The Problems with DeFi & Crypto

Published December 2022

In the wake of the FTX/Alameda collapse, which came after prior collapses of Luna, Celsius, Voyager, and Three Arrows Capital, many crypto industry analysts have pointed towards DeFi (“Decentralized Finance”) as a potential solution.

This article dissects some of the nuances of that view, grants that certain opportunities exist, but offers a rather critical assessment of the current state of the industry overall.

Additionally, this article touches on other cryptocurrency industry concepts including Web3, NFTs, tokenized securities, and the broader problem of creating coins that serve no purpose other than to enrich the founders.

Article sections:

CeFi: The Problem of Opaque Leverage

The purported benefit of DeFi is that the technology can supposedly decentralize and add transparency to various trading and leveraging services.

So, it makes sense to start this article by analyzing crypto CeFi (“centralized finance”) before getting into crypto DeFi (“decentralized finance”).

In the crypto asset industry, the two big types of centralized companies are exchanges and deposit/lenders. The term “CeFi” mainly refers to the latter, but more broadly can include both, especially since the two business models can be intertwined.

• Exchanges allow traders to swap around various crypto assets, and generally offer leverage to traders as well.
• Deposit/lenders (aka “liquidity providers”) allow people to deposit crypto assets and collect a yield, allow people to deposit crypto assets as collateral to borrow stablecoins or fiat currency, and allow some institutions to borrow money in an uncollateralized way.

There are other companies as well, such as pure custodians, technology developers, and so forth, but those are the two types of companies that are relevant for a comparison to DeFi.

Large portions of the legacy financial system are opaque. It’s difficult to determine how much liabilities any given entity has, unless it’s publicly traded. Even then, it’s still possible to commit fraud or to obfuscate the details with certain accounting tricks to some degree.

This tendency carried over into the CeFi crypto industry, but on steroids. Various trading firms and funds frequently take on leverage to speculate on crypto assets, and especially altcoins. Since very few of these companies are publicly-traded, almost all of it is rather opaque, even though it involves many billions of dollars.

Throughout 2021 and 2022, this industry began to run into problems for the cycle. The early problems began with the premium-over-NAV of the Grayscale Bitcoin Trust (GBTC) flipping to a discount-under-NAV. In other words, there was a time when the market price of the fund was a dollar forty for every dollar worth of bitcoin in the fund, and now the market price is below sixty cents for every dollar worth of bitcoin in the fund.

Chart Source: YCharts

Many trading firms had leveraged exposure to that vehicle, so this was a bigger issue for them than one might realize.

For years, GBTC was one of the few ways to get bitcoin exposure in the form of a security, which a number of regulated entities wanted. Therefore, it traded at a premium over net asset value “NAV”, since it offered something that was otherwise hard to get in that type of securitized package, including within a brokerage account.

As more funds and securities came to market, offering bitcoin price exposure for these regulated types of entities, GBTC became less unique, and its premium went away. Most close-end funds trade at a mild discount to NAV, and GBTC became no different.

The vast majority of my bitcoin exposure is directly in bitcoin itself (I buy through Swan Bitcoin). However, in my brokerage portfolios, I have used a small GBTC position to replicate bitcoin price exposure for lack of better alternatives. I have rebalanced its exposure from time to time, especially when its premium became excessive, like in this case with my No Limits portfolio:

Chart Source: YCharts

In addition to just being a way for a portfolio to get some bitcoin price exposure, GBTC also gave accredited investors an arbitrage trade for many years. They 1) could short bitcoin, and 2) send funds to GBTC to create new units of GBTC at NAV. They had to hold this position for a six-month lockup, and then could sell their GBTC shares for a premium over NAV and close their bitcoin shorts, thus pocketing that premium over NAV as a profit without exposing themselves to the volatile bitcoin price exposure that underlies both bitcoin itself and GBTC. Then, they could repeat this trade again and again.

This worked for a long time, until it became easier to access bitcoin exposure in various other regulated vehicles. At that point, there was no longer reason for the trust to have a premium over NAV.

This caught a number of trading firms off guard, since they were stuck with a massive bitcoin short position and a massive GBTC long position that, rather than trading at a premium as it used to, was now at a discount. In other words, they experienced a major loss from what they viewed as a low-risk trade, and that they therefore had on in size and with leverage.

So, that was strike one.

I covered this premium-to-discount flip back in one of my premium reports at the time, although I mainly focused on it as a cessation of a portion of the buying pressure on bitcoin:

Up against the structural bull market of the post-halving adoption cycle, there are two fundamental headwinds against bitcoin at the moment.

The first is potentially bond yields as described previously. If they keep rising, and the dollar index remains firm, and liquidity gets more tight, that should continue to pressure highly-valued growth stocks, and bitcoin may temporarily be lumped into that category by investors as well, especially in a broad risk-off environment.

The second is that the Grayscale Bitcoin Trust (GBTC) no longer has a positive premium over its net asset value or “NAV”. In fact, it’s trading at a slight discount to NAV. Canada now has a solid bitcoin ETF, firms such as NYDIG and SkyBridge have come to market over time and provided competition for institutional and accredited investor allocations into bitcoin. So, there is less of a reason for GBTC to have a premium. Most existing closed end funds for other asset classes trade at a discount to NAV, and GBTC has at least temporarily joined the discount club.

This discount to NAV is both good and bad. It’s good because it makes GBTC a better vehicle for holding bitcoin than it used to be, since you’re getting it at around net asset value rather than at a premium. It’s bad because it removes one of the sources of bitcoin demand.

GBTC was the biggest buyer of bitcoin in 2020. Some of this was for long exposure, and another big chunk was for market-neutral arbitrage. For that second part, accredited investors and institutions could buy into GBTC at NAV with a six-month lock-up period, and then sell six months later at the market price, and that market price generally had a premium over NAV. Simultaneously with their purchase at NAV, they could short bitcoin elsewhere, and thus make a non-directional investment that simply lets them extract the premium over NAV every six months with no exposure to bitcoin’s price.

This process made a lot of money for folks, and permanently sucked up a lot of bitcoin. GBTC basically converted liquid bitcoin to illiquid bitcoin, locked away in cold storage. If the GBTC premium remains minimal or negative, that trade is done, and thus that specific source of demand and liquid-to-illiquid conversion process is done.

-Lyn Alden, February 28th 2021 premium report

Strike two was when Terra/Luna blew up, and that was basically a ponzi scheme from the start. The people involved lured retail investors in with artificial unsustainable 20% yields. I warned about Terra/Luna during April and May 2022 near its highs, and then wrote a post-mortem on it called “Digital Alchemy” in May 2022.

One of the themes of that post-mortem is that when liquidity and general business conditions are improving, crypto ponzis tend to be built, and when liquidity and general business conditions are deteriorating, crypto ponzis tend to be revealed and break apart:

Chart Source: Trading Economics, annotated by Lyn Alden

A number of leveraged trading firms had exposure to Luna, which made the subsequent blow-up in the crypto industry even more severe than I would have guessed at the time. The biggest surprise to many was the fall of Three Arrows Capital or “3AC” for short, which had been impaired by the GBTC discount and then was hit again by the collapse of Luna, which the 3AC team had been particularly bullish on.

Three Arrows Capital was a large crypto trading firm that had been around for ten years, and they were using a lot more leverage than most people realized, since it was opaque and they were quietly borrowing from many different sources that were not necessarily communicating with each other. Multiple lenders including Voyager and Genesis had huge unsecured loans out to 3AC. BlockFi had a huge loan to 3AC as well, but it was collateralized, which reduced the total impact to themselves. Celsius and a couple dozen other firms also had loans out to 3AC.

So, the resulting implosion of 3AC brought down large swaths of the crypto lending industry, with just a handful still standing afterward. The overall risk management in the space was bad, although some were better than others. Many of the lenders were lending to just a handful of the same massive borrowers, like 3AC.

I explored CeFi platforms in early 2021 to understand the ecosystem. Back in February 2021, I endorsed BlockFi in one of my articles, as a small allocation to consider for novel things like stablecoin yields, gold token yields, etc. I emphasized its risks and the fact that deposits were not FDIC insured, and recommended that at most, only a small part of someone’s assets should be on it, with the majority being in self-custody. However, a year later in February 2022 while BlockFi and the broad industry were still functioning normally, I withdrew my endorsement, due to no longer viewing the risk/reward as being worthwhile.

Unlike a number of lenders, BlockFi managed to get through the subsequent May/June 2022 crypto lender collapse, while other CeFi deposit/lenders like Celsius and Voyager failed. BlockFi avoided making concentrated uncollateralized loans, which at least minimized some of the hits to their solvency status relative to many other lenders, and gave them a path to keep processing withdrawals and keep operating with investor support.

However, BlockFi’s subsequent involvement with FTX/Alameda in June 2022, with liquidity provisioning and a buyout offer, sealed their fate. After the collapse of FTX/Alameda in November 2022, BlockFi joined most of the other deposit/lenders by having to stop processing withdrawals.

Overall, the biggest losses in the CeFi industry came from either 1) making uncollateralized loans to leveraged entities with opaque balance sheets or 2) custodying assets with leveraged entities with opaque balance sheets. And the problem with opaque balance sheets, of course, is that it’s hard to know for sure how much they are leveraged, especially when there is outright fraud involved in some cases.

What DeFi Aims to Accomplish

In contrast to CeFi, trading and leveraging occurs on various blockchains as well, in what is generally termed “DeFi”. As previously mentioned, this stands for “decentralized finance”.

The foundation for this activity consists of layer one smart contract blockchains, such as Ethereum, BNB Chain, Tron, Avalanche, Solana, and others. These systems allow a computing environment to be embedded into a blockchain. This effectively becomes a federated computing environment, meaning a computing environment that is spread across multiple machines, and thus able to be observed and confirmed by multiple different entities.

This computing environment can also be built on layers/sidechains on top of other blockchains like the Bitcoin network (e.g. Liquid or RSK), but most of the activity thus far has been on these layer one smart contract blockchains.

After the computing layer, the next layer up consists of two main parts: decentralized exchanges and decentralized deposit/lenders. The decentralized exchanges allow traders to swap in and out of various crypto assets, similarly to how they would on a centralized exchange. The decentralized deposit/lenders (the most common term being “liquidity providers”) allow users to either 1) deposit crypto assets into the protocol to receive a yield or 2) deposit crypto assets as collateral to borrow another type of crypto asset, with the most common asset on the deposit and the borrowing side being stablecoins. Whether or not these are actually as decentralized as they claim to be will be discussed in a later section of this article.

After that, there are other types of DeFi assets. Most of these are equity/governance tokens associated with controlling and potentially earning profits from those exchange protocols and deposit/lender protocols.

However, there are a lot of questions around what any of this means in the long run. Here are some examples of things that can happen with DeFi:

Person A has a bunch of bitcoin, transfers it into Wrapped Bitcoin (“WBTC”), and so now it’s a custodial bearer asset that is tradeable on the Ethereum network. They then deposit that WBTC as collateral on Aave (a borrower/lender protocol) to borrow stablecoins. They send some of those stablecoins back to a centralized exchange and sell them for normal fiat currency, which they withdraw to their bank to use for daily spending. They now have leveraged bitcoin, with multiple layers of counterparty risk to hacks and custodian problems, and as well as a chance of liquidation if the price of bitcoin goes too low.

Person B has a bunch of ether, and deposits it as collateral into Aave to borrow a bunch of stablecoins. They then trade those stablecoins on a decentralized exchange called Uniswap for some DeFi equity/governance tokens (let’s say AAVE and COMP) as well as UNI, which is the coin associated with that same decentralized exchange. So they have leveraged ether as collateral to buy a bunch of DeFi protocol equity/governance tokens (AAVE, COMP, UNI).

Person C doesn’t own much crypto assets, but decides to convert some fiat currency into stablecoins, and deposit those stablecoins into Aave and Compound to earn a yield. In this sense, they are funding the collateralized loans to Person A and Person B. Until the Federal Reserve increased interest rates this year, these stablecoin deposits earned much higher yields than they would get with a safer FDIC-insured bank deposit or a Treasury bill, albeit with much higher risk, and so this usage of capital kind of competed with junk bonds or similar ways to earn a high yield in traditional markets.

If this all sounds familiar, here is what I wrote back in January 2021:

One of my concerns, when reviewing the biggest use cases for decentralized apps, is that a lot of the use-case is circular and speculative.

Ethereum is heavily used for decentralized exchanges of crypto tokens, crypto stablecoins that serve as liquid units of account for trading crypto tokens, and lending and earning interest on crypto tokens which is a practice that serves as a liquidity/borrowing source for traders of crypto tokens. To a lesser extent, it is also used for gamified ways to earn or trade various crypto tokens.

So, it’s a big operating system powered by crypto tokens, for the purpose of moving around… crypto tokens.

A healthy banking system in the real world would consist of people depositing money, and the banks making various loans for mortgages and for business financing, to generate real-world utility.

A speculation-based banking system, on the other hand, would consist of a bunch of banks taking deposit money, and then lending to speculators in the nearby stock market, along with technology providers that make this easier, and then what those speculators are trading mostly consists of shares of those banks, shares of those tech companies, and shares of the stock exchange, resulting in a big circular speculative party. The biggest use case so far for Ethereum is a decentralized version of that circular speculation-based system.

–Lyn Alden, An Economic Analysis of Ethereum, January 2021

When we look back almost two years later from my January 2021 piece that initially covered this industry, I can’t really say that it’s any different. It has been a circular and speculative party with little or no real-world utility the entire time, and the industry has made little if any improvement on that front.

In fact, a March 2022 study found that 97.7% of the coins traded on Uniswap were rug-pulls. A rug-pull is when developers and investors hype up a project, extract value from it as investor money pours in, and have no intention to actually execute on their plans.

The Ever-Present Risk of DeFi Exploits

DeFi offers some benefits of transparency, but it also offers a huge attack surface for hackers/exploiters.

These are commonly referred to as “DeFi hacks”, where someone figures out how to steal funds from a smart contract. In reality, it’s better to think of them as exploits or arbitrage opportunities than hacks.

“Code is law” was a common adage in the early days of DeFi (and of course, stretching back prior to DeFi). If there’s a bug in a smart contract, then someone can exploit it and potentially give themselves an advantage, up to and including taking assets in a way that the contract did not intend. This is similar to a poorly-written real-world contract, where a clever lawyer can find loopholes and help a client to abuse a contract in a way that was not intended when it was written. After all, if code is not the final arbiter of a smart contract, then what is the point of a smart contract?

The Bitcoin network is the most streamlined blockchain, with nearly 14 years of operating history. It’s purposely simple, purposely changes very slowly, and is purposely resistant to change except in the case of overwhelming consensus. Despite all of that, the Bitcoin network has still encountered a number of serious bugs over the years.

So, what hope do ever-changing and highly complex smart contracts have? Anyone who holds funds in DeFi or other smart contracts should assume that there is an ever-present risk of code exploits and loss of funds. You’re getting a 3% yield? Great. Weigh that against the probability of a 100% loss occurring at any point over the year, and then repeat that year after year. The risk is amplified when smart contracts from different blockchains or different layers interact with each other.

More than two and a half billion dollars worth of crypto assets have been exploited from smart contracts over the past two and a half years:

Chart Source: The Block

Collateralized vs Uncollateralized: That’s the Key

Many DeFi proponents point to the fact that most CeFi lenders failed in 2022 while DeFi contracts continue to operate.

While there is a grain of truth to that, we should examine the underlying reason: collateralization. CeFi lenders that made fully-collateralized loans generally held up well also. If they had to liquidate a client, it was the client that was ruined rather than the lender. The trouble occurred as CeFi lenders made under-collateralized or non-collateralized loans to entities that they thought were trustworthy (who then went and gambled it away in DeFi, such as on LUNA tokens, and were unable to pay back the loans).

Due to DeFi’s automated nature, it’s very hard to do it in a way that makes sense without over-collateralization. So, by its very nature, DeFi consists of mostly over-collateralized leverage. The lesson here is not that DeFi is better than CeFi; it’s that when it comes to volatile assets in particular, over-collateralized loans are safer than under-collateralized or non-collateralized loans.

In a DeFi environment, a depositor mainly has exposure to collateralized lending (a good thing, as far as lending is concerned), but also faces constant smart contract exploit risk (a bad thing). In a CeFi environment, a depositor may have a exposure to some blend of collateralized and non-collateralized lending (a bad thing), but has greater protection from exploits (a good thing).

My takeaway from the crypto industry events of 2022 is not that DeFi is better than CeFi.

Instead, my takeaway is that with these highly volatile assets, chasing yield is inherently unwise. And to the extent that cautious lending is done, it should mainly be over-collateralized lending.

Bitcoin offers the user the ability to self-custody their own units of a finite liquid asset, and to send or receive permissionless payments with that asset, without relying on a centralized third party. In my view, that’s the signal through the noise, and that’s more powerful than many people yet realize.

Intermediate-term usage of stablecoins for savings and payments in developing countries, where accessing dollars is difficult, is another good utility use-case. They should be aware of counterparty risks, and overall I’d like to see greater and greater transparency of stablecoin collateral.

Almost everything else involves speculating, or involves picking up nickels (yield) in front of a steamroller (opaque counterparty risks and/or code exploits). The fact that I dabbled in yield-seeking for a year, even with a small amount of capital, and even though I stopped well before the blow-ups happened, is something that I consider to have been an error when navigating through this industry.

The Centralized Shortcomings of DeFi

Aside from the circular, speculative, and sometimes outright fraudulent nature of the crypto industry including the DeFi sub-industry, there are centralization problems at the heart of the technology, even though it is marketed as being decentralized.

Centralized Smart Contract Blockchains

The foundation of the DeFi tech stack, the underlying smart contract blockchains, already start with some centralized aspects compared to the more decentralized Bitcoin network.

For example, the Ethereum network had difficulty bombs in the code for over seven years from its inception in 2015 until its proof-of-stake conversion in 2022. This reduced the power of miners and individual node operators, and enhanced the power of the head developers, which is a form of centralization. It allows them to push through a roadmap and change the protocol according to their vision, which basically makes it an investment contract. Even after the proof-of-stake conversion here in 2022, users of the network still have to wait for developers to implement staking withdrawals.

Binance, meanwhile, can pretty much ask the Binance Smart Chain to pause if there is a problem, like it did between October 6th and 7th of this year. The Binance chain in theory is a separate and decentralized system from Binance the centralized company, but in reality:

Source: CZ, the CEO of Binance (via Twitter)

Similarly, when Solana unexpectedly went offline on five separate occasions in 2022, the validator operators had to meet via Discord to manually restart the chain.

Many proof-of-stake chains operate like this. The technical or capital requirements to be a validator are quite high, which ends up making the operation of the system rather oligopolistic.

And unlike proof-of-work protocols, proof-of-stake protocols have no unforgeable history of the ledger, and so if the system intentionally or unintentionally goes offline, it’s a rather manual process to determine where the appropriate checkpoint is and where to restart the network from. Since it is costless to create a nearly unlimited number of alternative histories, each seemingly as valid as the next, there is no unforgeable, self-verifiable way to determine what the “true” history of the ledger is in a proof-of-stake system (that’s what proof-of-work does specifically), and so with proof-of-stake checkpointing, some authority or set of authorities needs to be trusted.

That’s why there are projects like Babylon Chain that allow proof-of-stake chains to insert unforgeable timestamps into the Bitcoin blockchain. It’s an attempt to mitigate some of the inherent circular problems with proof-of-stake systems by making use of the dominant proof-of-work system. They use the Bitcoin network as the checkpointing authority.

In addition to centralized difficulty bombs, centralized developer decisions, centralized validation, and/or the centralized checkpointing authority problem, there’s also the simple problem that in most cases, the smart contract blockchain nodes are too big.

Optimal blockchain privacy and decentralization occurs when a user runs their own node, or at least has the practical option to if they should need to. This allows them to verify aspects of the network for themselves, and allows them to initiate transactions themselves rather than asking a third party to initiate a transaction for them.

However, by adding higher throughput or more code expressivity right on the base layer of the protocol, it increases the processing, storage, and bandwidth requirements of running a node. In order to run a Solana or Binance node, you pretty much need enterprise-grade equipment or use a cloud provider, for example.

Ethereum nodes are lighter than nodes for Solana or Binance, but are still too bulky to run over Tor. According to ethernodes.org, there are only around 6,700 Ethereum nodes. Of those, over 4,400 are hosted by a provider (generally a cloud service), including 2,700 that are hosted via Amazon specifically. There are only around 2,300 non-hosted nodes.

Most users and apps instead rely on third-party node operators like Infura and Alchemy (which themselves make heavy use of cloud providers). When the US Treasury Department sanctioned the privacy-focused smart contract Tornado Cash in August 2022, Infura and Alchemy complied, and ceased processing transactions related to Tornado Cash. This means that many foreign people, including those who aren’t even subject to US sanctions, can’t use Tornado Cash unless they are willing to run their own Ethereum node, which is nontrivial to do and can’t be run over Tor.

In contrast to all of this, back when Satoshi Nakamoto invented bitcoin, he purposely made sacrifices in terms of bandwidth and complexity to make it as small and simple and decentralized as possible.

This made it possible for individual users to run bitcoin nodes comfortably on a laptop with a normal internet connection. The requirements to run a node expand more slowly than technological improvements in processing, storage, and internet bandwidth, so it directionally becomes easier to run a bitcoin node over time rather than harder. The goal of the Bitcoin network from inception was to cut out all of the unnecessary fat to keep it as lightweight as possible.

Governments are good at cutting off the heads of a centrally controlled networks like Napster, but pure P2P networks like Gnutella and Tor seem to be holding their own.

-Satoshi Nakamoto, November 2008

Centralized Custodial Assets

Aside from some of the centralization aspects on the underlying smart contract blockchains that the DeFi industry relies on, the actual DeFi use-cases tend to have even more reliance on centralized entities.

The vast majority of DeFi total locked value relies on centralized custodial stablecoins and other centralized custodial assets. Stablecoins make up a large portion of the lending and borrowing in the pseudo-decentralized deposit/lending protocols, and stablecoins are common trading pairs in the pseudo-decentralized exchanges.

A fiat-collateralized stablecoin, such as USDT or USDC, is one where a centralized issuer holds assets in the form of bank deposits, Treasury bills, repurchase agreements, commercial paper, or similar types of assets, and issues redeemable token liabilities that are tradeable on a blockchain. In other words, there is a centralized issuer that manages the collateral and processes redemptions, but the liabilities are digital bearer assets for the holders, and thus can be traded between people efficiently and automatically with no further action needed by the centralized issuer. The centralized issuer can, however, still choose to actively freeze specific addresses as requested by law enforcement or due to various code exploits.

In addition to the heavy reliance on centralized custodial stablecoins, DeFi on Ethereum makes heavy use of Wrapped Bitcoin “WBTC”. This is a custodial product whereby bitcoin is held in custody, and its token liabilities can be leveraged or traded on the Ethereum blockchain. The amount of custodial bitcoin wrapped on Ethereum rivals the amount of custodial bitcoin held by the largest crypto exchanges. Much like stablecoins, this is a centralized product whose liabilities are bearer assets.

The worst-case scenario for how this could play out on Ethereum, has already played out on Solana. There are tokens on Solana representing wrapped bitcoin and wrapped ether, to allow those assets to be leveraged or traded within the Solana ecosystem. The problem, however, is that FTX was the issuer of those assets, and FTX is now bankrupt. As a result, those custodial assets de-pegged and lost almost all of their value:

Chart Source: Coin Gecko

Attempts at Synthetic Stablecoins

Some stablecoin developers have tried to get around this reliance on centralized issuers and custodians. After all, if most of the value of the assets traded on “decentralized finance” protocols are themselves completely centralized, then is that term even appropriate? Just because the liabilities of a centralized entity are bearer asset tokens, doesn’t make the system decentralized.

MakerDAO, for example introduced DAI several years ago, which began as an ether-collateralized synthetic stablecoin. What this means is that rather than being redeemable for actual dollars like USDT or USDC are, DAI is backed by an over-collateralized amount of ether and balanced with a stabilization algorithm, to synthetically represent one dollar.

Fiat currencies are centrally-managed ledgers. Trying to peg a pseudo-decentralized ledger (e.g. a crypto-collateralized stablecoin protocol) to an actively-managed and centralized ledger (e.g. the Federal Reserve system) is always going to come with various limitations and risks. In this case, using a volatile asset as collateral means that there is a reasonably high chance of sudden liquidation of that collateral. Sudden liquidations are likely to occur during tumultuous market periods, which leads to chain congestion and extremely high transaction fees as too many people scramble for the exit at once, and too many liquidations are triggered at once, for the network to handle properly.

In March 2020, during the global market crash associated with COVID-19 becoming a pandemic and various economies locking down, the price of ether crashed, and in an emergency situation, MakerDAO ironically voted to add centralized USDC fiat-collateralized stablecoins as a form of DAI collateral. This is because a crypto-collateralized stablecoin (which is basically the attempt to back a low-volatility asset with a high-volatility asset) is inherently either fragile or capital inefficient. Ever since then, USDC has been a very large percentage of DAI’s collateral. USDC could freeze DAI’s collateral and basically end that project at any time, if asked to by the government.

In order to have an arbitrarily low probability of liquidation, a crypto-collateralized stablecoin requires an arbitrarily high ratio of over-collateralization. In simplistic terms, if you want the stablecoin to avoid having to liquidate even with a 75% drawdown of the collateral, then you need 4-to-1 overcollateralization. If you want the stablecoin to avoid having to liquidate even with a 90% drawdown of the collateral, you need 10-to-1 overcollateralization.

This would be extremely capital inefficient if handled that way, and therefore most protocols will try to get around these levels by relying on incentive mechanisms to bring in more collateral from the community when it is needed, rather than keeping it there all the time.

For example, newer crypto-collateralized stablecoins like Liquity and Zero aim to be 100% crypto-collateralized via incentive mechanisms. Liquity “LUSD” is collateralized by ether, and Zero “ZUSD” is a fork of it on the RSK sidechain of the Bitcoin network that is collateralized by RBTC, which is RSK’s merge-mined federation-wrapped version of bitcoin.

The way this works for Zero is that ZUSD synthetic stablecoins can be created when someone deposits RBTC into the smart contract as collateral and receives ZUSD as a loan on their collateral. If they get liquidated (which occurs if the value of the RBTC falls below the maintenance threshold on the contract), they lose their RBTC but keep the ZUSD. The system overall optimizes towards a 1.5x or higher level of system-wide overcollateralization, although individual loans can be as low as 1.1x overcollateralized. If the system as a whole reaches sub-1.5x levels of collateralization, it liquidates loans under 1.5x levels of collateralization and changes the incentive mechanisms for borrowing to encourage higher levels of collateralization. Importantly, there is a stability pool that incentivizes holders of ZUSD to deposit and support the lending. If loans get liquidated, these ZUSD depositors get their funds transformed into RBTC at a discount to the market price of RBTC (which is conceptually kind of like selling put options to wait and buy RBTC at a discount, since most of these participants would generally be bullish on RBTC). So, the system encourages excess ZUSD that is floating around in the market, to come back and get burned in exchange for the ZUSD holders receiving RBTC, to reduce the chances that the dollar amount of ZUSD is ever not fully backed by a greater dollar amount of RBTC.

These incentive mechanisms are interesting. LUSD, with its longer history than ZUSD (and that ZUSD is based on) has managed to maintain its USD peg throughout the 2021 and 2022 bear markets, where ether (the collateral for LUSD) was at one point down by around 80% from its high. Here is a post from May 2021 analyzing how it held up well in an ether flash-crash scenario, thanks to a properly-working oracle and a properly-working stability pool. However, it has been less than two years of operation overall, and LUSD is tiny compared to fiat-collateralized stablecoins like USDT and USDC, meaning that DeFi as a whole is still incredibly reliant on custodial assets.

I view bitcoin as being better collateral than ether, all else being equal, and so I naturally would prefer DeFi on the Bitcoin network, at least to the extent that I would be interested in DeFi to any meaningful degree. I don’t plan to leverage any of my bitcoin, and I’m happy to hold bank dollars, money markets, or T-bills to the extent that I want liquid dollar exposure, so I’m not exactly the target audience here.

Ongoing holders of LUSD and ZUSD have to trust 1) that the underlying smart contracts won’t be exploited for the foreseeable future, 2) that the incentive mechanisms will continue to work for the foreseeable future to properly maintain over-collateralization through all market conditions, 3) that the price oracles won’t be gamed in any destabilizing way, and 4) that the governance of the smart contract won’t become misaligned with users or otherwise captured (referring either to the specific contract governance or the underlying computational layer governance).

Centralized Oracles

Tying digital assets to real-world information involves a centralized oracle, or a quorum of several centralized oracles to try to spread out the oracle readings. An oracle is a source of information that a smart contract requires in order to execute its function.

For example, tying a crypto asset to the dollar means that the smart contract needs to know what the dollar-denominated price of that crypto asset is, which means it needs information from an exchange.

Similarly, a sports betting smart contract needs an external source of truth that collects the information from the real-world sports game, so that the smart contract can award the gains to the winning speculators.

This reliance on one or more oracles represents yet another point of centralization. Who controls the oracle(s)? How easy is it to manipulate a given oracle or set of oracles and exploit a contract?

Centralized Governance Actions

Many deposit/lender protocols and exchange protocols have centralized web-based user interfaces, and centralized companies supporting them. The underlying technology may be open source and accessible without them (requiring the user to run a node, or otherwise be rather hands-on technically), but for most users, that web-based user interface is how they access the services.

There have already been precedents for these centralized companies and interfaces removing certain tokens from their trading or leveraging environments, either when asked to by a government or pre-emptively to try to avoid breaking securities laws.

And many of these systems have far more centralized control than they let on. For example, as Jameson Lopp pointed out earlier this month, the DeFi protocol called Serum on the Solana blockchain markets itself as fully decentralized in its Twitter bio and elsewhere, and yet right under its bio there is a pinned tweet about how it went defunct due to centralized control.

This is what you see when you look at their Twitter bio as of this writing:

Source: Project Serum (via Twitter)

How can something be considered “fully decentralized” if one centralized entity holds the upgrade authority?

Many of these protocols try to to answer that question by breaking up control of the service by using governance tokens. Either from an initial coin offering or from airdrops to users, these tokens can be distributed, and allow for voting on various governance actions that relate to the operation of the service. These same tokens may also earn a share of profits generated by the protocol.

While this is interesting in theory, it begins with several problems.

First, as with most things in crypto, the vast majority of governance tokens are held by whales, meaning that a small number of wealthy entities retain the controlling share of voting power.

Second, voter turnout tends to be low, which gives highly active and incentivized parties even greater control over the protocol’s governance in practice.

Third, because it is pseudonymous, these governance models tend to be more easily gameable than real-world democracies. Pay-for-votes, entities secretly controlling a larger total share of the governance than the market realizes, and other problems make it hard to operate in a truly decentralized way.

The co-founder of Ethereum, Vitalik Buterin, recently brought up the economic problems associated with governance tokens, and I agree with him:

Source: Vitalik Buterin (via Twitter)

So, recurring profits may be able to support token value (e.g. an equity security in digital form), but governance alone is an insufficient reason for a token to hold sustained value. And regardless of whether they earn profits or not, they’re likely going to be rather centrally-held and controlled in practice.

Overall, there is a high probability that DeFi protocols will face greater scrutiny and regulation over time. And because they have so many centralized attack surfaces, it’s not that hard for regulators to clamp down on them, reduce their usability, and increase their trackability.

When it comes to the DeFi ecosystem, their blockchain nodes mainly run on centralized cloud providers, most of their locked value relies heavily on centralized custodians, and users primarily interact with the ecosystem through centralized web interfaces maintained by centralized companies.

DeFi Doesn’t Solve the Fiat Onramp Bottleneck

One of the criticisms that people in the DeFi industry tend to aim at bitcoin, is that bitcoin is heavily reliant on centralized exchanges and brokers. The vast majority of its buying and selling occurs in centralized exchanges or through centralized brokers.

“That’s why we need DeFi,” many of them say.

However, we need to conceptually separate the phases of 1) post-onramp speculation/trading vs 2) actual onramping and utility.

If you want to trade in DeFi, how do you start? Do you magically teleport your capital into a DeFi ecosystem? No. First, you go through a fiat onramp exchange, like Coinbase or Kraken, by transferring money from your bank to the exchange. Or you go through some other centralized payment provider. Then, you can buy various crypto assets, and move those crypto assets into a DeFi environment. From there, you can trade and leverage those crypto assets across various smart contracts.

So, DeFi isn’t cutting out the bottleneck of relying on centralized exchanges or centralized bank connections for the fiat onramp part of the process. DeFi merely offers post-onramp smart contract environments to trade or leverage crypto assets, as a competitor to the alternative of remaining on those exchanges to trade and leverage crypto assets there.

But realistically, how many people should be trading or leveraging crypto assets anyway? These aren’t “banking” services; these services are mainly for speculators.

The Bitcoin network, on the other hand, has a similar onramp bottleneck. You send money to an exchange or broker, buy bitcoin, and then from there you can withdraw your bitcoin from the exchange or broker. From that point, you are financially “self-sovereign”, meaning you can self-custody your own bitcoin, and use the decentralized network to send or receive permissionless bitcoin payments globally. Additionally, there are some multi-signature escrow services that you can use, if for some reason you want to get a loan (in fiat or in stablecoins) while using your bitcoin as collateral.

The only way to go around the onramp bottleneck, should centralized exchanges ever all be shut out from the banking system, is peer-to-peer purchases. In addition to mining, that’s how people got into bitcoin in the beginning, before exchanges existed.

There are now methods like Bisq or RoboSats or Hodl Hodl or Paxful or Azteco for people that want to buy bitcoin without going through a centralized exchange, and sometimes with anonymity. The downside is that there is limited liquidity; these types of services only work for buying or selling modest amounts of bitcoin. However, the number and size of these types of services would likely substantially increase if centralized exchanges are shut out from the banking system.

As a tangible example, Nigeria shut out crypto assets from its banking system nearly two years ago. Nigerian banks are disallowed from letting customers send money to crypto exchanges. And yet, Nigeria has among the highest bitcoin/crypto adoption in the world on a per-capita basis, and bitcoin/crypto in the country has much higher adoption than the country’s central bank digital currency, the eNaira. How is this possible? Because they use various peer-to-peer methods to acquire bitcoin. They can even do remote work such as programming or graphic design, and get paid by foreign clients in bitcoin straight to their own self-custody, which they can then use for global payments.

Where there’s a will, there’s a way. And when official consumer prices  in aggregate have gone up about 5x since 2010 due to ever-expanding money supply, and when authorities have arbitrary power to freeze bank accounts of protestors, there’s certainly a will.

The “killer app” of bitcoin is simply using it for what it was originally designed to do: self-custodying and sending/receiving permissionless payments in what has thus far been the most decentralized, secure, and immutable crypto asset.

Trading/leveraging is something that a subset of bitcoin holders may choose to do, but it’s not as though the world is in desperate need for more ways to speculate on ten thousand crypto assets, especially when DeFi is only relevant post-onramp and has nothing to do with the on-ramping process from the existing fiat banking system.

Section Conclusion, and Further Reading

In conclusion for this section, DeFi environments are trying to address a genuine trading/leveraging problem, but generally consist of multiple layers of partial centralization.

-The underlying smart contract computational layer is often not as decentralized as it claims to be, thanks to validator oligopolies or developer control, the reliance on a checkpointing authority due to there not being an unforgeable history of the ledger, and the general difficulty in the ability of users to run a node due to high bandwidth and storage requirements.

-Any significant trade-able asset that refers to some external data, such as price or some real-world connection, requires some centralized or partially-centralized custodian or oracle.

-Governance in practice, even for purely digital assets, often is centralized and can be traced back to a centralized business entity or small group of individuals.

-Any potential areas of actual decentralization in leveraging/trading protocols that may occur in this industry only apply once the speculator gets past the fiat onboarding bottleneck anyway; DeFi doesn’t solve the fiat onboarding bottleneck.

For those that want additional detail on the nature of DeFi’s speculation, recursive leverage, and/or centralization problems, I recommend “Only the Strong Survive” (a September 2021 research report by Allen Farrington and Big Al) and “Green Eggs and Ham” (a long-form research article by Allen Farrington and Anders Larson).

The Problem of Arbitrary Seigniorage

When founders and early venture capitalists put together a tech startup, they generally tie their fortunes to the success or failure of that idea. They invest in rather illiquid equity, and the main way to unlock that equity and get successful exit liquidity involves either going public or being acquired.

To go public, they have to go through an expensive disclosures process, where they open up their books, reveal the major ownership, and discuss risks in detail. The median length of time for a startup to go public from its founding is over eight years.

To be acquired, they need to build something attractive enough for another business to want to buy them out. In other words, professionals with MBAs or other business experience/education review their business and decide to buy it.

Therefore, the fortunes of the founders and early investors of the startup are usually tied in a significant way to the underlying fundamentals of the business that they built and financed. The company needs some revenue, some use-case, and to go through some degree of due diligence. They have to spend years building a company that either another company wants to buy, or that gets big enough and sticks around long enough to go public, with all of the necessary disclosures.

In the crypto world, it has been different. Founders and early investors can create a project, sell the coins publicly (generally to accredited investors or overseas to avoid public securities laws now, ever since there was a crackdown in domestic public initial coin offerings), work on it for a year or two or three, market it heavily, get it listed on a crypto exchange, and then dump the hyped-up coins (which likely are unregistered securities) on public retail speculators with exaggerated or outright false claims about the project’s level of decentralization and utility.

In other words, the founders and early investors can separate their own profits from the actual success of the project’s fundamentals. They don’t need to spend the better part of a decade building a business that is good enough for another business to want to acquire it, or that can go through the SEC’s process for entering public markets. They can just create hype and dump their coins on the retail public, for the sake of fast exit liquidity.

“Seigniorage” is the profit that a government makes by issuing its own currency, especially as it relates to the difference between production cost (near zero) and its market value. Blockchain technology has enabled private entities to benefit from seigniorage as well. They can create a crypto semi-liquid/fungible asset for very little cost, hype it up, and try to profit from it. Because very little value is being created in the process, it’s mostly a zero sum game where the creators and promoters of the coins make the money, and retail speculators lose the money.

Bitcoin doesn’t meet the definition of a security, because it never raised capital. Instead, the open source software was created and then just put out there. Based on on-chain analysis, it’s pretty clear that Satoshi Nakamoto didn’t sell his coins either; he walked away from the network back in 2010 without any clear financial benefit, and the network has continued without him in a rather decentralized way.

However, the technology that Satoshi Nakamoto created to enable peer-to-peer payments and savings, has also been repurposed by others for peer-to-peer scams, frauds, and what is basically digital penny stock pumping-and-dumping in the broader cryptocurrency industry.

As this keeps happening, I think one of two things will happen.

For one, regulators in more countries may clamp down on this practice even more than they already have. The US has already limited the ability to sell unregistered initial coin offerings to the onshore public, and they may further limit the ability of onshore exchanges to sell them to the public post-offering as well.

Secondly, regardless of whether that regulatory risk materializes or not, people will be burned by the crypto industry over and over until they start associating cryptocurrencies with scams. This has already occurred to some degree, and it’s a mostly accurate heuristic.

“Does it Need a Token?”

The problem with the crypto industry has nothing to do with cryptography. Nobody would blame any developers for researching interesting technologies and building interesting projects.

The ethical problems only arise if they try to make millions of dollars from that work, prior to the fundamental success of that work.

When evaluating any cryptocurrency or adjacent project, if it has its own coin or token, always ask, “does it really need a token?” Usually the answer is no. And the reason why it has a token anyway, is to benefit the creators/founders in terms of fast exit liquidity regardless of whether the underlying project offers any real value in the long run.

As an example, suppose someone invents a ride-sharing app called Rebu, except this one is branded as a “Web3” project that is “decentralized”. The founding team and early investors create their own Rebu coins, give themselves most of it, and sell some to raise capital. They spend two years working on the app and hyping it up, and get Rebu coins listed on some crypto exchanges, a lot of retail speculators buy the coins (which are likely unregistered securities, despite being sold to the public now), and the Rebu developers and early investors use that opportunity to exit their Rebu coin positions with huge multi-million dollar gains. And then people realize, “Wait, wouldn’t it be easier to buy Rebu rides with dollars rather than having to convert dollars to Rebu coins first? Doesn’t this just add unnecessary friction?” And then of course the project goes nowhere and eventually falls apart, Rebu coins collapse in value, but the developers and early investors already exited and got rich.

Web3 is an industry marketing term for a subset of cryptocurrencies to try to offer a more decentralized internet experience than the Web2 that we’ve become accustomed to, with its large and centralized social media companies (Facebook, Youtube, Twitter, and so forth). While the goal is admirable, the problem is that of course most of these projects want to issue their own token, most of them are not really decentralized, and most of them will fail (although many of the creators will get rich anyway, thanks to fast exit liquidity).

There have been a number of developments that have offered an alternative.

For example, Block, Inc. (SQ) has a business unit called TBD that has been working on what they call “Web5”, which is a technology set that allows for decentralized interactions, without a new coin or token. Block’s CEO, Jack Dorsey, has been very critical of the problematic financial incentives related to Web3 and its associated tokens, while acknowledging that the goal of creating a more decentralized internet is an important one.

As another example, a number of developers have been building a tech stack using the Hypercore protocol. Example technologies for this include Slashtags and Holepunch. These technologies, as they mature, can potentially allow for decentralized identity and decentralized applications, which covers much of what Web3 technologies aim to do. These Slashtags and Holepunch protocols don’t have coins, because they’re not necessary.

I’ve been testing and using Holepunch’s first application called Keet, which is a peer-to-peer encrypted video, filesharing, and chat app. It also has built-in Lightning payments. It’s currently in alpha development, but it works very well so far, with much higher resolution, lower latency, and more private video conferencing than server-based products like Zoom (ZM) if you are only involving a handful of people in the video call.

Another technology in the works from these groups utilizing the Hypercore protocol is called Pear Credit, which is a peer-to-peer accounting system that, if successful, will allow for stablecoin transfers, and other centralized bearer-asset transfers, in a very efficient way, with no separate coins attached.

This continues to be a very dynamic field, and we’ll see what things look like over the next 3-5 years. But it’s important to keep in mind that the vast majority of cryptocurrencies that have been created, fail to persistently accrue long-term value. Many of them are rug-pulls or pump-and-dump schemes, and in general simply allow the creators to financially benefit from the project regardless of whether the project’s fundamentals end up being successful or not.

As I noted in my Digital Alchemy piece, and then as Swan.com further quantified in their internal research this summer, only three out of over 20,000 coins in the history of the industry have managed to reach higher-highs in bitcoin-denominated terms on their second crypto bull cycle.

If you look around and don’t know where the exit liquidity is, then you’re the exit liquidity.

Upgrading the Tech Rails

I have been structurally interested in bitcoins and stablecoins for years now, and continue to be.

With bitcoin, a rather decentralized system allows users around the world to make permissionless payments and to self-custody a finite bearer asset. It comes with volatility and risks, but is a true innovation, and in my view continues to offer great promise over the long run. When we think globally, it’s hard to understate how many people have a savings or payments problem, either due to persistent inflation and developing-world currency failures, or due to authoritarianism and financial censorship.

With stablecoins, a centralized issuer creates dollar liabilities in the form of a bearer asset, backed by collateral, and thus allows people to access dollars around the world in jurisdictions that otherwise make it rather hard to access dollars. Stablecoins come with counterparty risk which can be somewhat mitigated by increasing levels of transparency regarding the collateral. I’m not very interested in stablecoins for leveraging/trading by wealthy people in developing markets, but I am substantially interested in stablecoins for payments and savings in small amounts by people in developing countries. This can be implemented with other monetary assets like gold as well, and has been.

Are there other use-cases for blockchain technology, or similar types of distributed ledgers? In theory, sure.

What these following two categories have in common, is that much like stablecoins, they have a centralized issuer but the liabilities can trade as bearer assets in an automated way. This can offer substantial utility. In other words, they represent the potential for upgraded tech/distribution rails for centralized securities to trade, settle, and custody on.

Tokenized Currencies and Securities

The normal trading window for US equities is from 9:30am to 4pm, five days per week, and adds up to 32.5 hours. Since there are 168 hours in a week, that means that US equities can be traded just 19.3% of the time. From there, they subtract certain holidays, and probably get down to around 19% flat.

Is it reasonable to expect them to trade the other 81% of the time, too? Like bitcoin and other crypto assets do? I think so.

Additionally, equity and other security trades take days to fully settle. The time has come down over the years, but it’s still operating on legacy settlement rails. What if each trade could fully settle in minutes?

Lastly, it’s pretty hard for most people (at least outside of upper classes) in developing countries to access equities in general. This applies to both their domestic equities as well as to US equities.

What if traditional securities, such as stocks and bonds from around the world, plus all commodities and currencies, could be tokenized and accessible to anyone in the world with a smart phone, tradeable 24/7, and fully settle within minutes? Much like stablecoins, they would still be centrally-issued, but the liability side would be a digital bearer asset, and a rather efficient one at that.

Tokenizing traditional assets seems to be a reasonable expectation, and it would just represent an upgrade to the tech rails that existing securities operate on.

Digital Collectibles

NFTs, or digital collectibles, or “first edition receipts” as I prefer to think of them, continue to be of interest to some people.

These could be in the form of a digital artwork that is otherwise able to be copied but has what is basically a “first edition receipt” associated with it. Alternatively, they could be in the form of a video game item that can be transferred to other games or traded on an open market outside of the game. They could also be things like concert tickets that can be transferred around as digital bearer assets. Some people may use them to directly support their favorite musician or artist.

Back in my January 2021 article, I expressed openness to the idea of digital collectibles, and for example discussed some reasonable use-cases of crypto gaming NFTs:

Nowadays, there are a number of crypto-based games. I’m not as much of a gamer as I used to be, but if I were, I could certainly see why blockchains can potentially add something of value to the gaming ecosystem. The idea of having items/pets/characters that the user can hold independently of the game publisher, and maybe even have those items/pets/characters recognized by other games as well, certainly is cool.

-Lyn Alden, An Economic Analysis of Ethereum, January 2021

In July 2022, analyst and VC Nic Carter made the case for twinned NFTs, where a physical luxury product has a chip in it that has an associated NFT.

Most tech-savvy luxury brands probably thought about ‘doing an NFT’ last year. Hopefully, they thought better. Now that the hype has cooled, these brands will start to realize that the real innovation is not exploiting fans by selling them overpriced JPEGs with dubious utility, but by twinning merchandise with a persistent digital property. This elevates a hoodie from just a piece of cloth with a logo on it, to a verifiable representation of the brand in emerging digital spaces, a long-term ironclad communications channel between consumer and issuer, a counterfeit-resisting device, and a means of fair secondary exchange.

[…]

Wearing the shoes around, locational triggers grant you further experiences. Your wallet fills with goodies — a POAP here, a rebate there. You discover that the NFT comes with access to events thrown by the designer. Your ticket to their next art show consists of the chip embedded in the shoe. You earn a skin from attending the event and promptly use it to customize the digital version of your shoe. Basic biometric monitoring tracks your time spent wearing the shoe and builds a usage profile together with the locational data. Some users prefer stealth mode, but you don’t mind sharing the data — you permission its release to the manufacturer in exchange for a direct USDC payment to your NFT-associated wallet.

Later, you decide to sell the shoes. You strike a deal with a buyer, putting the NFT and the funds in escrow, while you mail the shoes. When they get the package, they scan the tag, safe in the knowledge that they are receiving the genuine item. They verify the shoes are in good condition and the escrow releases the NFT to the buyer and the funds to the seller.

–Nic Carter, Redeem-and-Retain NFTs sre the Future of Luxury Goods, July 2022

Similarly, Coinkite has a product called the SATSCHIP, which is a chip that can be embedded into a physical artwork. As they describe it:

Think of it as a Bitcoin private key an artist can embed into a work of art! The piece carries that private key and it can never be separated from the artwork, nor used by the artist after the art is sold.

[…]

SATSCHIP’s purpose is to allow artists to embed Bitcoin value into their works.

Any passer-by can verify the originality of the work using a simple tap of their phone. The owner of the work can use the private key to sign a message to verify their ownership and control of the work at any time.

–Coinkite, SATSCHIP FAQ

I’m not much into art or consumerism, so these trends aren’t really for me, but I don’t dismiss them as potential markets that could emerge at more scale. I don’t really know.

But in practice, whether it’s digital art, digital game items, twinned physical-and-digital items, or otherwise, the current iteration of NFTs has been highly speculative, and rife with purposeful price manipulation (which is way easier to do with non-fungible assets than highly-liquid and fungible assets). Developers often create unfun games and then shove tokens or NFTs in there, rather than make an inherently fun game and then see if, to any minor extent, some transferable value could enhance the enjoyability of the game in some way.

In my premium reports over the past year and a half, I have been less-than-enthusiastic about this entire industry so far:

The most expensive trading cards in the world are worth a few million dollars, so I guess I’m not one to judge what art is. However, I could get a set of Michael Jordan, LeBron James, Kobe Bryant, Wayne Gretzky, and Tom Brady rookie cards, along with the rarest Black Lotus card from Magic the Gathering, and the first edition Charizard card from Pokemon, together for less money than that top alien CryptoPunk. I think I’d take all of those cards over that, but what do I know. The risk/reward certainly doesn’t look compelling to me.

-Lyn Alden, August 8, 2021 Premium Report

Basically, owning NFTs is a way to display one’s crypto wealth, along with price speculation. Collectibles have always been popular, and displaying digital collectibles on Twitter and elsewhere seems to enhance that popularity, at least for the moment. While I think NFTs offer interesting future potential, I would be very cautious with prices of these current items for the long run. The space is very speculative, not very liquid, and has a high probability of looking like a lot of previous crypto busts of history.

-Lyn Alden, September 5, 2021 Premium Report

While the NFT craze has caught on among certain groups of influencers, a big concern that many people have pointed out is that NFT sets are easy to manipulate the price for, especially in a broadly speculative environment of negative real interest rates, meme stocks, meme coins, and SPACs with no revenue. Since they are non-fungible and trade for large amounts of money, people can sell NFTs between their own accounts or between close contacts at ever-higher prices until they convince other people to buy in at high prices, and then sell some of their NFTs at those inflated prices to those new entrants, who thought they were buying into a legitimate market pricing environment. I don’t know to what extent that is happening in the industry but this big $532 million self-sale with a flash loan doesn’t have good optics.

-Lyn Alden, October 31, 2021 Premium Report

The fifth could be a broad and persistent cryptocurrency bear market, which we might or might not be in now. NFTs would likely be particularly vulnerable in that sort of downtrend due to their lack of liquidity.

-Lyn Alden, December 12, 2021 Premium Report

Indeed, volumes and prices of NFTs have collapsed significantly over the past year.

Chart Source: Dune Analytics, @rchen8

Final Thoughts: Pandora’s Box is Open

Satoshi Nakamoto’s invention in 2008, which itself incorporated decades of prior cryptographic and computer science work, opened Pandora’s box.

Holding and transferring money or money-like assets internationally, without going through the existing banking system, suddenly became possible. This technology cannot be un-learned. The ability to do this is open-source, widely distributed, and known now.

A Canadian can pay a Nigerian for some graphic design work, and in such a way that goes around either country’s banking system. Vladimir Putin’s political opposition can raise donations even if Vladimir Putin’s government shuts them out of the Russian banking system. Venezuelans can self-custody bitcoin or dollar stablecoins amid hyperinflation, and bring them with them if they leave.

There are 180 circulating fiat currencies in the world across nearly 200 countries. Most of these are extremely fragile, and prone to recurring major devaluations. Each one has a local monopoly, but the vast majority of them are useless and hard to sell outside of their home jurisdictions. It’s hard for people in many developing countries to save liquid value over years and decades, let alone the fact that even the US dollar has lost over 98% of its value since it went off the original gold peg.

Last month, I asked a question on Twitter as a thought experiment and discussion starter:

Imagine you live in a developing country with an ongoing severe currency devaluation problem.

You want to sell your existing home, hold it in some stable liquid value, and then probably buy a different home in 2 years.

What do you hold it in?

The range of answers was surprising. Many people from developed countries didn’t understand the problem, said they would just hold dollars, and seemed to wonder why the question was even asked.

The problem, of course, is that many people in developing countries outside of the upper class have trouble opening foreign bank accounts. Many of them don’t even have domestic bank accounts. In Egypt, for example, a country of 100 million people, 74% of them don’t have a bank account. In Nigeria it’s 55%, in Indonesia it’s 50%, and in India it’s 23%. Those who do have bank accounts often don’t have easy access to foreign currencies at fair exchange rates. Those fortunate enough to have foreign bank accounts, often pay rather high fees for that service; it’s not exactly fast or efficient to do business with a foreign bank.

In nations with ongoing severe currency devaluation problems, it’s often either 1) hard to get your hands on dollars or 2) only possible to get them at a false exchange rate or 3) risky to store them in domestic banks because they could be confiscated and forcibly converted back to the local currency.

Some people answered by saying they would hold physical cash dollars or gold. Imagine you’re in an apartment in a developing country, with a house-value worth of dollars or gold hidden somewhere. Every time you leave the home to work or shop, there’s a small part of you that is aware of the possibility of losing your life savings due to a burglar, a fire, or similar problem.

I received a lot of responses from people in developing countries as well, and they were more knowledgeable about the challenges of the question since many of them deal with them on a regular basis. Many of them said they do simply hold large amounts of physical dollars, as risky as that is. Other ones said they would hold cars or other physical assets, which is inefficient. Still others said, “I just couldn’t ever do this; I can’t sell a home and hold the value in liquid form for any meaningful length of time.”

So, here in the year 2022, there are still vast percentages of the global population for which the basic concept of “savings” remains a challenge.

It should be trivial to sell something of significant value, and hold that in a liquid and safe form for a couple years until that value is redeployed.

The fact that it isn’t trivial, shows how problematic the global financial system is, especially for people in developing countries. Fiat currencies are centrally-managed flexible ledgers with local monopolies over a given jurisdiction, and most of them are managed very poorly. It’s really bad if you’re not in the top couple dozen jurisdictions in this regard.

And then there is the problem of financial censorship. The nonprofit organization Freedom House classifies countries as “Free” or “Partly Free” or “Not Free”. Only 20% of countries meet their definition of “Free”, which is down from 46% in 2005. In many countries, bank accounts are subject to rather arbitrary freezes, and as mentioned above, it can be challenging for working class people in developing countries to even access a bank account in many cases because it’s just not worth it to a bank to bother with such small balances. And for millions of people that find themselves as refugees at one point in their life, they generally have trouble bringing most or all of their wealth with them.

So, there is a lot of work to be done in order to enhance the world’s relationship with money. Storing and transferring value shouldn’t be rocket science in 2022. The percentage of people in the world with a smartphone has already exceeded the percentage of people with a bank account, and is rising at a faster rate. There’s no reason why everyone with a smart phone shouldn’t be able to access basic financial services including good money. Even feature phones can access some of these technologies, up to a certain degree.

Trading and leveraging are not basic financial services; they are secondary services mainly for people who already have substantial capital. The first and larger opportunity is to improve payments and savings for many people globally, for people in both developing and developed countries. That’s what bitcoin and stablecoins offer, with various trade-offs over different timeframes.

“Access to better trading rails” is a reasonable goal to work towards, but it’s not as big of a problem to solve as “access to better forms of money for payments and savings”.

The technology in this industry evolves over time and will continue to do so. There will be various impacts to various industries, and it’s hard to say at this time how large those impacts will be or how fast they will occur.

Everyone will make mistakes as they navigate this new and complex field, but the path forward is to keep mistakes small, to emphasize utility over speculation, and to focus on identifying the largest problems to solve.