Those who have been around crypto will be used to the fluctuations in price and sentiment that this year has brought. What is – so far – unique about 2020 in crypto, is the unveiling and delivery of DeFi to the world. As Bitcoin wallet addresses skyrockets to new highs, Bitcoin has successfully flattened to a pulp the late summer DeFi token bull run. During this winter’s inevitable crypto volatility it is important not to loose the woods from the trees.
The nascent DeFi space is much more than yield farming and financial memes such as Yam, YFII and Sushi swap. DeFi rather, is unique insomuch as it signals another exciting direction of innovation in crypto which has captured the imagination (and animal spirits) of the space. Don’t let the Bitcoin juggernaut fool you, the flurry of DeFi activity has unlocked innovation like never before. DeFi perhaps is vaulting towards re-hypothicating an organic bond market, in other words… recreating the basic yield structures that underpin financial markets.
Raoul Pal – a recent convert to the Blockchain space – summarizes DeFi specifically as „the market struggling to price capital in the crypto world.” While real interest rates have been negative over much of the developed world for years – the first time in financial history ever – crypto is forging rates through market experimentation.
This is wildly innovate. Possibly a unique selling point that speaks the language of traditional finance, and offers to decentralize -and possibly tokenise- all types of markets everywhere. This will inevitably create difficulties for the regulatory side, but this space is known for moving fast and breaking things. Regulatory regimes will need to work monstrously hard to stay abreast with developments. This type of regulatory nightmare is coming from all sides as most global central banks race towards an entirely new digital and financial regime of their own through the much publicized – Central Bank Digital Currency or (CBDC).
Furthermore, the pandemic also short-circuited a lot of narratives in our financial world. Wirecard – potentially – signalled the end, of financial experimentation with a broad negative interest rate, stimulus directed to bloated banks and the death volley to the ancient regime. Why so deterministic? Well today, the open secret is that everything is being renegotiated. Viewed from this context, the DeFi world – albeit submerged in interoperable jargon of smart contracts and governed by vastly different tokenomics- could not come fast enough. Forget the soothing talk of the SDGs and tepid promises of ‘greening finance’ while the Global South is plunged into financial crisis. What is clear is that the world is desperately gasping for less debt but more investment. Today after 12 years of QE and Central Banking word salads, a more authentic market is needed, something more likely to come from outside the banking system.
DeFi **entered the Chat**
Being short for – decentralized finance – DeFi can be summed up as re-imagining decentralized open market finance on top of blockchain technology. DeFi offers a number of exciting opportunities such as redefining peer-to-peer lending, insurance, privacy, derivatives, 24/7 payment mechanism all without operating though a centralized exchange. Indeed, as centralized exchanges (CEXs) come under greater regulatory scrutiny and hacking scandals become more prominent, the DeFi space has within months, rocketed past the $10 Billion ‘value locked’ mark. This protocol development phase is all the more symbolic as the scaffolding of the current financial system creeks from the severe stress of the pandemic. Ana Andrianova, CEO of Akropolis says that;
„we are seeing the entire financial infrastructure stack being rebuilt from the ground up, with such financial primitives as decentralized stablecoins, automatic market-makers, price-less synthetic assets, reflexive bonds, to name a few. A parallel financial ecosystem emerges with no dependency on the legacy banking system – a key feature that few appreciated until the recently unfolded crisis.
The financial melee the coronavirus has brought legacy markets is one of the main reasons for which central banks are orientating towards CBDC’s. A debate is currently raging around their eventual implementation in all corners of the world. Meanwhile Kristalina Georgieva, the IMF Managing Director, vigorously proclaimed in October the notion of a ‘new Bretton Woods moment.’ The question of how a programmable central bank money would impact banks, society, sovereignty and privacy were central to discussions between the BIS, the FED, the BOE and the ECB. This is the new territory we are wading into today one when innovation and platform based economies are merging with banking and personalized finance.
The soon-to-be new monetary regime seems to hinge on the spectre of mass behavioural economics to both derive and implement the value proposition of CBDC’s. Central banks will be the Facebooks of banking obtaining value from the AI analysis of your spending and micro-targetting policy at you. Sounds scary right? But with now 80% of global central banks currently engaged in what seems a global central bank digital currency arms race, the West looks years behind China in the implementation of this coveted new Central Bank tool. But where does DeFi fit into this new digital finance wild west?
„DeFi has the potential to completely reinvent the world’s financial systems, merging the scale and familiarity of the traditional economy with the security, efficient and transparency of the public blockchain.“
Despite the euphoria, many of these projects are work-in-progress and most DeFi applications cannot be considered meaningfully decentralized by any measure. The Cambridge 3rd Cryptoasset Benchmarking Study explains how “the majority of these applications are still dependent on kill switches, centralized oracles, or some other centralised support or maintenance.” The idea behind many DeFi projects is rather to tend towards decentralization as development continues – and this will allow the space to bloom an eco-system of many blockchain varieties that balance trade-offs differently.
This discussion can be seen through a recent twitter exchange which accused the Serum DEX (SRM) of hiding a centralized point in their DEX exchange which showed up as a full exchange withdrawal smart contract. On the other hand, Armani Ferrante, an engineer at Alameda Research insisted that decentralization should be increased over time and that that there was nothing to worry about – “or you can wait years for a perfectly decentralized app that nobody wants.”
This recent exchange is typical of twitter feuds within a nascent crypto space – but this all depends on what time horizons people have. Just as with Bitcoin, that perfectly decentralized Dapp could be a valuable addition to crypto if it is technically feasible and short term pressures don’t muddy its design. But the crypto market isn’t the same. Some projects want to mimick the current financal system – just tokenized- and others want to solve democratic deficits through governance models and tokenomics.
The emergence of alternative governance structures comes with new incentive mechanisms that are designed to reimagine democracy for the 21st Century. The cypherpunks ethos was the initial fuel of the DeFi movement just as centralized exchanges began feeling the pressure to conform to global AML/KYC regulations. Recent headlines from the US and Chinese authorities show the clamping down on CEX’s by targetting stable coin operations is problematic to regulators as parallel development of CBDC increases pace. For example, BitMEXs‘ fate in the US while in China OKEX’s seizure demonstrates how sensitive authorities are around the issue. This jostling to control stable coins, over the centralized – on and off ramps – to crypto could not only incentivize the push to DeFi further, it shows how structually important building a DeFi digital ecosystem will be both in against and in collaboration with CBDC’s. Of course, debates about privacy and custodial control of assets isn’t very far away either.
Despite the huge price fluctuations during the 2020 DeFi boom and bust cycle, DeFi is the second most cited future development of the Cambridge benchmarking study that is anticipated to be a game changer for service providers. Binance, the most powerful crypto exchange, has been accused of making a ‘Tai-Chi‘ named plan to skirt global regulators by going through its US California branch to feed its Cayman Islands registered company to evade clampdown. Moreover, CZ, the CEO of Binance, has sought diplomatic immunity to avoid regulators as the exchange feels the heat from the DeFi swing. His evasive moves can be seen as a scheme to avoid regulatory control over his heavily retail focussed exchange.
Skirting regulatory frameworks I hear you ask? The head of growth and strategy at privacy focused DuckDuckGo, Adam Cochran, explains in a 25 part tweet thread that DeFi is still within the grasp of authorities. He states that,
„Dao or no Dao you can find developers with admin keys, users who create front-ends, companies hiring individuals to work on protocol and others who enable or profit from the contract, to be in violation on the BSA (Banking Secrecy Act).“
In this event, Cochran states that this would kill the protocol with the majority of the participants instantly exiting upon hearing the news. What we know is that DeFi pushes towards a positive time value of money, exploring natural rates while promising – if not purely decentralized – then an open, secure, accessible and ultra-fast, smart contract run protocol. This automation and execution of an interoperable network of smart contracts with different coding languages… what could go wrong?
The 3rd Cambridge Benchmarking Study identifies several risks to DeFi. Indeed, smart contracts aren’t new but being fully dependent on them to automate and self regulate financial processes will add huge risks especially in this early period:
The risks outlined above are serious and will urge caution for the space. Time and development will be needed to iron out the smart contract risks and oracle data feed risks mentioned but the growth of smart contract analytic firms and protocol auditing requests does show the intent of the DeFi space to streamline and clean their protocols.
Forbes magazines Steven Ehrlich discusses with MakerDao’s, Steven Becker the ways forward for the DeFi space. Becker was focussed on transparency and community as serious mechanisms by which DeFi platforms can grow and gather people to their platforms. Not being opaque and following the path that stable coins such as Tether which has perplexed crypto users still shrouded by doubt. Growth of the community by trying to create loyal customer base with attractive perks all the while remaining transparent about the risks involved in the platform was Becker’s suggestion for DeFi platform growth.
By having social benefits embedded within their ‘DNA’, they make the platforms more attractive in the long term to customers. The aim is to have a diverse set of MKR or DAI token holders which translates into diverse liquidity and use cases. This could be achieved by targetting token holders with different, or personalized sets of behavioural incentives to solidify that diversity similar to CBDC’s. Steven Becker clarifies that „there is a big difference between social finance (SoFi) and decentralized finance. In a nutshell, social finance is trying to pull social impact, where I think decentralized finance is actually in a really awesome positions to sort push that impact.“
For this required set of diversified customers and token holders there would need to be a greater general crypto adoption wave. Kraken Intelligence recently suggested the generational shift to millennials acquiring wealth would naturally happen. To this point Krakens report titled, „Inheriting USDs And Acquiring BTCs: How ‘The Great Wealth Transfer’ Will Fuel ‘The Great Bitcoin Adoption.’“ The key finding was that millennials and Gen Z would be the drivers of this digital pilgrimage to BTC, ETH and DeFi adoption.
The Kraken report found that if millennials invested at least five percent of their wealth in bitcoin, then this could potentially drive the price of bitcoin to $350,000 in 2044. As a result, from a $971 billion investment, this would give millennials around $70 trillion. Yves La Rose, the CEO of EOS Nation says,
“The foundational tools for DeFi are being built at an ever-increasing pace in order to be there when the flood gates open. I expect to see a significant influx of traditional money flow into the ecosystem in the coming months as people start to realize the machine can’t go brrrrrr forever.”
As the doors open on this little known but much talked about segment of the market, I finish with musings from Jonathan Beller, who philosophizes about DeFi and its emerging possibilities. Beller proposes that DeFi can begin where the Internet failed. By building an emerging post monopolistic and extractive structure which engenders horizontal governance, trust and shared co-authored creativity.
He claims we need to radically renegotiate the nature and value behind our interactions online. Beller continues stating that, monetary media and communications media have converged as economic media. Communication, computation and finance have already converged. As the current financial frameworks are no longer fit for purpose Beller proposes that „our communication is increasingly our economy, and our economy is our communication.“ He proposes that in this emerging world, we offer our capacities in and as our messages, we collaborate on intellectual and physical creation of projects and products, be they dance moves, software, online education, political or community organizing and farmed goods.
DeFi could be the scaffolding for this radical re-imagination needed in both traditional financial markets and the upcoming one. „We receive liquidity over the same medium we use to communicate from a trust-worthy network of peers who will share a stake in our activities as we share a stake in their.“
Instead of being an extractive and centralized we can realign finance with democratic values which in the age of ecological movements may be non-extractive, co-operative and a trusted peer-to-peer governance architecture. These forms of postmodern kinship with trusted peers who are reputationally vetted and historically known can have the capacity to transform societies. Equity for participation – a potential new slogan in a democratic, decentralized finance.
Therefore, despite the crippling and awful knock-on effect of this pandemic, real as they are, a genuine source of enthusiasm during 2020 has been the blossoming under our noses. The DeFi moment is upon us and with ETH 2.0 around the corner we must continue with caution for there are many dangers ahead ….. but the night is still young.