiscal stimulus in response to Covid-19 meaningfully increased disposable incomes, which in turn caused demand to skyrocket in the post-pandemic consumer rebound.
On the supply side, disruptions in manufacturing and transportation networks (driven by prolonged lockdowns in China as well as geopolitical instability in East Europe) pushed up prices of everything from commodities and inputs to shipping and end products.
The combined result saw inflation spike to levels not seen in a generation, and eventually pushed Central Banks (led by the Fed) to raise rates at a near-record pace.
With China’s reopening this year in particular, prices tied to commodities, manufacturing, and transportation will begin to recede. Meanwhile, the war in Ukraine has seriously accelerated political efforts to adopt alternative and sustainable sources of energy.
That said, inflation is likely to persist above the Fed’s target in the near future as the energy transition takes time and countries and companies reconfigure supply chains to prioritize self-reliance, keeping prices high and permanently denting margins for multinational corporations.
So, while the Fed is likely to soon call an end to its aggressive rate hike strategy, it is unlikely to cut them in 2023, leaving risk assets in an enduringly difficult position.
An important point as we think about a potential recession and prolonged bear market is that thanks to post-2008 regulatory changes, commercial banks remain well capitalized, meaning that while the cost of capital has risen dramatically, the major institutions underpinning global capital markets are well positioned to avoid a credit crunch.
Active developer counts in crypto have staying power in down markets, so the rich talent that came into the space in 2021 and 2022 is largely here to stay, with the opportunity to now go heads down with plenty of cash to deploy.
The bigger question is how traditional high-growth companies find a way forward now that their most reliable levers of profitability – cheap debt, free flowing capital markets, and margin expansion by building in and sourcing from emerging countries – have been seriously curtailed.
Another crucial point: US equity markets benefited from $7.5 trillion in stock buybacks following the 2008 Financial Crisis.
In other words, perhaps the biggest driver of the decade’s explosive equity markets (other than a highly favorable macro environment) has been the companies themselves.
With corporates now facing pressing alternative uses for excess capital – as well as new taxes on stock buybacks – a major tailwind behind rising equity valuations is now firmly in the rearview mirror.
Throughout crypto and traditional markets alike, conventional fundamental metrics have gained renewed importance for investors.
2022’s astounding levels of fundraising means there is plenty of dry powder sitting on the sidelines, but fund managers – especially larger institutions who were publicly burnt by investing heavily in the most speculative of opportunities in recent years – will be far more selective going forward.
We’re likely to see a downstream shift in capital deployment as investors concentrate capital in companies with entrenched product-market fit, meaningful revenues, and strong competitive advantages.
Further, we’ll see a major divergence play out between a small group of obvious winners, in which investors congregate en masse, and the remaining players which are deemed too risky for serious investment.
For late-stage private investors, higher borrowing costs and tighter IPO windows will significantly hinder performance in the coming years. As leverage and multiple expansion respectively become less reliable sources of value creation, firms will need to rely even more on earnings growth. A secondary strategy for mature portfolio companies might involve buy-and-build or bolt-on investments to achieve scale and synergies.
Either way, operational value-add will replace financial engineering and an easy macro environment as the principal driver of returns – a shift which should eventually boost company fundamentals and slowly help normalize private (and ultimately public) markets in Q3 and Q4.
Notably, valuations have yet to meaningfully correct in the private markets. A large part of this is because so many companies raised significant amounts of capital last year and have sufficient runway to avoid repricing their equity by going back to market.
The Pandemic was highly effective in accelerating worldwide integration of digitally native behavior across use cases like payments, work, social, and healthcare.
- Global 5G usage will triple by 2025, representing over ¼ of all mobile connections. By 2030, more than 80% of the world will have 5G access.
- Conversely, estimates suggest that by 2030, there will be a human talent deficit of over 85 million people, representing $8.5 trillion in lost value.
The result is that billions of new users will come online in a world increasingly constrained by geopolitical tensions and unequal access to resources and opportunities.
These opposing forces will drive millions of new internet participants to engage with social, commercial, and work environments underpinned by open blockchains as their gateway to the world.
Crypto rails will liberate and connect talent with resources and opportunities, transcending the obstacles innate to legacy infrastructure.
This will be particularly evident in rising flows of global technical talent to Web3’s leading teams.
We’ll also see significantly more net-new innovation and startups originating in historically underserved regions like Southeast Asia, North Africa, and South America.
Given Emerging Markets already dominate the Global Crypto Adoption Index, this’ll be a natural transition in which existing users evolve from participants to builders of the future.
THEMES TO WATCH IN 2023:
Ethereum Becomes the Predominant Blue Chip Digital Asset
While headlines centered on crypto’s more distressing moments, Ethereum had another exceptional year, solidifying its role as the predominant innovation platform and settlement layer.
The Merge was a monumental achievement during which Ethereum seamlessly upgraded its consensus mechanism from Proof of Work to Proof of Stake while maintaining 100% uptime for the tens of thousands in transactions and billions in value operating across the network.
Ethereum’s extraordinary economic capacity and underlying architectureis now complemented by its shift to an eco-friendlier profile (a reduction in energy consumption of some ~99%), sustainable economics (100% direct and indirect revenue pass through to long-term holders) and predictable supply (slashing supply issuance by some ~95%).
The net result is that Ethereum now has an asset with corresponding cashflows that can be valued, an energy profile that will satisfy the mandates of major institutions, and an ownership instrument tied to the settlement layer of the future of commerce.
Investors dramatically deepened their understanding of blockchain technology in 2022.
This year will see those same investors shift their focus from BTC to ETH as Web3’s principal productive blue-chip asset.
Distributed Validator Technology
One major evolution introduced by the Merge is in the shift away from a PoW consensus mechanism – in which economies of scale favor centralization of control across a small number of miners – to PoS, which opens the door for a much wider base of potential participants in network validation.
That said, if Ethereum is to realize its potential as the world’s settlement layer and a true global supercomputer, much work remains to be done in effectively decentralizing its network of validators.
Just 4 entities dominate Ethereum staking, with Lido alone controlling roughly ~30% of validators.
Distributed Validator Technology (DVT) is a new primitive that allows Ethereum Proof of Stake (PoS) Validators to be run across multiple nodes operated by a diverse community or group acting as a single validator. Obol Labs is a leading developer of DVT and is building Charon, a middleware client that coordinates individual partial validator signatures in order to create an aggregate signature on behalf of the Distributed Validator.
DVT’s initial deployment will be on Mainnet but will eventually expand to Layer 2s and other ecosystems like Cosmos. SSV is another team building to enable the decentralized future.
DVT can minimize correlation risk by diversifying across geographies and client configurations, reduce downtime and potential slashing risk, but most importantly, it’ll play a significant role in the democratization of staking in the coming years.
Institutional Momentum Picks Up Where It Left Off – Quietly
One important difference between this winter and those of past cycles is that we’ve cleared a point of critical mass in terms of institutional adoption.
As FTX’s collapse ripped through crypto markets, leaders everywhere – from Congress to major institutional investors to technology executives – recognized that it was CeFi that was to blame.
DeFi worked exactly as designed.
Fraudulent centralized entities were using client funds to engage in risky on-chain behavior across DeFi. In one remarkable example, as Celsius’ house of cards collapsed the company was forced to pay back $95 million of its debt with Aave and Compound thanks to the immutable code governing its agreements.
DeFi is leading a revolution that is using smart contracts to reimagine the global financial system, and in a major early test – it performed phenomenally well.
Perhaps institutional adoption of open blockchain technology should be considered inevitable.
In 2022, Stripe unlocked crypto payments for its sellers, with Twitter integrating Stripe’s technology for U.S. based creators to accept crypto payments including USDC. Starbucks reimagined its loyalty program using NFTs, while Reddit launched its Avatar Initiative, with users minting over 5 million NFTs to date – surpassing OpenSea for the total number of users owning NFTs.
Fidelity surveyed 1,052 institutional investors and found that 58% owned digital assets, while 35% believed digital assets to be an independent investment class. Fidelity has also enabled its institutional clients to trade ETH.
BNY Mellon, the world’s largest custodian bank and America’s oldest bank, launched a Digital Asset Custody platform for ETH and BTC, while the Financial Accounting Standards Board revised its treatment of digital assets to make it significantly easier for companies to hold crypto on their balance sheets.
Real World Assets are another exciting frontier. Stablecoins have proven prolific as an early use case. Volumes are up 600% over the last two years, with stablecoins executing an astonishing $7.4T in transactions during 2022 – beating the combined volumes of Mastercard, American Express, and Discover.
RWAs are now expanding beyond the initial use case thanks to teams like Centrifuge, GoldFinch, and Maple Finance, who are paving the way for global institutions to eventually bring trillions in financial transaction value on-chain.
Ondo Finance is bringing US Treasuries and institutional-grade bonds on-chain, allowing stablecoin holders to invest in US Treasuries through a tokenized fund with regulated service providers.
Parcl is another fascinating project committed to bringing liquidity, efficiency, and transparency to the world’s largest asset class with a focus on retail investors.
Their synthetic real estate asset protocol, powered by the Parcl Price Feed, promises to rebalance a global market worth $300T in favor of everyday investors to counter the overwhelming dominance of institutions in the asset class.
The Layer 2 Battle Heats Up
The value of ETH denominated TVL bridged to L2s rose 120% in 2022, with Arbitrum and Optimism in particular attracting talent, capital, and users in large numbers respectively.
Optimism is undergoing a huge enhancement in its scalability infrastructure with Bedrock – an upgrade that will allow for consensus/execution client separation, significantly reduced transaction fees, and sets the stage for the decentralization of sequencers (a major criticism of existing L2 architecture).
Optimism experienced an 847% increase in transaction activity throughout the year, with incentive and education programs including OP Quest playing a major role. Meanwhile, the development of OP Stack – designed to empower builders to create custom Layer 2s – will likely drive further expansion of Optimism’s impressive user base.
Arbitrum also saw its transaction count grow markedly, with an increase of 590% from Q1 to Q4 last year. GMX was the most popular dApp deployed, but the launch of its Nitro upgrade – which introduced increased throughput and better calldata compression – was another boost. Though Optimism initially beat Arbitrum to market, Arbitrum’s open approach has allowed it to rapidly gain market share.
GMX drove an astounding $81 billion in trading volumes last year and kicked off a wave of complementary dApps building around the exchange. The resumption of Arbitrum Odyssey should also help position Arbitrum to continue its strong momentum into 2023.
Meanwhile, Polygon had an incredible year on the business development side, emerging as the partner of choice for many of the largest companies in the world looking to enter Web3. The Polygon team has already made serious inroads on the ZK front by developing a suite of products leveraging the nascent technology, including Hermez, Zero and Miden.
Relatedly, 2022 saw an incredible amount of excitement around Zero Knowledge technology. Emerging consensus suggests rollups built with ZK Proofs will win out over the long term.
The bigger question concerns the ability of teams like Optimism and Arbitrum to pivot their tech stacks should that future play out. Optimism’s development of Bedrock – set to go live sometime in Q1 – would seem to imply the core builders are adjusting their positioning already.
Zero Knowledge Technology
Zero Knowledge Technology benefited from an explosion in interest and capital committed during 2022, and was a headline topic at most conferences, while billions in investments flowed into ZK startups.
2023 is poised to be a major year where the promising technology is finally tested in the wild, with the battle between zkEVM and non-EVM compatible L2s set to dominate. A few teams are working to bring the Ethereum experience to a ZK-enabled environment, while a different group are working on completely separate Virtual Machines to enable a range of new possibilities.
StarkWare (building StarkEx and StarkNet) has emerged as one of the early dominant players amongst the latter, with StarkEx (their initial product) having facilitated $797 billion in cumulating trading volume across 313 million total transactions. The team’s decision to build using the programming language Cairo, rather than around the Ethereum Virtual Machine, means their technology breaks free from a number of limitations tied to EVM architecture and is directly compatible with Account Abstraction.
Matter Labs’ zkSync aims to build the first EVM compatible ZK rollup with native integration of Account Abstraction, though it remains unclear how close the team is to achieving true EVM-compatibility, and whether it can deliver a better user and developer experience by pursuing EVM compatibility.
Meanwhile, Polygon is designing multiple ZK-based solutions – Hermez, Miden, and Zero – and is allocating an audacious $1 billion of its treasury to the space. Polygon is another player building towards zkEVM compatibility.
Others, including Scroll, Aleo, Aztec, Espresso, and even ConsenSys are building their own solutions with different end goals and design choices around security, privacy, and scalability.
Ultimately, the ZK field is crowded but well-funded. 2023 will be the year where the few winners put distance between themselves and the rest of the pack, with differentiators centering on architectural design choices (ie: EVM vs non EVM), as well as business development initiatives (Polygon has done exceptionally well thus far).
The latter may well play a more decisive role this year as dApps and users pay less attention to incremental technological advantages between competing solutions.
App Specific Rollups Expand and Optimize Ethereum’s Horizons
App Specific Rollups are another field that will pick up strong momentum in 2023. As scalability infrastructure matures, many protocols and dApps will find that general purpose rollups are redundant and inefficient in their use of data given their need to mirror the underlying chain and optimize for a wide variety of applications and use cases.
Rollups specifically designed for a single application or purpose are able to leverage the base settlement layer’s security and liquidity while still optimizing for an explicit use case. The outcome is an environment that is secure, efficient, and benefits from the broader ecosystem within which it exists – without relying on risky cross-chain bridging for liquidity transfer.
There are arguments in favor of standalone App Chains – namely, the ability to optimize the entire stack by using different layers (ie: settlement vs execution vs data availability) designed for specific functions.
That said, benefits to building atop a unified settlement layer include the aforementioned security advantages and avoidance of liquidity fragmentation (without taking on unnecessary risk), so App Specific Rollups remain a highly exciting solution in the near term.
Visionary early projects include Stackr and AltLayer, among others. Further development around trustless bridging, including the incorporation of ZK technology, will almost certainly play a determinative role but we’re still some distance from this reality.
NFT Technology / Use Case Expansion
NFTs had a blowout year in 2021, with momentum continuing well into 2022 despite the market downturn. The number of unique NFT traders reached 10.6 million in 2022, increasing 877%, while total sales grew 10% to reach 68 million.
OpenSea remained the dominant marketplace in 2022, but upstarts including X2Y2 and Magic Eden had big years (even when accounting for a ton of wash trading), while SudoSwap was able to capitalize on the bear market’s rejection of NFT royalties.
2023 will see further erosion of OpenSea’s dominance as creators and specialized platforms continue to innovate around concepts like royalties, utility, and other concentrated applications of NFT technology, while teams like Reservoir are enabling a future of curated market experiences by aggregating and making liquidity & orderbooks accessible.
NFTFi will drive new innovation around NFTs as a financial and productive asset. Emerging frontiers including Lending/Borrowing, Renting, Fractionalization, and Derivatives will gain additional traction as blockchain rails transform digital art from the speculative to the productive.
Last year, total loan volume using NFTs as collateral reached $500M in one indicator of the momentum behind this emerging paradigm.
Wallets in Web3 have historically taken the form of Externally Owned Accounts like MetaMask, with an address identifier and a pair of private and public keys. This solution offers guaranteed ownership and deep cryptographic protection to users, but also means that if a user loses its key (without a backup seed phrase), they lose access to their account, as well the assets contained within it.
The other issue is that there is a restrictive link between the account controlling the assets and the signer with the power to move the assets.
Account Abstraction is a new solution that breaks that link, enabling transaction authorization to become programable by transforming accounts into smart contracts.
A core unlock here centers on social recovery: in the event a user loses their private key, Account Abstraction can build in additional functionality around replacing the key with authorization, including multi factor authentication. AA also enables multiple signers to hold transaction authorization power to better reinforce security and protect against fraud, while multiple transactions can also be bundled to enable single approval.
In one interesting application, Visa is exploring AA for use in enabling auto payments.
EOAs were an incredible early innovation, but to unlock mainstream entry into Web3, AA is a potentially critical advancement that provides better user comfort and improves the overall experience around ownership and self-custody of digital assets.
EigenLayer & Re-Staking
A hurdle in the development of new decentralized infrastructure and applications is the need to scale capital rapidly in order to secure the underlying architecture in a way that prevents a single actor from attacking or manipulating it.
Beyond initial VC investments and mercenary capital attracted through token incentive programs, many projects struggle to attract and develop a high-quality underlying network of cryptoeconomic trust.
A proposed solution comes from EigenLayer in the form of re-staking – a new primitive that unlocks the rehypothecation of staked ETH from Ethereum’s consensus layer to be used by new infrastructure seeking to build a robust security layer. Stakers can choose to re-stake their ETH in a way that extends cryptoeconomic security from the base layer to other protocols in the ecosystem.
As previously fragmented pockets of capital consolidate, the overall network becomes more resilient, while stakers get exposure to additional yield (albeit at the expense of opening themselves up to greater potential slashing risk).
EigenLayer’s solution therefore promises to bootstrap development of new infrastructure and applications throughout the network, while freeing up staked ETH to become even more productive.
Web3 Social & Decentralized Identity Gets Even Bigger
Decentralized Identity kicks off 2023 with a ton of momentum. ENS – which enables users to create and own Ethereum-based domain names – had a defining year.
Over 2.8 million ENS names have been created by more than 630,000 unique users. ENS also announced a partnership with Coinbase, making ENS usernames available to Coinbase IOS and android users.
ENS operates much like a DNS does, translating and linking wallet addresses to human-readable identifiers, and will be a critical piece of infrastructure as more of the world moves on-chain.
POAP is another core primitive that has connected on-chain identities to off-chain activities, allowing communities and their members to build identity and shared experiences using NFT technology. To date, 4.5 million POAPs have been issued by 800,000 unique wallets around shared interactive experiences.
Its partnerships with companies like American Express and Adidas are also indicative of its real-world potential.
Farcaster is building the social network of the future using a permissionless protocol open to developers who can freely build applications using Farcaster’s open data layer. Over 30 such apps have been built on top of Farcaster already, offering fascinating insight into social network effects in a decentralized world.
Farcaster’s approach is already expanding the design space around on-chain social networks in a number of fascinating ways.
Lens is another decentralized social media protocol in which users create a profile by minting an NFT. In order to engage the network (follow someone, create content, etc) Lens users mint additional NFTs on-chain, thereby creating an ever-expanding social graph in which users have full ownership of their social identity. Follower NFTs are programmable and can also be encoded with additional value.
This core unlock removes the power and censorship traditional Web2 media companies retain over their users and represents a major step towards true permissionless social discovery.
Web3 Social and Decentralized Identity primitives are positioned to have an explosive 2023 and will be one of the most exciting arenas for innovation within Web3.
2023 will be an incredible year of collective innovation, free from the noise and speculation that muddied recent years.