Part 6: Web3 Cryptocurrency & DeFi
This is the sixth in a series of articles on Web3.
Cryptocurrency
Cryptocurrency is perhaps the most controversial part of Web3, an ink blot test for anyone who looks at it. Web3 advocates see cryptocurrency as the foundation of Web3, a decentralized means of storing and transferring economic value that can’t be influenced by those running governmental or financial institutions. To them, cryptocurrency is the essential element that returns financial control and economic opportunity to ordinary individuals.
For many investors, cryptocurrency is a path to financial security denied them by an economic system they see as rigged for elites. This interview from a Wall Street Journal article of two such investors is typical: “Sage Giddens and Billy Curtis, both 22, ... say they buy crypto because other opportunities for building wealth feel fruitless or out of reach. … Real estate requires too much upfront capital, they say, and their jobs don’t pay enough to accrue meaningful wealth. Mr. Curtis said that getting a college degree could improve his job prospects, but he considers higher education to be a “scam” because he figures he would be losing a significant chunk of his income to paying off student debt.” The Investors Who Still Think Crypto Can Make Them Rich - WSJ
Others, the legendary investor Warren Buffett among them, consider cryptocurrency a vehicle for speculation and illegal activities with no intrinsic value. “Assets, to have value, have to deliver something to somebody,” Buffet said, “Whether [Bitcoin] goes up or down in the next year, or five or 10 years, I don’t know. But the one thing I’m pretty sure of is that it doesn’t produce anything,” Buffett said. Warren Buffett gives his most expansive explanation for why he doesn't believe in bitcoin (cnbc.com) Others point out that cryptocurrency is hardly decentralized with ‘approximately 0.01% of bitcoin holders control 27% of the 19 million Bitcoin in circulation.’ Compare this to the US economy where the top 1% control a third of all wealth. Bitcoin’s ‘One Percent’ Controls Lion’s Share of the Cryptocurrency’s Wealth - WSJ
Others still take a pragmatic view. Cryptocurrency has value because people believe it has value. They don’t see a difference between believing in cryptocurrency and believing that piece of paper with Benjamin Franklin’s picture on it is worth $100.
What is Cryptocurrency?
Cryptocurrency is a ledger entry on a blockchain listing ownership of a cryptocurrency and which only changes by a consensus vote of the community that governs that cryptocurrency. The decentralized nature of cryptocurrency prevents governments from debasing it by creating an oversupply. Central banks can no longer regulate financial markets and money supply for economic stability, but they also can no longer enable political goals such as economic sanctions. All transactions are anonymized making it difficult for a government or financial institution to track your economic activity.
As of this writing, there are over 19,000 cryptocurrencies, each with a different purpose and character. This article will focus on Bitcoin since it represents over 40% of all cryptocurrencies by value.?
Is Bitcoin a Currency?
Cryptocurrency enthusiasts call for Bitcoin to be national legal tender. Two countries, El Salvador and the Central African Republic, have done so. However, while there are many stores of economic value, including real estate, gold and nearly any barter good, what differentiates these stores of value from practical currencies are some essential elements.
By these measures, Bitcoin is not a currency.
Privacy
Bitcoin transactions are public but anonymized. Anyone can audit the blockchain but the only identifier they will see on a transaction is the users wallet address. With no directory of wallet addresses, theoretically every transaction is private.
Practically, however, transactions can be correlated. The police do this with anonymized cell phone IDs. By knowing where a person was at certain times of day, they link the phone ID to an individual and then track their movements. Likewise, if you find a one or more Bitcoin transactions that you know originated from a person or entity’s wallet address, you can find every transaction using that wallet address.
Dan Olson in his Line Goes Up podcast The Problem with NFT’s at timestamp 1:27:00 describes the process of tracking cryptocurrency transactions:
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“This makes it pretty easy to see that Laina Morris, Overly Attached Girlfriend, paid $153 on March 31st to mint the Overly Attached Girlfriend NFT, followed by a $205 reserve on April 2nd to list the NFT on Foundation. Ethereum whale Farzin Fardin Fard then bought the token on April 3rd for 200 Ethereum, 30 of which went to Foundation, with Laina getting the remaining 170, which she transferred into USD using the exchange service Kraken in a block of 105 on April 4th and a block of 65 on April 22nd for a combined total payout of $374,726.”
Ease of use
With protocols alone, it's very difficult to use Bitcoin. You have to: (a) create a private cryptographic key using the SHA256 hashing algorithm, (b) create a public cryptographic key from the private key, (c) create a wallet address from the public key using a hashing function, (d) create a transaction minimally consisting of a data structure containing the wallet address, the amount of bitcoins to be transacted, destination wallet address, (e) send the data structure to a Bitcoin node via a remote procedure call, and (f) query a Bitcoin node for confirmation that a transaction is complete.
If you followed all that, you might ask how anyone except someone technically sophisticated uses Bitcoin. The answer is they don't. A normal person uses a Decentralized Finance application. As the difficulty of using Web 1.0 protocols led to Web 2.0, difficult to use cryptocurrency protocols led to rise of Decentralized Finance.
Decentralized Finance (DeFi)
The initial value proposition of Decentralized Finance was to make cryptocurrency transactions simple. However, once DeFi developers created the Web3 equivalent of sending money by Western Union, they realized that they could offer a range of financial services. The list of DeFi services below would be recognizable to any Wall Street financier. What Is DeFi? Understanding Decentralized Finance – Forbes Advisor
Core Mission of Financial institutions
Financial institutions exist to allocate assets and money to their most productive uses. However, committing money to others involves risk and risk management is at the core of what financial institutions are all about. There are a wide variety of risks in finance. Market Risk involves changes in interest rates, inflation or geopolitical events that can cause the value of investments to decline. Credit Risk is where a borrower defaults on a loan or bond. Liquidity Risk arises when an asset may not be sellable at a desired price or time. Operational Risk involves loss resulting from inadequate or failed internal processes, people, and systems, or from external events. Regulatory Risk result from violations of laws or regulations. The list goes on. The 2023 collapse of Silicon Valley Bank, for example, involved the mismanagement of market risk involving its asset portfolio.
While governments today regulate the risk that traditional financial institutions are allowed to carry, there was a time when institutions or governments didn’t either regulate or manage risk. The banking systems in the US in the mid-1800’s during what was called the Free Banking Era had no central bank or federal banking regulation. “[This] 80-year period [was] characterized by considerable financial instability. [S]tates allowed virtual free entry into banking with minimal regulation. Throughout the period, banks failed frequently, and several banking panics occurred. The payments system was notoriously inefficient, with thousands of dissimilar-looking state bank notes and counterfeits in circulation.” A Brief History of Central Banks (clevelandfed.org)
The description above could describe Web3 DeFi. There are 19,000 cryptocurrencies in circulation and counting. The payment system is inefficient. Anyone can enter the DeFi world with no regulatory oversight.
Cynics would say that modern DeFi has taken the lessons of the Free Banking Era, not to learn from those mistakes but as a roadmap on how to operate. The collapse of DeFi in 2022 was caused by all the same behavior that led to the Great Depression:
The web commentator Dan Olson stated the problem succinctly if hyperbolically: “Cryptocurrency does nothing to address 99% of the problems with the banking industry, because those problems are patterns of human behavior. ... The problem is what people are doing, not that the building they’re doing it in has the word “bank” [on it].” ?Line Goes Up – The Problem With NFTs - YouTube
Central Reality of Decentralized Finance
DeFi in practice is unregulated, risky and prone to taking down large amounts of customer and investor value. It’s also highly centralized, consisting overwhelmingly of corporations and funded by big money investors.
The collapse in 2022 of DeFi companies has led to a debate in crypto blogs, Discord channels, and Reddit pages about the need for DeFi regulation. Regulation and the rise of the federal banking system stabilized the US financial markets in the 20th century and some in the Web3 world hope that it will do the same for DeFi markets. Federal and state regulations limit the risk financial institutions can take with customer assets. There are firewalls between the banking and brokerage operations. Banks have minimum capitalization and auditing requirements in exchange for the US government being a lender and insurer of last resort.
Regulation of DeFi has many unanswered questions. What is the core customer value of DeFi and how is it better delivered than today's regulated institutions? If DeFi is regulated, what makes it different from existing regulated financial institutions? Isn't a centrally regulated decentralized financial institution an oxymoron?
The opinions expressed in this article are solely my own and do not represent the views or opinions of others, including my employer.