Crypto can protect us from our ourselves

“Power tends to corrupt, absolute power corrupts absolutely”

This phrase was coined by the British Historian, Lord Acton, in 1887. Today, it sometimes feels like we are making this observation more and more frequently.

What does this have to do with Crypto?

Because Crypto is in its core about “Decentralization”?—?means away from a single central person or institution, where such power structures tend to grow. Decentralization is simple and at the same time it is a complex and nuanced concept.

Public and decentralized blockchains, or applications build upon them, enable us for the first time in human history to coordinate people towards a common goal in a way where the rules are defined by neutral immutable code. Since everybody can join and no one can be excluded one might expect chaos, but many of this organizations (aka networks or protocols) work already astonishingly well. They work because of a brilliant mix of Game Theory, incentives and disincentives, orchestrated by Tokens (Crypto Assets).

But at the same time Decentralization feels still distant and abstract and hard to grasp why we would need it. So let’s therefore have a look on two concrete examples. I told these two stories the last year many times to investors in order to explain the difference between the status quo and crypto. Both happened in Q1 2022. They are eye opening.

1. The 2022 Nickel Short Squeeze?Scandal that is little known

“Rules matter until they don't”

• Xiang Guangda (Chinese billionaire and owner of the worldwide largest Nickel production capacities) dramatically increased his own Nickel production in early 2022, which made him to believe that Nickel prices will fall. He entered a huge bet on falling prices (short selling), leveraged by JP Morgan which gave him the money to make it a gigantic bet on falling Nickel prices.
• He was sure to win. What he did not consider was the invasion of Russia in Ukraine in Feb 2022. Russia has with Nornickel (formerly known as Norilsk Nickel) the largest Nickel production in the world and was suddenly cut-off from global markets.
• As a result, Nickel prices skyrocketed (60% in one day) and Xiang Guangda together with JP Morgan faced margin calls (liquidations) of 3bn USD which they could not raise in short time (twice the amount of Xian Guanda's company's annual earnings).
• Then the London Metal Exchange (LME) did something unprecedented by using its central power to safe Xiang Guangda. How? they canceled a whole day of trading. CANCELED not stopped! A power misuse which made some large market participants state that this is the beginning of the end of modern markets. Whom to trust if not the LME, a 140 year old commodity exchange?
• All was justified as “prevention of a market collapse” Too big to fail! sounds familiar?

There are many of such examples. Every bank, but also corporate bailout, at the end incentivises higher risk taking. As long as you know that you are different (”too important”) you might be tempted to take higher risk. Thats what we increasingly see since 2008.

Source: all details about the Nickel scandal were summarised in this blog post.

2. The Maker DAO`s nearly 600m USD Liquidation (Decentralized)

“Code is law" ?—?for everybody

In a simplified explanation Maker DAO is a decentralised lending platform. Users can supply crypto assets (ie. Ether) as collateral and take out a loan in USD. The collateral has to be always substantially higher than the loan (roughly 150% overcollateralization). Everything is managed by smart contracts (=code) without any humans beeing involved. When however the value of the collateral falls and approaches the value of the loan the smart contract automatically liquidates the position (means you loose your collateral but can keep the much lower loan).

In January 2022 (two month before the above Nickel scandal) the crypto markets had again one of their volatile days, means prices crashed. This was problematic because there was one large, very large loan on the Maker DAO protocol at risk to be liquidated. It was a 600m!! USD loan. It’s liquidation would have led to an even more severe market collapse.

The founder of the Maker DAO protocol tweeted the following:

“Maker is about to market dump $600 million worth of ETH unless someone can phone up this 7 Siblings guy and tell him to top up his vaults in the next 30 mins. I’m confident the Dutch Auctions will hold up but not sure how the market will react”

If that liquidation would have created so much damage why they, as founders of Maker DAO, just not made an exception? Because they can’t: no one could have stopped that liquidation. The code is neutral and does what it was meant to do. It liquidates the 600.000.000 USD loan of a Wall Street Billionaire in a same way it liquidates 100 USD loan taken by a student. Neither connections nor bribes can help.

The only thing the founder of Maker DAO was able to do was to search for the owner of the loan (7 Siblings was his pseudonymous name/address) on Twitter. At the end 7 Siblings woke up on time and prevented the liquidation but not by calling his friends to intervene but to play by the book.

Take away

In order to prevent such severe power abuses like in the case of the LME, we created rules, a lot of rules. Every scandal brings more rules. Yet it seems the rules cannot prevent this from happen. It rather seems even the opposite happens. The economy and average people are burdened by more and more bureaucracy while big financial scandals continue to happen. Thats not efficient.

Public Blockchains, powered by Crypto Assets (Tokens) have the potential to be a neutral base layer that everybody can trust.

But we also need to be realistic. Not everything in Crypto or DeFi is working today. These are still young and quite complex systems which need time to evolve. Yet the speed of innovation in this open source principled industry is mind-boggling and the learning curve is so steep which makes me believe that the big potential of a more decentralised economy is real.

But decentralization is not black nor white, as one sometimes get the impression when following the emotionally very biased discussions on it. While i personally believe decentralization will create totally new business models which we currently cannot even imagine, i also also believe that it can enrich our current centralised systems and make them more robust and resilient against abuse.

At the end, it is also about having options. Having an alternative will increase competition and therefore increase the quality of all market participants, whether they are decentralized or centralized.