Monthly Market Review - August 2022

For August, we will look at some trading action going into The Merge, and discuss the sanctions around Tornado cash and its broader impact.

In August, the market let the air out of the digital asset space recovery, with most of July’s gains wiped out. As with July, this movement can largely be attributed to the broader macro environment with continuing uncertainty around how the Federal Reserve will react to inflation. As perhaps the highest risk asset class worth over c. $1 trillion, crypto remains very sensitive to rate movements. Overall, the correlation between the two remains high. Ethereum outperformed the broader crypto market (although still down slightly), with expectations around The Merge reaching their zenith. The Merge, which we covered last month, is scheduled for the middle of September. There has been relatively high trading volume around The Merge, with the volume of Ethereum options and futures now exceeding Bitcoin for the first time.

There are a few interesting graphs of trading action around The Merge. For example, the open interest of futures contracts denominated in ETH is at an all-time high. Additionally, the perpetual futures funding rate has turned sharply negative. This occurs when the derivatives markets are trading below the spot market, indicating strong short demand.

This demand could come from speculators betting on a failed or delayed merge, although the more likely reason would be Ethereum holders covering a portion of their spot Ethereum to de-risk going into The Merge. A potential strategy they could be deploying is shorting ETH futures and going long spot ETH, potentially collecting any ETHPOW (ETH proof of work) airdrop. ETHPOW is a potential fork of ETH, where some miners refuse to migrate to proof of stake and keep a proof of work chain.

As much as The Merge has driven trading activity, overall trading volume is still significantly down. This is particularly true for retail investors whose trading is down considerably. For example, Robinhood’s crypto trading volume in July is down 59% YoY compared to July 2021.

One of the most worrying news stories was the sanctioning of Tornado Cash and the arrest of one of its core developers. The sanctions were due to its alleged use by the Lazarus Group, a North Korean hacking group. Tornado Cash is a mixing service which serves to obfuscate transactions and allow for privacy on the blockchain. All incoming transactions are sent to a pool, which in turn, sends transactions out. As the pool gets bigger, it becomes impossible to detangle the transactions and work out who was transacting with who. Tornado Cash is non-custodial, so the smart contract never has control of the funds in the pools. As a result of the sanction, all U.S. persons and entities are prohibited from interacting with Tornado Cash or any of the Ethereum wallet addresses tied to the protocol.

This is a rare case where the U.S. is sanctioning technology, for these sanctions are being applied to the smart contract, which is a technology and not a person. There are many legitimate use cases for mixers, which help enable financial privacy. For example, if you receive money from a supplier or contractor and do not want them to know your on-chain behaviour (or financial wealth), or if you are donating to a polarising cause.

The reaction to the U.S. sanctions by many of the centralised organisations in crypto was interesting. GitHub removed the open-source smart contract code from its website and suspended the accounts of all contributors. Infura and Alchemy, which are RPC services that index the blockchain and allow easy access, started to block requests to the Tornado Cash addresses. Many blockchain applications use these services. Circle blacklisted the sanctioned addresses, effectively freezing the USDC within these accounts. Some frozen addresses were pool addresses, so $75k of unsuspecting Tornado users’ funds were also frozen. It’s the first case where Circle has frozen a pool instead of a specific user’s address.

The trend of blocking privacy services is worrying as privacy is critical for many predicted uses of the blockchain. For example, businesses will be hesitant to use on-chain transactions if competitors can examine all their books. What happens if a larger chain like Ethereum includes upgrades such as zk-SNARKs that enable private transactions? Does the U.S. allow this to happen, or does it only allow blockchains that enforce traceable transactions? We will keep monitoring future regulator action as this space develops.