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Gravity Fund

Crypto Predictions for 2023

2022 was a challenging year for crypto. Gravity Fund managed to navigate the year relatively unscathed, and as of the writing of this post, we’re carrying a gain on our overall portfolio and, more specifically, a gain on our crypto portfolio. Not bad following a year in which the crypto sector, as a whole, drew down ~70% and traditional financial markets (Nasdaq, S&P, Bonds, etc.) presented no safe haven. More on how historically bad 2022 was for investors below.

  1. A couple of disclaimers before you dive in:
  2. We publish both sector and individual investment theses for free, and many have gleaned insights from them, but nothing herein is investment advice. Publishing our theses allows us to synthesize, generate feedback upon and further refine them. Do your own research.
  3. In each thesis, we borrow liberally from other authors, founders and investors who have already delivered amazing insights on a given topic. Any accidental plagiarism of those authors/founders/investors is unintentional and will be corrected.
  4. I and/or Gravity Fund own assets discussed in this report. Core holdings are marked with an asterisk throughout.

All art generated via Stable Diffusion 2.1. Prompts outlined in the caption of each piece. You should give it a try. It’s fun.

An oil painting of a crypto investor in a row boat, in a choppy winter storm with the Ethereum logo projected in the sky like the bat-light by Winslow Homer, highly-detailed, dramatic lighting

WHAT HAPPENED?

For non-crypto-native readers, that sub-header is a reference to Sam Bankman-Fried, who is going to jail for a very long time.

First, a quick word on the predictions we put out last year compared to what actually happened in 2022.

  • On the macro front, we predicted that conditions in 2022 would tighten relative to 2021, with the Fed tightening and shrinking its balance sheet. We expected a total of nine rate hikes prior to Q4 2024 that would bring rates in line with what the Fed historically referred to as a ‘neutral rate’ of 2.5%. While we were directionally correct here, we were an order of magnitude wrong in terms of the pace and extent of the tightening. Regardless, this was one of the macro trends that made us very cautious heading into 2022, and that caution served us well.
  • We predicted that crucial Web3 infrastructure pieces would gain significant traction in 2022 in terms of developers and users. It was amazing to witness this happen in real time throughout the year, despite a very challenging crypto market environment. Developers entered the sector at a record pace, and several blue-chip infrastructure projects significantly outperformed the broader sector in this regard.
  • We predicted that Alternative Layer-1’s (Alt L1s) were just getting started. L1s are a subset of crypto infrastructure that provide computation (via network nodes) and programability (via smart contracts) to the application layer. Per the previous infrastructure point above, we were correct in that several Alt L1s significantly outperformed ETH* in terms of developer traction YoY. This will pay dividends down the road. However, from a price/valuation standpoint, we were incorrect, as all the Alt L1s suffered larger drawdowns than ETH*. On the flipside of that coin, we would expect them to outperform ETH* to the upside during the next bull market.
  • We predicted that cross-chain solutions would flourish in 2022. Cross-chain solutions can be thought of as either interoperability solutions, which are often used to facilitate the seamless transfer of assets between applications and chains, or composability solutions, which allow for shared infrastructure between applications, such as deploying an application on several chains with minimum work. Interoperability flourished in 2022 with chain-specific bridges (Avalanche Bridge, etc.), Optimistic Bridges (Nomad, etc.), Rollup Bridges (Arbitrum, Optimism, etc.) and app-chain / relay solutions such as Polkadot and Cosmos. 2022 was a Cambrian Explosion of interoperability solutions. Composability solutions (Layer Zero, REN*), on the other hand, have proven more difficult to build, and we have yet to see a sector leader emerge. Because of the difficulty involved in building these solutions, we haven’t seen an explosion of projects as we saw with interoperability solutions. We continue to believe that a cross-chain composability solution represents a ‘holy grail’ opportunity in the crypto sector.

Overall, I would give our 2022 predictions an 7/10, mostly because we dramatically underestimated how bad the macro environment would get. We saw significant progress relative to our crypto predictions/theses in 2022, and believe these theses are more intact today that they’ve ever been.

Two final charts to sum up 2022:

It was the best of times, it was the worst of times.

Describing 2022 as a historically bad year for investors is an understatement. Since 1871, there have been only seven years in which US stocks have experienced statistically significant larger drawdowns. In each of those years, nominal returns on bonds ranged from 1% to 15% providing a relative safe-haven. Nominal return on bonds in 2022 was -17%. Safe havens were hard to come by. Crypto wasn’t spared. As mentioned previously, the cumulative market-cap of the sector pulled back from $3.1T to $859B, a drop of ~70%. From a Sharpe ratio perspective, crypto’s risk-adjusted return actually performed in line with US and global stock indices through 2022 and did much better than US bonds. Prior to the fallout in November, an equally-weighted basket of BTC* and ETH* offered a negative Sharpe ratio of 1.08 compared to an average negative Sharpe ratio of 0.90 for US stocks. This is a significant deviation from the trend observed in the last crypto winter, when digital assets underperformed nearly all traditional risk assets.

With that magnitude of market doom and gloom as the backdrop, we saw active developers in the crypto sector grow by 5%, marking a new all-time high. The importance of this cannot be overstated. As we’ve seen with previous crypto downturns, developers tend to stick around, outlasting the downturn and using that time to build the innovation that powers the next cycle. We’ve said it before— devlopers beget users, which in turn beget more developers, and so on.

Which brings us to our 2023 predictions.

An oil painting of a cold winter blockchain city with skyscrapers under construction by Johannes Vermeer, highly detailed, dramatic lighting

Crypto Winter is Here, it’s Time to Build

OK, I jumped the shark on the first prediction. 2022 was a bad year, especially for the short term thinking, the greedy, the over-levered, and the unethical. The long-term builders may have been temporarily hurt by association, but they will remain long after the garbage from this cycle has been taken out. Beneath the wreckage of 2022 is a stronger foundation than we’ve ever had before: $10s of billions in dry VC capital, an all-time-high influx of world-class talent, millions of new users, and four years’ worth of “zero-to-one” type innovations in crypto infrastructure to build upon.

The army of developers building through this crypto winter is 250% larger than the one that built through the 2018-2019 crypto winter. Those developers produced Solana*, OpenSea, Uniswap*, Aave, Punks, ENS*, Filecoin*, USDC*, etc., and the list goes on.

The other significant paradigm shift versus the previous cycle, is that developer infrastructure was essentially non-existent in the last crypto winter. Whether it be test suites, automated tools to catch common bugs in smart contracts, or having IDE support for Solidity, the tools available for new developers as they enter the space have improved 10x.

250% more developers, with proper tooling this time. It will be incredible to watch what gets built during this crypto winter. It’s time to build, and there’s no rest for the weary. We’ll survive and advance. In 2028 we will look back with wonder upon what we built in the crypto winter of 2023.

An oil painting of Mr. Smith goes to Washington, holding up the Bitcoin whitepaper, on the floor of Congress by Norman Rockwell

Regulatory Clarity is Coming (Finally)

2022 was a busy year for Congress and the regulatory apparatus. We believe 2023 could end up being transformational for crypto in terms of regulatory clarity and permanent law. We expect the new Congress to continue working on one or more of the current legislative proposals that had drawn bipartisan support, such as the Digital Commodities Consumer Protection Act (DCCPA), which would empower the CFTC to oversee spot markets in digital assets, and/or the McHenry-Waters draft bill on stablecoins.

We expect to see an end to the SEC vs. CFTC turf war as a result of whichever legislation passes. We should also make progress on setting standards for disclosures and consumer protections. The turmoil in crypto markets in 2022 has provided a sense of urgency among lawmakers to clarify which government agencies have oversight over what and to define the path forward on basic risk controls for crypto-asset activities.

Those that attended our Q4 investor event and listened to Representative Tom Emmer’s (head of the Congressional Blockchain Caucus) remarks know that he’s a strong and knowledgeable advocate for the sector. As the House Majority Whip, any crypto legislation that passes the house will need his buy-in. This gives us optimism that not only will we get regulatory clarity in 2023, it will be bi-partisan, innovation friendly, common sense regulation.

An oil painting of a treasure pile of USDC and Tether coinage by Thomas Moran

Stablecoin Adoption will Accelerate

I don’t think the mainstream understands how much better the stablecoin UI/UX is compared to traditional money-transfer and payment services. They soon will. Stablecoins are simply superior products along every competitive dimension.

This has resulted in a truly remarkable adoption rate since their introduction.

In 2022 stablecoins settled more than $7T on-chain. This is significantly more than Mastercard ($2.2T), American Express ($1T) and Discover Card ($200B) combined. In 2023, stablecoins should surpass the settlement value of all the card networks combined.

Stablecoins ended 2022 at a $9T annualized run-rate. At that run-rate, stablecoins are already at 12% of ACH ($72T) and 1% of Fedwire ($990T) volumes. This is notable because although the traction of stable coins to-date has been phenomenal, there’s still massive headroom for growth.

This comes at a time when the US wants to prolong the dollar’s status as the world’s reserve currency holder. Stablecoins allow the US to achieve that end without the shackles of a Central Bank Digital Currency (CBDC)— something that no foreign country will hold for national security and privacy reasons.

We expect Circle’s USDC* (backed by Goldman, with $45B custodied at Blackrock and BNY Mellon) to be the main benefactor of any stablecoin legislation.

We think it seems fairly evident that the historical arc of the world’s financial rails will end up as blockchain-based systems using smart contracts.

An oil painting of a sci-fi landscape with massive infrastructure project under construction by Thomas Cole, highly-detailed, dramatic lighting

Decentralized Physical Infrastructure will Thrive

Decentralized Physical Infrastructure Networks help bootstrap decentralized networks of physical hardware. Things like file storage, wireless access, and cloud computing require lots of capital expenditure. A LOT of capital expenditure- it cost billions upon billions of dollars for Amazon to build out the physical hardware for its cloud storage infrastructure and billions upon billions of dollars for Verizon to build out the physical hardware for its wireless communications network.

Tokens have proven effective at incentivizing and catalyzing the development of physical infrastructure networks, by coordinating decentralized hardware investment at scale. The first example of this was, of course, the buildout of the decentralized BTC* mining network. More recently, we’ve seen projects like Filecoin* (cloud storage) and Helium (wireless communications) coordinate the build-out of very large, physical infrastructure networks at a remarkable pace, requiring very little capital expenditure from a centralized entity.

Filecoin* has built out a 17 exabyte (17 billion gigabytes) cloud storage network to date. Measuring its network in terms of exabytes puts Filecoin* in the conversation with the big three cloud storage providers (Amazon, Google and Microsoft). The entire build-out of this network was coordinated and incentivized using the FIL* token. The magnitude of this achievement is difficult to overstate. Additionally, once fully operational, we believe, the Filecoin* network will be faster, more secure, and a fraction of the cost of Amazon S3. These properties are inherent to the decentralized structure of the Filecoin* network, and apply to most decentralized physical infrastructure networks.

It’s difficult to imagine how centralized entities can compete with projects that don’t require centralized capital expenditure to build expensive networks, and provide a better product to end users at a fraction of the cost. Given these advantages and the successful model demonstrated by numerous projects, we expect to see more decentralized physical infrastructure projects gain traction in 2023 and beyond.

An oil painting of stainless steel American rocketship under construction by Alfred Bierstadt, highly-detailed, dramatic lighting

Synthesis

Wecome to 2023. If you made it through 2022 and you’re still actively investing, congratulations!

Many of the predictions/theses that we outlined in last year’s note remain intact. We continue to believe in the Alt L1, Infrastructure, and Interoperability predictions/theses outlined in that letter. We could have dedicated a sub-section under the ‘Crypto Winter is Here’ section to each of those sectors and we’re actively talking to amazing founders building, right now, under those sectors. We expect to see continued innovation, built throughout this crypto winter, emerge from those sectors.

At Gravity, we will be focusing on those theses, as well as those outlined in this post, in 2023. We’re excited to be working with builders to bring forth innovations that will power the next crypto cycle!