2024 Crypto Outlook
by Ryan Shea
- “The stage is being set for the next bull cycle”. With those words I ended last year’s outlook. Given the Trakx Top10 Crypto CTI is up over 80% year-to-date, the bullish outlook has been more than validated.
- After the shenanigans of 2022, the crypto industry was firmly in the regulators sights last year and a swath of new laws were introduced to ensure it brings more legal clarity to the asset class and greater safeguards for users.
- While not everyone in crypto welcomes increased governmental oversight, in reality it is an important conduit for greater public adoption. It also provides the necessary foundation for the long anticipated institutional adoption which will receive a strong boost if (when?) the SEC gives the green light to spot crypto ETFs, something widely expected to occur in early 2024.
- As I outline below, rising crypto adoption will present some challenges, but this is a good problem to have and will see the tech stack made more robust as a result. In many regards, 2024 will be about building on the momentum regained last year as the industry continues to mature.
Last December I outlined what I considered would be the three key “macro” trends impacting the crypto industry during 2023. They were, in no particular order: increased government involvement, increased transparency and the greening of crypto.
So how did I do?
Well, two of these predictions were on the money, one less so.
Two Hits ...
Let’s begin with the successes. Government involvement in crypto certainly increased, most visibly in the form of regulation. In October, the G20 adopted a regulatory roadmap for crypto assets based on the IMF-FSB Synthesis paper “to ensure effective, flexible, and coordinated implementation of the comprehensive policy framework for crypto assets”. At the more granular nation-state level, the US, via the SEC, adopted a regulation via enforcement approach, while the EU and the UK took a less contentious path, introducing legislation in the form of MiCA (adopted by the EU parliament in April) and the Financial Services and Markets Act (adopted by the UK parliament in August).
Increased regulation does not go down well with crypto-anarchists, but for the asset class to experience wider support it is, as I outlined last year, a necessary albeit not sufficient condition because it brings with it a perception of legitimacy. Moreover, regulation serves as an encouragement to institutional adoption – a long anticipated trend within the crypto industry. Judged on the basis of the numerous spot crypto1 ETF applications filed with the SEC from top tier tradfi firms over recent months, there certainly appears to be considerable institutional interest already. And, especially following last year’s crypto clean up, I would be extremely surprised if the SEC does not green light such products in 2024.
Another way in which I envisaged increased government involvement in crypto was via continued research and development of CBDCs – central bank issued digital currencies. According to a recent Bank of International Settlements (BIS) report, 93% of central banks are currently working on digital currencies. Given the BIS, which is colloquially known as the central bankers’ central bank, is one of the supranational bodies spearheading their development - as I noted in a research note published back in July - even more progress in the development and eventual roll-out of CBDCs is likely over the coming 12 months.
Source: Atlantic Council
The second success was in relation to the greening of cryptocurrencies, specifically Bitcoin because it is the only major cryptocurrency that continues to utilize the computationally expensive Proof-of-Work consensus protocol. Updated estimates put the share of renewable energy sources used by Bitcoin miners at greater than 50%, making Bitcoin mining one of the fastest decarbonizing industries in the world - and all without the need for a single government green subsidy. There is also a growing appreciation of the value of Bitcoin mining rigs in helping to balance an electricity grid increasingly powered by intermittent renewables, such as wind or solar. Both of these developments challenge the prevailing narrative that cryptocurrencies – and Bitcoin in particular – are bad for the environment. In reality, they could turn out to be a huge positive by providing economic incentives to facilitate the switch from fossil fuels to renewables as envisaged by Net Zero.
Crypto Narrative Shift
Source: Twitter @DSBatten (Definitely worth a follow for anyone interested in this topic).
... And One Miss
And the miss? Increased transparency.
In the aftermath of the FTX failure many centralized exchanges began publishing proof-of-reserves to limit contagion, namely providing wallet addresses allowing external parties to independently verify the extent of their crypto holdings. While a step in the right direction, such action fell well short of proof-of-solvency, which is the more pertinent metric for users. However, providing such proof would require audits of all assets and liabilities, including those off-chain. I expected to see progress in this area but, on this, I was wrong. Most crypto firms (including the issuer of the world’s largest fiat-backed stablecoin USDT) remain unaudited, relying instead on more limited financial reporting such as attestations. In other words, greater transparency is still firmly on the to-do list.
That was last year, what about 2024?
Like last year I want to concentrate on the top three big picture trends that I anticipate will impact crypto markets over the coming 12 months.
Real World Asset Tokenization
The first is tokenization of RWA (real world assets). Legacy financial infrastructures, having been built out incrementally over many decades, are fragmented and very inefficient at recording, storing and transferring value. By tokenizing real world assets, essentially representing claims to these assets digitally on an electronic platform or blockchain, incumbent tradfi players and/or new crypto entrants can exploit these efficiency gains. Not only that, but because tokenized RWA can be fractionalized it opens them up to a more diverse investor base as well as making them more liquid. As such, relative to their tradfi equivalents, tokenized RWA are potentially both better and cheaper.
Tokenized RWA will almost certainly be deemed security tokens by the various regulators around the world, as defined by the famous Howey test. Hence, rigorous KYC/AML checks and more stringent recording of transactions will be required from entities involved in RWA-backed tokens. Due to the fact that tradfi firms have a long (admittedly sometimes chequered history) of operating within heavily regulated environments, they have a natural advantage over crypto firms that do not have such familiarity or experience. That said, many tradfi firms do not have the expertise with blockchain technology and developing this internally would be expensive both in terms of time and money. A better approach, and therefore one more likely to be implemented in my opinion, is for the tradfi and crypto firms to increasingly collaborate in a bid to grow what is currently a $2bn+ market2 into an estimated $16tr market by the end of the decade (or 8,000X in crypto lingo!).
Moreover, by introducing a yield that is derived from real world activity as opposed to being derived from crypto native lending (primarily used to generate trading leverage), tokenized RWA stand to make crypto less self-referential and hence less vulnerable to disorderly deleveraging episodes like the one witnessed last year that caused some crypto lenders to fail and generated sizeable losses for many unsuspecting crypto users – see image below.
Lessons From The Last Crypto Winter
Source: Twitter (@stupid_origin)
In one sense, this represents a continuation of a pre-existing trend because tokenized RWA has been one of the fastest growing assets in DeFi. A good example of this is the crypto lender MakerDAO. Roughly half of its $5bn balance sheet now comprises RWA (the vast majority of which are held in the form of T-bills) and these assets generate roughly two-thirds of the protocol’s revenue, a marked contrast to Maker’s original design as a crypto-backed stablecoin issuer.
However, tokenized RWA will not be for everyone operating within DeFi. One of the primary advantages of DeFi is that there is, by definition, no centralized entity with a position of authority. As a result, DeFi protocols permit users to interact anonymously if they wish. But, as mentioned above, tokenized RWA will be classified by regulators as security tokens, meaning anyone holding them will be forced to comply with KYC/AML checks. This puts them outside the scope of DeFi players who wish to maintain their privacy/anonymity. Even deploying zero knowledge proof-based technologies like Private Proof of Innocence (PPOI) that allows DeFi users to remain anonymous yet able to prove that their funds are legitimately sourced, will not suffice. In other words tokenized RWA could be the next big thing in crypto, but it comes with a price tag attached.
Overcoming The Blockchain Trilemma
The second trend that I see significantly shaping the crypto landscape will be the ongoing search for scalability. The market leaders – Bitcoin and Ethereum – are notorious for having low transactional bandwidth. Bitcoin, for example, can process just seven transactions per second (tps) at best. Ethereum is not much better at between 15-20 tps.
In a world where crypto adoption is rising such low transactional volumes are inadequate. One of the most popular analogies used in crypto is the adoption of the internet. Currently, there are an estimated 400 million crypto users worldwide – just under 5% of the total population. In terms of the evolution of the internet, this is equivalent to the year 2000. Over the following decade, internet adoption rose five-fold to more than 2 billion users, equating to an average annual increase of over 160 million users. Assuming – and it is a big if – the analogy continues to hold, then blockchain processing power of low double digit tps is simply not going to cut it.
At present, there are two avenues for increasing transactional bandwidth. Use off-chain scaling solutions, known as Layer 2’s, for the older more established blockchains, or transition to higher performance Layer 1 blockchains such as Solana and Avalanche that have processing power measured in thousands of tps.
However, as per the famous blockchain trilemma, there is a downside of increasing transaction volumes to levels approaching those achieved by fiat money card processors like Visa or Mastercard; either security or decentralization must be sacrificed. Of the two, centralization is usually the one that gets compromised.
Layer 2 scaling methods typically require some form of trusted entity to relay transactions from the Layer 2 back to the Layer 1 blockchain, whereas high performance blockchains – such as Solana - demand greater compute resources to run nodes, which serves as a more subtle but nonetheless centralizing force on the blockchain infrastructure.
The search to loosen the constraint of the blockchain trilemma has been ongoing for some years. One current area of focus is rollups, which batch transactions on the Layer 2 blockchain and then relay this “bundle” back to the Layer 1 blockchain in order to inherit its level of security. They come in two main flavours - optimistic and zero knowledge (ZK).
Optimistic rollups are so named because they assume all Layer 2 transactions are valid by default, but transaction finality is only achieved after a pre-defined time period, to give users the opportunity to challenge transactions they consider invalid. ZK rollups overcome this finality delay by including validity proofs3. Relative to optimistic rollups, ZK rollups are computationally more complex to design and implement and they need to be designed with care to ensure that sequencers that validate transactions are not centralized.
Like many things in crypto, overcoming scalability issues are a work-in-progress, which is only to be expected given the relative immaturity of the industry (barely a teenager). Yet, if the internet analogy holds, the next several years will see a surge in crypto adoption on a scale never before seen in the industry. This injects an increasing sense of urgency towards making progress on technological innovation, as well as strengthening demand for high performance blockchain alt-coins.
Now for the third and final trend set to shape the crypto industry in 2024. I admit, I was tempted to include the quadrennial Bitcoin halving event - slated for mid-April - when the block subsidy for mining a Bitcoin block drops by 50%4. As I noted in a recent monthly update, the three prior halvings triggered substantial rallies in the price of Bitcoin. As a result, this event (or even just the anticipation of it), means it is certain to be an influence on the entire crypto space in 2024. However, this event has been well-flagged already and it felt like too easy low-hanging fruit to include in the list.
Instead, my third and final macro trend is exactly that, macro. To be more specific, what I am referring to is a growing realization by the general public that monetary and fiscal policies in many of the world’s leading economies are on a collusion course.
Even for non-economists, unfamiliar with the finer details of macroeconomic policy, it was clear as the year progressed, and as central banks kept interest rates high, that government finances suffered as a result. For example, the cost to the US Treasury of servicing its 120% debt/GDP load hit $1tr in the last fiscal year – a big number by any standards.
When it comes to debt sustainability calculations there is no magic number per se (although anything above 100% GDP tends to set off alarm bells), what really matters is the response of politicians. If the Biden administration had tightened its fiscal belt and raised taxes or cut public spending, such a large interest rate bill would not be overly concerning. Investors in US bonds would have got the message loud and clear; Uncle Sam will repay your bonds, in full, in fiat money whose purchasing power will not be compromised. Of course, no such thing happened.
To make matters worse, it has long been known that public spending on pensions and healthcare will surge in the coming decades due to population ageing. Slow moving demographic trends tend not to make the headlines, and hence fail to attract much attention from politicians. However, like the frog that slowly boils to death, unless something is done to counteract them, the end result is unavoidable.
In a fiat system, money is backed by the fiscal credibility of the issuer, namely the government. Given how precarious the public finances are in most of the major economies, many in the crypto community expect the fiat money system to collapse with a hyperinflationary bang. To me this seems overly dramatic. Instead, history suggests it is much more likely governments will coerce central banks into helping them finance their debt by running accommodative monetary policies and letting inflation gradually erode the real value of the debt. This may be less spectacular than a global collapse in fiat money, but it nevertheless implies a bullish environment for crypto.
To understand why I did some back-of-the-envelope calculations to determine what level of interest rates would be required to stabilize debt/GDP ratios based on the OECD’s primary budget deficit projections which incorporate the cost of aging – see chart. It turns out that stabilizing the debt/GDP at 120%5, which don’t forget is still extremely high by historic standards, would require real interest rates being held at -3%… for decades.
OECD Structural Primary Balance (% Potential GDP)
Such projections imply a cumulative decline in the purchasing power of fiat money6 across almost all of the world’s major economies in the region of 70% relative to the 2008 peak (the purchasing power of fiat money is already 30% below that level – see chart). This would exceed the losses witnessed during the debt run-up in the 1930/40s due to the Great Depression and World War II.
Historic Fiat Money Total Return Drawdowns
Source: Author calculations
Admittedly, this argument could have been made at any point over the past several years (indeed, I have been pointing out the precarious nature of government finances ever since the 2008 Great Recession), so why do I think it will become a serious crypto influence in 2024?
For much of the past decade, the inflation outlook was such that central banks deemed it necessary to keep interest rates close to zero. As a consequence, there was no tension between fiscal and monetary goals throughout this period. This, however, came to an abrupt end when the inflation outlook deteriorated and central banks stamped on the monetary brakes. The genie is now out of the bottle.
One rather obvious canary in the “fiscal” coal mine is Japan. Its debt/GDP ratio is off the charts at 226%, half of which is owned by the BoJ following decades of QE. As the central bank found out last year, this makes normalizing monetary policy extremely difficult (look at the effect on the JPY). In all likelihood, the BoJ is trapped and they probably know it. 2024 could well be the year when the rest of the world comes to the same realization.
Moreover, it will not take too much imagination on the part of investors to join the dots and conclude that government debt in most of the major economies – including the US - is also on an unsustainable trajectory. As the chart above illustrates, historically, the most popular method used by governments to bring down the debt is via higher inflation - the scenario depicted in the crypto positive Printer Go Brrrr meme – see image.
The only way governments can avoid such an outcome is if they grasp the fiscal nettle and introduce sustained fiscal tightening on an unprecedented scale. Given that tax burdens for the OECD as a whole are already at their highest levels in over 50 years, the existence of the Laffer curve strongly implies that fiscal consolidation will have to come via public spending cuts on such political hot potatoes as pensions and healthcare.
Could this happen?
Will it happen… in a US presidential election year?
I somehow doubt it.
1Presently, the SEC has received applications for both BTC and ETH spot ETFs.
2This figure excludes fiat-backed stablecoins like Tether and USDC.
3 Because ZK rollups reduce the amount of transactional data shared with the Layer 1 they also enhance privacy.
4After the next halving the block subsidy will drop to 3.125 BTC.
5For the economic nerds, I assume that the potential growth rate of the economy is 1.8% - in line with the estimates by the Fed and the CBO (ie, I am ruling out Dei Ex Machina like cheap and abundant energy from nuclear fusion or an AI-driven surge in productivity).
6 Don’t forget we are not talking about bank notes, which is what is usually shown in fiat doomster charts, but interest earning deposits in the commercial banking system.