What to Expect for Ethereum and Blockchain Infrastructure in 2023

This is the final installment in a three-part series of predictions for 2023 created by members of the Brevan Howard Digital team. In Part One they explored the gaming industry, while Part Two was devoted to NFTs and digital goods.

At the infrastructure layer, we expect 2023 to go down as one of the most significant years for scaling Ethereum. Recent events have caused a “flight to quality” L1s, in particular Ethereum, where the majority of customers, liquidity, and infrastructure reside, as well as a desire to harden what’s already working versus seeking out the next shiny, new L1.

Similarly, we expect a decrease in web3 hacks with developers utilizing better security practices and tools and building on more proven protocols.

We also expect positive shifts in trading market structure as exchange and custody functions are increasingly separated, both on centralized venues and via the increasing use of DEXs.

In terms of new crypto legislation in the US, we expect a lot of noise, but little action.

Conversely, we anticipate increased enforcement activity from US federal and state regulatory agencies.

Stablecoins: Volumes surpass those of Visa

The use of stablecoins to move dollars around the world continues to be the quiet killer web3 application. On-chain stablecoin transaction volume, which does not include off-chain trading at centralized exchanges, is already at ~$9tn in annualized run-rate.

On-chain stablecoin volumes now significantly exceed the volumes processed by Mastercard (~$2.2tn in 2021), AmEx (<$900bn in 2021), and Discover (<$200bn in 2021).

In 2023, on-chain stablecoin volumes will grow to well over $15tn, outpacing volumes at the largest card network, Visa, which processes ~$12tn in annualized volume.

We predict that on-chain stablecoin volumes will not only surpass Visa volumes, but will also likely surpass the aggregate volume of all four major card networks.

Trading: Uniswap overtakes Coinbase, as DEX spot trading market share reaches a new ATH.

The failure of FTX and other centralized / custodial platforms will drive overdue changes to crypto trading market structure, including increased usage of non-custodial wallets and non-custodial exchanges.

This change will drive the DEX to CEX spot trading volume percentage to an ATH of over 30% in 2023. Uniswap volumes have already been gaining on Coinbase volumes and even surpassing them on occasional days.

In 2023, Uniswap will decisively overtake Coinbase in trading volumes. We consider this a major symbolic shift in the industry as the most well-known DEX surpasses the most well-known centralized exchange in the US (although not globally).

Custody and settlement (finally) start to separate from centralized exchanges

One of the idiosyncrasies of crypto market structure has always been that the entities referred to as “exchanges” (e.g. Coinbase) perform many functions that, in traditional markets, are performed by separate entities.

In the crypto market, an exchange is often not only an exchange, but also a brokerage, a custodian, and a clearing/settlement provider. This vertically integrated structure provides some benefits but also creates significant capital inefficiency and risk.

This year, we anticipate centralized exchanges will increasingly enable seamless trading from non-custodial wallets. We also expect that institutional traders will increasingly be able to hold assets with a trusted custodian while trading those assets across several exchanges.

This custody/trading model has long been desired by traders and has gained some limited traction (e.g., Copper Clearloop). However, it has failed to gain widespread adoption due to exchange pushback.

The alleged fraud and failure of FTX will finally change this paradigm as large traders and market makers demand the separation of custody and exchange.

Crypto options volumes break ATH (coin-denominated), and Deribit falls below 75% market share

In 2022, crypto options volume grew strongly on a coin-denominated basis as traditional funds and institutions continued to enter this market. We believe crypto derivatives trading will increasingly be layered into existing fund strategies as a supplemental asset class to express macro or idiosyncratic event views.

Furthermore, web3 businesses will leverage derivatives markets and structured products to manage treasury/balance sheet risk and generate yield. While Deribit has dominated the market, we believe other players will emerge that iterate on Deribit’s platform with better regulatory clarity, an improved customer experience for USD-margining, and faster addition of new crypto assets. These competitors will take market share as they get added to RFQ/aggregation platforms such as Paradigm.

Blockchain infrastructure: ETH is deflationary as the Ethereum ecosystem scales on L2s

One of the defining narratives of the last two years in web3 has been the rush to be early to the next hot L1 ecosystem. Now, with the market’s speculative fervor in check and an increasing focus on non-speculative web3 use cases, we expect to see a growing coalescence around the Ethereum ecosystem and L2s.

We are particularly bullish on roll-ups / zkEVMs (Type 1-4) and believe that transaction count on roll-ups will easily exceed and may double transaction volume on Ethereum in 2023.

With this increase in usage and volume, an interesting area to watch will be the battle for MEV by roll-up sequencers. Even if EIP-4844 is implemented, the overall increases in volumes across both Ethereum and L2s will cause ETH supply to be net deflationary for 2023.

Although we think the main L1 narrative for 2023 will be the continued and renewed focus on the Ethereum ecosystem, we also remain interested in developments across other L1 ecosystems, including Aptos, Cosmos, Mina, and Solana (particularly the Firedancer validator client).

Ethereum transaction structure matures, enhancing the user experience

Post-merge transaction validation and block building market structure will continue to evolve and mature in 2023. Expected developments include new block-building strategies focused on improving the user experience (versus capturing arbitrage MEV), MEV extraction starting to flow towards users/broadcasters, and an exponential increase in the percentage of private transactions versus transactions in the public meme pool.

User experience will also significantly improve as most wallets and applications enable some form of account abstraction.

The staking market will also continue to develop, with liquid staking becoming dominant and distributed validator tech getting closer to production. In 2023, over 60% of ETH staked will be staked via liquid staking protocols/solutions. We also expect to see innovations around re-staking solutions that will impact tokeneconomic models and applications’ ability to scale quickly.

Smart contract security: Crypto hack/exploit value falls dramatically

2021 and 2022 were record years for crypto hackers, with over $3bn in hacks each year. We believe the value hacked will substantially drop in 2023 and continue to decline in future years even as the overall crypto market size grows exponentially.

This will happen due to a maturation of the security practices and services available in the industry, including formal verification, audits, bounties, monitoring tools, and automated “firewalls.” The increasing migration of TVL and activity to more hardened protocols may also assist in lowering the value at the highest risk in newer less tested protocols.

Regulation: Continued Regulatory Uncertainty in the US Coupled with Increased Enforcement

Here’s where things stand in the US post-FTX and post the November mid-term elections, which saw the Republicans retake the House and the Democrats hold onto the Senate:

• Certain policymakers are far on one end of the spectrum, wanting significant regulation that is adverse to crypto (e.g., Elizabeth Warren (D-MA) and Sherrod Brown (D-OH)) while other policymakers are on the other end of the spectrum and expected to stop any proposed regulation that could disadvantage the growth and development of crypto in the United States (e.g., Patrick McHenry (R-NC) and Tom Emmer (R-MN)). The seats that Emmer and McHenry will sit in in 2023 are critical: Emmer will be the House Majority Whip (the third most powerful House Republican in Congress) and McHenry will Chair the House Financial Services Committee.
• Many different legislative efforts are underway from the likes of McHenry, Glenn Thompson (R-PA), Brown, Warren, Debbie Stabenow (D-MI) / John Boozman (R-AR), and Cynthia Lummis (R-WY) / Kirsten Gillibrand (D-NY).
• Significant litigation, the outcome of which will surely be significant for the industry, is also underway, including cases that affect Grayscale, Ripple, Ooki, and Tornado Cash.
• Nearly all top regulators who have meaningful influence on the crypto industry met with FTX at least once, which undoubtedly has harmed trust that the crypto industry had painstakingly built up over many years.

Oddly, the result of all of the above and the alleged immense fraud committed by Sam Bankman-Fried may result in no new crypto legislation being passed in 2023 (with the exception of stablecoin legislation).

With policymakers on such opposite sides, will they be able to come together in the middle and agree on crypto legislation that is able to pass both chambers?

That currently seems unlikely. On the one hand, doing nothing could be viewed as positive: (i) poorly considered, reactive regulation has the potential to be destructive and (ii) the industry buys more time for DeFi to grow, harden, thrive, and gain material, sticky adoption.

On the other hand, legislative inaction could be harmful because this industry sorely needs regulatory clarity on matters like asset classification to move to its next stage of growth.

Conversely, we expect to see increased enforcement activity from federal and state regulatory agencies in 2023, which we expect to pick up in intensity due to FTX. Fortunately, we are a well organized industry with fantastic advocacy groups including the Blockchain Association, Coin Center, the Chamber of Digital Commerce, the DeFi Education Fund, and the Crypto Council for Innovation, each of which is staffed with phenomenally talented folks who are standing at the ready to represent the industry 24/7/365.

As Colleen Sullivan said in a prediction she made at the end of 2020: While the crypto industry currently has tremendous momentum behind it, these systems are not safe yet and they need our continued efforts to protect them… as an industry, we must roll up our sleeves and spend time ensuring that policymakers and regulators understand the true benefits that decentralization and crypto bring to global economies and, most importantly, to all individuals.

Conclusion: Where we’re headed in 2023

Entering 2023, many folks are down on crypto, but at Brevan Howard Digital, we’ve never been more excited.

We’ve seen multiple crypto market cycles and know that it is when the hype dies down that builders build, non-speculative use cases accelerate, and great investments are made. It’s also when the industry refocuses on how the fundamental web3 innovations of digital ownership and open-network value transfer can positively impact the world.

In 2023, we expect to see web3 significantly impact some of the largest markets in the world, including payments, branded goods, and gaming.

We also expect substantial advances in the underlying blockchain and market infrastructure that will enable the technology to scale and reach its full potential.

2023 will be the year that the great web3 adoption cycle quietly accelerates, and we can’t wait to do our part to help fuel that acceleration.

Additional research and reporting by Drew Van der Werff, Alex Matthews, and Ross Trachtman

The commentary contained in this document represents the personal views of its authors and does not constitute the formal view of Brevan Howard. It does not constitute investment research and should not be viewed as independent from the trading interests of the Brevan Howard funds. The views expressed in the document are not intended to be and should not be viewed as investment advice. This document does not constitute an invitation, recommendation, solicitation or offer to subscribe for or purchase any securities, investments, products or services, or any investment fund managed by Brevan Howard or any of their affiliates. Unless expressly stated otherwise, the opinions are expressed as at the date published and are subject to change. The authors and Brevan Howard may have taken positions in the assets and companies discussed in the commentary. No obligation is undertaken to update any information, data or material contained herein.

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