Top Stories of the Week - 6/2

This week we write about the US national debt, Circle “de-risking” USDC’s collateral out of treasuries and into overnight repo agreements, and liquid staking protocol Rocketpool launching on zkSync Era. Subscribe here and receive Galaxy's Weekly Top Stories, and more, directly to your inbox.

Default Avoided – But Big Issues Remain

Pres. Biden and Speaker McCarthy strike deal to raise national debt limit; House and Senate pass legislation and send to White House. The agreement is neither the clean increase that Biden sought for the nation's $31.4tn borrowing cap, nor the sweeping package of drastic spending cuts and major changes demanded by House Republicans. The deal will largely freeze non-defense discretionary funding in the coming fiscal year, impose some restrictions on the SNAP food assistance program, and raise the possibility of across-the-board cuts.

The deal also includes spending caps for fiscal years 2024 and 2025 with sequester and enforcement mechanisms, including and automatic continuing resolution (CR) with a 1% across the board cut if all 12 appropriations bills are not passed at or below the required spending levels by January 1, 2024.

The deal passed the House 314-117 with majorities in both parties voting in favor, though more Republicans (71) voted against the deal than Democrats (46). Democratic support was essential for the bill given that the House is currently split 222 Republicans to 213 Democrats. Members of each party’s extreme wings voted against the bill, with some House Freedom Caucus members saying, “the deal just does not go far enough to get America back on track,” (Randy Weber (R-TX)) and Congressional Progressive Caucus members saying “the recissions in funding… will have an impact for our constituents.” The Senate passed the deal around 11pm Thursday in a 63-36 vote that was, like in the House, opposed by extremes in each party but carried by moderates.

For background, raising the debt limit allows the U.S. Treasury to borrow more money to pay the bills it has already incurred. A failure to raise the limit could result in the U.S. defaulting on its debt obligations, an outcome that observers from both sides of the aisle and around the world view as catastrophic for the American and global economies.

Contrary to the common narrative, though, the U.S. has arguably defaulted on its debt obligations several times before.

• In 1814, during the “War of 1812” against the British, the U.S. Treasury was unable to pay its bondholders, with Treasury Secretary Alexander J. Dallas remarking “the dividend on the funded debt has not been punctually paid; a large amount of treasury notes has already been dishonored.”

• In 1933, President Franklin D. Roosevelt refused to pay bondholders in gold as agreed when the securities were sold, a clear abrogation of the contracts and arguably a default.

• In 1971, in response to rising inflation, President Richard Nixon cancelled the convertibility of the U.S. dollar into gold, among other actions. Prior U.S. bills had read “this certifies that there have been deposited in the Treasury of the United States of America 10 dollars in gold coin payable to the bearer on demand.” One could argue that cancelling this conversion amounted to a breach of contract with dollar holders and thus a default on obligations.

• In 1979, the U.S. Treasury missed payments on ~$122m in T-bills. Investors were ultimately paid back with interest.

Treasury Secretary Janet Yellen has said the Treasury will be unable to pay its debts after June 5, which is this upcoming Monday. If the Senate passes the deal today, Biden will sign and narrowly avert a default in the closest debt-ceiling standoff since Obama’s presidency.

Our take

On this deal specifically, the automatic CR in the case that all 12 appropriations bills aren’t passed at or below the required spending limit will be an important forcing function to push typically contentious appropriations processes. For years, Congress has neglected to do its job and properly pass budgets and appropriate – instead funding the government through negotiated agreements and continuing resolutions. Frankly, the threat of sequestration may still not be enough to force Congress to actually conduct a proper appropriations process. But if it is enough to force them into action, there may be an opening for tacking on riders and effect policy changes, even in cryptocurrency policy. For example, members could stipulate that market regulators cannot use money for enforcement of a certain industry unless they provide clear rules for that industry. It’s not necessarily probable, and riders can be added that are negative to our industry of course, but in any case these appropriations bills will create new pathways for policymaking. Right now, in a normal legislative, non-spending debate environment, getting crypto legislation done seems extremely unlikely. But crypto policy can be tacked onto something, it might be a different story, and a real appropriation process will give us a whole lot of somethings.

Stepping back, while all sides agree that a default on existing debt obligations would range from serious to catastrophic for U.S. credibility and power, let alone the global economy, the reality is also that the nation’s debt is a major problem. In the last 10 years, the national debt doubled from $15tn to $31tn. This level of debt as a percentage of GDP is only comparable to World War 2 at nearly 130%. And that debt – $31tn – doesn’t consider the obligations the government is currently promising workers in the future. Some estimates suggest the actual debt – that is, money owed today and money promised in the future – exceeds $200tn. Today, about 7% of the federal government outlays go to paying interest on the national debt, but it could reach 27% by 2050. Servicing the debt will itself be perhaps the largest single line item in the federal budget, and the rest of the money will mostly go to programs to pay senior citizens (Medicare, Medicaid, Social Security, etc.) leaving almost nothing for other programs.

There are a range of factors contributing to the problem, including an aging population, rising rates, and, of course, excessive unfunded spending by the federal government. But at its core, the problem is one of governance. The Fitch ratings agency said that it was considering downgrading the U.S. government’s credit rating from due to “deteriorating governance” and that is truly an understatement (S&P already downgraded the U.S. to AA+ following the shenanigans around the debt-ceiling impasse of 2011). Fitch is right on point – the United States has become practically ungovernable, hopelessly oscillating between two extremes nearly incapable of compromise, each claiming apocalypse if the other controls the Executive Branch, and a fiscal situation that simple arithmetic suggests will require earth-shattering tax increases (likely politically impossible) or monumental spending cuts (likely politically impossible) or hyperinflation (devastating). For now, the government appears poised to avert an imminent default, with the two sides essentially haggling over 1 or 2 percent and kicking the can further down the road. But those bills will one day come due.

These sagas, both the micro of the debt-ceiling and the macro of the nation’s deteriorated governance and long-term national debt, highlight how poorly our institutions are functioning. It’s no surprise that trust in institutions is basically at an all-time low. But decentralized and peer-to-peer technology can be a solution that helps bring transparency and agency to governance processes where those in control today are neither willing or able to bring trust back into the system. Against this backdrop, Bitcoin’s fundamentals start to make a lot of sense. The dollar will continue to depreciate, as it has for more than a hundred years. The Federal Reserve will always print more money, at least until it collapses (which I am convinced is inevitable, though it could happen in 2 or 10 or 50 or 100 years). The legislative branch has been abdicating its responsibilities – on budgets, warmaking, regulation, and myriad other topics 0 resulting in ever-centralizing control by an executive incapable of controlling its excesses or balancing its ledgers.

As an individual, owning bitcoin – specifically controlling bitcoin private keys – provides protection against the bail-ins and wealth confiscations that typically accompany defaults and serious systemic and banking crises (see Argentina, Cyprus, Greece, U.S. Executive Order 6102, etc.), while its terminal fixed supply will ultimately provide protection against currency devaluation. And, of course, on a philosophical level the absurdity of the U.S. fiscal and monetary situation just looks comical against the transparent and predictable nature of Bitcoin. -AT

Circle Dumped its Treasury Bills

Circle rebalances USDC Treasury holdings, replacing US Treasuries with overnight repos. Over the past month, as lawmakers negotiated the debt limit, Circle took precautions to reduce exposure to U.S. debt in case of possible default. Circle CEO Jeremy Allaire said in an interview earlier in May that the Circle Reserve Fund managed by Blackrock did not hold Treasury bonds maturing beyond the end of the month, and would be rotating assets entirely into cash and overnight repurchase agreements.

The most recent USDC attestation report, as of April 28, showed US Treasuries totaled $30.1bn in the Circle Reserve Fund, which accounted for ~83% of total USDC reserve assets while the remainder was held in cash. As of June 1, per Circle's and Blackrock's website, the Circle Reserve Fund totaled $26.9bn entirely in tri-party repo agreements with major banks with a weighted average maturity of 1 day and yielding an implied interest rate of 5%.

Our take

Circle's precautionary measures to protect USDC amid the US debt ceiling showdown comes after the recent banking disruption in March that led to USDC's price decline to $0.88, the largest depegging in USDC's history. Following the event, Circle aimed to reduce risk from the banking system by moving most of its cash reserves into Bank of New York and other large GSIBs (global systemically important banks). Now by rotating from US Treasuries to overnight repos, Circle improves the liquidity profile of USDC reserves, enabling the stablecoin issuer to quickly meet greater demand for redemptions. Still, as a secured form of short-term lending, repurchase agreements come with other additional risks over Treasuries including counterparty credit risk, though repos generally offer higher yield than cash-lending rates - the SOFR (Secured Overnight Financing Rate) was 5.08% as of May 31.

A potential US government default could subject Tether, which holds a large portion of USDT reserves in US Treasuries, to greater turbulence in the bond market compared to Circle following its rebalancing of USDC reserves. Despite Circle's attempts to improve its treasury management practices, USDC supply has continued to slide since the depeg event, down 34% from its March-high to $28.6bn as of June 1. Meanwhile, Tether has seen USDT supply expand to new highs of over $83bn. Tether's continued share gains at the expense of USDC reflects greater demand for offshore stablecoins as the US financial system experiences instability and as crypto faces an increasing hostile regulatory environment.

Even with the unfavorable operating environment, Circle still has several promising product developments that could rejuvenate demand for USDC. Last month, Circle launched CCTP (Cross-Chain Transfer Protocol), which sets a new standard for bridging USDC (discussed in our prior newsletter). In addition, Circle is launching USDC natively on Arbitrum beginning next week on June 8. Compared to the existing primary version of USDC on Arbitrum that is bridged from Ethereum (to be renamed as "USDC.e"), native USDC issued by Circle will be integrated into CCTP, providing Arbitrum users with greater connectivity and faster, cheaper withdrawals. -CY

Rocketpool Launches on zkSync Era

The sixth largest staking entity on Ethereum, Rocketpool, announced on Thursday a new integration with Layer-2 rollup zkSync. Matter Labs, the development team behind zkSync launched V2 of their rollup, dubbed zkSync Era, back in March 2023. ZkSync Era is notably the third largest rollup by total value locked next to Arbitrum and Optimism. It is also one of the few zero-knowledge (ZK) proof-based rollups that have launched over the last six months that is considered a zkEVM, meaning the rollup achieves some level of compatibility with the Ethereum execution environment used to deploy smart contracts and decentralized application (dapps).

Rocketpool is the first liquid staking protocol to announce its launch on zkSync 2.0, which aside from Rocketpool supports 58 other projects, ranging from decentralized finance (DeFi) applications to wallets and bridging protocols. Details around the integration with zkSync has not yet been shared by the Rocketpool team. However, judging from Rocketpool’s prior integration with Arbitrum and Optimism, it likely involves the use of a bridging protocol to send ETH from Ethereum Mainnet to zkSync, then a swap of the ETH for Rocketpool’s liquid staking token rETH on a decentralized exchange (DEX) live on zkSync, and finally a wallet that can support the monitoring of assets held on zkSync.

Generally, the benefit of transacting and swapping tokens on a Layer-2 rollup versus Layer-1 Ethereum is faster processing speeds and lower costs. Aside from Rocketpool, the largest Ethereum staking provider Lido has also in the past announced expansion plans to Layer-2 rollups through custom bridging protocols with both Arbitrum and Optimism. Similarly, the second largest Ethereum staking provider Coinbase is heavily investing in Layer-2 technologies with the launch of their own Layer-2 rollup called Base. The Base test network has been live since February 2023. The Coinbase team announced on Saturday, March 27, that they have been making good progress towards a mainnet launch of Base but did not share further details around a potential date or timeline for the launch.

Our take

The launch of Rocketpool on zkSync is one of many examples in recent months of high-profile Ethereum-based dapps and companies expanding services to the Layer-2 ecosystem. The growing adoption of Layer-2 rollups by dapps and the increasing migration of end-user activity to rollups as a result is propelled as of late by the focus of Ethereum core developers on shipping Ethereum Improvement Proposal (EIP) 4844, which is a code change that is designed to further reduce fees on rollups through the introduction of a new “blob” transaction type. The prioritization of EIP 4844 as the next major code change in Ethereum’s forthcoming Cancun/Deneb upgrade slated to activate sometime this Fall or Winter next year affirms the importance of rollups for the long-term scalability of Ethereum and the need for dapps built on Ethereum to eventually migrate the majority of their operations to a more cost-effective rollup.

The fact that Rocketpool was the first to launch as a liquid staking protocol on zkSync is not surprising given that Rocketpool manages considerably less staked ETH on behalf of end-users than its largest competitors such as Lido and Coinbase. Rocketpool can take greater risks experimenting with newer rollup technologies like zkSync 2.0, which as mentioned above is only roughly 3-months old. In general, Lido as the largest staking provider on Ethereum has moved slowly when it comes to introducing new features or operations to its protocol, being one of the last liquid staking providers to enable staked ETH withdrawals. On the topic of Layer-2 rollup expansion specifically, Lido has stated that their plans are to support their liquid staking token, stETH, on "all sufficiently proven Layer-2 networks with demonstrated economic activity.” While this criterion is clearly subjective and could be more liberally applied by Lido’s competitors like Rocketpool, it does highlight the nascent stage of development that most rollups on Ethereum are currently in and subsequently, the risk for dapps migrating to rollups before they are battletested.

Despite the excitement around rollups and the potential scaling benefits of the technology for Ethereum, it is important for Ethereum stakeholders to be aware of the risks for hacks and bugs, as well as the reality of high degrees of centralization, that exist on rollups due to their novelty, especially ones launched so far this year such as zkSync 2.0. Moreover, it is important to understand the tradeoffs that exist today for end-users and dapp developers transacting on a rollup vs mainnet Ethereum in terms of user experience, security, and decentralization. Over time, the capabilities of rollups are expected to improve and the launch of liquid staking protocols, as well as other types of dapps, to Layer-2 rollups is needed to battle test the technology. However, given that rollups remain in an early stage of development despite their increasing adoption, Ethereum stakeholders should keep a close eye on forthcoming upgrades to rollups of which there are likely to be many in the months and years ahead, as this will be the trend to watch to best evaluate the progress being made to Ethereum’s scalability roadmap. -CK

Other News

• Bitcoin miner revenue climbs to $916 million in May

• Avalanche hits 1 million monthly active users for the first time

• MakerDAO votes to ditch $500M in Paxos Stablecoin from reserve assets

• Circle says it's launching USDC natively on Arbitrum

• Cumberland halts Filecoin trading, citing 'regulatory environment'

• Sotheby’s to auction off more 'Grails' NFTs from 3AC in 'largest ever' sale of its kind

• Stablecoin issuer Tether to mine bitcoin in Uruguay

• Optimism, Sui set for large token unlocks, worth a combined $650 million

• BRC-721E token standard converts Ethereum NFTs to Bitcoin NFTs