Why the detachment of DeFi from real economy limits token values to zero.
Generally speaking, you would expect that when people invent better way of doing things, they replace the old with the new, although this is not what always happens.
Sometimes, it is because a change would just cost too much. To this day, the U.S. has not adopted metric system, despite the known fact that conversion errors cause planes to run out of fuel midair and much worse. Other times, it is because the change is so fundamental that it would lead to a complete replacement of the incumbents who resist?
That money is a bad database is something we like to talk about here again and again. You would think that money is moved around the world by some giant interconnected network of computers, but that is wrong. It is still based on hundreds of years old system of correspondent banking. When you send someone money abroad, all that actually happens is that two banks update their spreadsheets — your bank has an account at the bank of your recipient, which essentially just means that your bank is owed some amount by the recipient’s bank. After the transfer, your bank is owed less by the recipient bank, which adds it to the account of your recipient.
Money is a system of thousands of spreadsheets —network of offsetting debts that the banks each keep their own record of on their own databases running million of lines of low-level code from 1960s and commands like “ADD” and “DEDUCT.” These divided databases are connected via a messaging service like SWIFT. They all keep checking and comparing their versions of truth. It is not all that surprising, then, that when you send someone money cross-border on Friday, it arrives later next week, if at all.
It is for these reasons that bitcoin could become the new base layer of money, something we’ve talked about before. But let’s now look at the finance industry more widely and ask ourselves whether and to what extent DeFi could be its future.
Spaghetti.
Built on top and using this bad database called money is a vast universe of layers and layers of financial products: loans, stocks, bonds, derivatives and thousands of other certificates representing some asset, stream of income or other value, but they are all just a guarantee of some counterparty, represented as zeros and ones split across thousands of separate databases patched together through communication networks.
Replacing this convoluted fragmented system with one database — a single version of truth — is the threat that crypto poses to the traditional financial system. In short, your crypto wallet is your identity, is your economic remote control. You trade one token for another by connecting your wallet and sending the token to a program on blockchain or take out a loan by sending a token to a program on blockchain that stores it as collateral and sends you another token back as a loan. All of these transactions are just commands in code that interact with and change the state of the one database — blockchain. (Yes, this is simplistic; we are in the midst of a heyday of programmable blockchains, and the incompatibility between them is a problem that we’ve discussed).
Software is eating the world has been the mantra of the post-2010s startup world, but until now, it has only transformed the private sector. Now though, software is about to transform the government-protected industry of finance.
PxQ/V.
There were many attempts to tokenize real assets, i.e. to elevate ownership of real things to blockchain. This did not, naturally, fit the existing rules that protect the incumbents running the bad database, and there was not, naturally, any effort (with notable exceptions of countries like Switzerland, but even there limited) to reinvent the rules to accommodate superior technology. To the extent that the tokenization seeks to represent securities, it is mostly practically impossible and very much watched and hunted. I do know this phase of blockchain evolution quite well, having founded a tokenization advisory company in Switzerland, where I did a lot of work with lawyers to find best ways to tokenize various forms of securities.
Crypto has grown much larger since then, but it has also become more detached from anything real and productive. Paraphrasing Lyn Alden, the programmable blockchains are large operating systems powered by tokens to move around tokens.
A highly cited paper by John Pfeffer makes the argument that, in broad terms, programmable blockchains are like TCP/IP protocols in the internet era, hence their value atmature equilibrium(i.e. when all tokens are allocated, when the speculative phase is over) is very low. To explain this, he argues that the value of utility tokens that are powering these programmable blockchains (powering in the sense that blockchain is a database that has to be maintained by some form of consensus mechanism and tokens are an incentive to miners to provide this processing power, energy, etc.) is M = PxQ/V, where M is the total value of all tokens, P is the price, Q is the quantity and V is the velocity, or the measure of how frequently the token is used and reused in the system. Over time, the PxQ will be equal to the cost of computing resources required to power the blockchain, i.e. mining, and V will be high given the lack of friction and higher transmit efficiency of decentralized systems more generally (said differently, tokens won’t be accumulated by anyone, it will be easy to always just-in-stock buy them to use the blockchain). In his view, programmable blockchains are essentially new plumbing for digital business models:
Over time, the PxQ will be equal to the cost of computing resources required to power the blockchain, i.e. mining, and V will be high given the lack of friction and higher transmit efficiency of decentralized systems more generally (said differently, tokens won’t be accumulated by anyone, it will be easy to always just-in-stock buy them to use the blockchain). In his view, programmable blockchains are essentially new plumbing for digital business models:
The network value of a tokenised version of a dematerialised network business (a social network, Uber, AirBnB, a betting exchange, etc.) will by construction be a small fraction of the enterprise value of its centralised, joint-stock-company equivalent. Holding the number of users constant, you basically take the fully-loaded IT budget (including energy and a capital charge) of those companies (representing PQ) and divide by some (likely high) velocity V. The disruption of traditional networked businesses by decentralised protocol challengers will represent an enormous transfer of utility to users and an enormous destruction of market value. Great for users, the economy and society; bad for investors.
The paper came out in 2017 and it is an excellent analysis that is nearly impossible to argue with, except for: 1. it argues that the price of the token is limited (regardless of how much demand there is to use the blockchain as plumbing) because any programmable blockchain can be instantly forked at near zero cost, which (although this has certainly happened in past, e.g. Sushiswap vampire attack) has not been nearly as frequent as explained (indeed contrary to Pfeffer’s argument that doing this copy-paste in the blockchain world is much easier than it would be to, for example, copy-paste Facebook, you could argue that insurgents in both cases would face similar chicken-and-egg problem of initial adoption by users) and 2. after two years of lockdown, we now know that artificial scarcity can indeed transform blockchain records, i.e. tokens to a social status symbol (NFTs) that people are invest millions in.
There is another thing. Being an optimist, although it might be true that blockchains will perform the role of infrastructure to move around zeros and ones, i.e. the new gen. of TCP/IP, there is no reason why real value cannot also be locked in the protocols long-term. In other words, if more of how people economically interact day-to-day moves to blockchain, tokens can represent real things.
Degen finance.
DeFi has managed to convert complex financial concepts like exchanges, insurance, derivatives and lending into a counterparty-free automatic code, but that code is still moving around things that are not connected to anything real or productive.
Put differently, economic actors don’t borrow money in DeFi to build a factory, they borrow tokens to speculate on short-term movements of tokens. To the extent that there is nothing that would create real value in the DeFi universe, all value appreciation and all income paid out by the decentralized applications (dapps) are a result of external capital inflows and illusionary price bidding. And if this is true and the new money pays for the old, then DeFi is a textbook Ponzi scheme.
To demonstrate this, we do not even have to look at extreme cases like Anchor Protocol or Axie Infinity, which enjoyed their share of publicity in media. Compound is a well-known dapp backed by Coinbase, a16z and other big names. It allows users to lend and borrow. Borrowers send crypto into the dapp to mint a cToken, which serves as the collateral against which they borrow. They borrow to speculate, either they want to buy more crypto so they take a loan, or they want to short some crypto, so they borrow it to sell it in the market. Fine, but, oh wait, also users get COMP token, which is like ownership stake and allows them to vote on proposals and participate in governance. Each day, approximately 1,139 COMP is be distributed to all users of the protocol, meaning both lenders and borrowers receive it. Free money? Yes. And also, you can deposit COMP back to the dapp to borrow more. This is only one example, but we do not have to be more exhaustive to demonstrate the fact that DeFi projects seek to attract as much liquidity as possible in a vicious cycle that bids the prices up with no real end use case.
You could say that trading and speculating in traditional financial system is similarly abstract and detached from real productive things, but that would not be accurate. Concepts like hedging and derivatives were invented precisely out of the necessity of real economic actors, such as farmers selling their future harvest upfront, or companies fixing their loan rate to be able to manage their expense and continue producing. And yes, after five decades of financialization in Western economies, these concepts have become much much more levered, layered and speculative (OTC derivatives market size $12.6 trillion, ISDA), but they are still connected to productive value generating economy — cash flows from economic activity.
It’s hard.
The detachment of DeFi and crypto more widely from the real world is caused by very deep practical reasons. There aren’t the right legal boxes. No, you cannot elevate ownership rights of real things to blockchain, make them move seamlessly as dictated by the code of smart contract, create programmatically-ensured counterparty-free economies transacting them without notaries, custodians and many other middlemen. For now, this is only possible with tokens detached from reality.
You could imagine that over time the giant market for derivatives will move to blockchain, that the derivatives contracts will be written into smart contracts making their trading and settlement seamless, and in fact ISDA has already done some work on this, but that is not DeFi, that is just improving infrastructure.
Indeed it is very likely, we may never see the transformation of the old world’s legal and regulatory frameworks that would enable DeFi. Imagine how cumbersome would be inserting real world assets into DeFi using current frameworks, i.e. setting up legal entities to hold the real world assets, transferring ownership via intermediaries according to what happens on-chain, etc. Nightmare.
Teddy Woodward’s tweet explains how terrible this would be for collateralized loans against real world assets.
And if this is true, then we are back to Pfeffer’s argument that programmable blockchains and the dapps built on top of them, incl. DeFi can at best be the new plumbing for digital businesses like a decentralized Twitter or Uber. Profits will go to near zero as decided and owned by users and tokens will be valuable only to the extent that they will represent a social status symbol in those networks.
The logical conclusion would be that: 1. the NFTs are indeed a big thing and 2. the valuations of the programmable blockchains and dapps should be much much lower because, no, they will not be the next Amazon Web Services, since the decentralized digital businesses built on top of them will be a utility owned by users.
And that is perhaps not such a bad conclusion.