Crypto Coins have taken a recent tumble in the markets as traded against Fiat currencies, and it has caused a lot of noise about the future and value of the technology. So, let’s talk about the actual value of Block Chain and, more importantly, where this all must go from here.
The Wild Ride – How Do I Get On?
In the past, I have written about how to make and not make money mining cryptocurrencies, and to be honest, it was fun, and I made some money while at the Crypto Casino. Having participated in early crypto mining operations, I certainly value being early on the curve and experimenting with where things are going. But these early ventures didn’t reflect the whole story as the landscape continues to develop, so have new stories about what Crypto is and will become.
HODL Bros – How Do I Stay On?
During the infancy of crypto-economics, you would often hear a term “HODL.” Some said it was a misspelling of HOLD, but most thought of it more colloquially as “Hold On for Dear Life.” It became a mantra because holders of crypto-currency were subjected to massive swings in value, usually on the upswing as the market was irrationally growing as new people invested and the technology began to seed the zeitgeist of new get-rich-quick investors. Now that big whales have caught on to the phenomenon the crypto-market seems to be mirroring the financial markets, making this more akin to the vulgarities of market sentiment rather than the underlying value. In light of this, and some would say because of this, we see financial pundits talking about Crypto being a bad investment or even a Ponzi scheme.
What is significant about this? Markets crave instability but rely on fundamental stability. That dichotomy allows individuals to profit from predicting and even manufacturing those differences. The lesson here is that while pundits decry the short-term gains and losses of the market, they are, in essence, playing the short game. The market will make winners and losers until sufficient market pressure creates a stable solution. This is the long-term play.
Take from this one fundamental idea. The short term fluctuations of Crypto Currency is not the story. The long play is in creating and benefiting from the technology.
Digital Currency is the natural evolution of Paper Currency. Crypto Currency, by extension, is responsive to that evolution by recognizing not that we need a new currency but that how Digital Currency flows has too much friction and seeks a more efficient path. After all, Bitcoin shouldn’t be about the value against fiat currency but about the ways in which it allows for more fluid use of that value.
You may remember that when credit cards first came to broader use, a commercial demonstrated this value. It was a line of people getting their lunch, all looking rushed and possibly somewhat irritated. At the front of the line, our awkward protagonist was trying to buy their lunch with paper money. Imagine you’re in line, and someone starts digging through a change purse to find the exact money they need. This friction is the straightforward use case for Digital Money. Today, we expect simple transactions to be done digitally out of convenience – an inherent reduction in friction.
The modern evolution of this story is in consumer-to-consumer transactions where people want to give money to each other. The popularity of Venmo and a handful of other companies promise to make personal and commercial transactions the best way to create friction-less transactions – minus their 3% fee, much like credit cards.
So, where did BitCoin come into this picture? The promise was, in my view, flawed at first.
There was the idea that you could go to the coffee shop and buy your morning coffee with BitCoin. This presumption was based on two ideas. First was that BitCoin held a stable value, and second that it represented less friction than other types of transactions.
This demonstrably doesn’t seem right on both counts.
Many in the crypto community celebrate this fact every May 22, affectionately known as Pizza day. All the best stories start with “a Florida Man,” as does this one. On May 22, 2010, a Florida Man offered 10,000 BitCoins to anyone in his Crypto community that would buy him two pizzas. Of course, we now know that those two pizza costs him millions of dollars had he held on to his BitCoin holdings.
I bring up this story not out of FOMO (Fear of Missing Out) but because it illustrates BitCoin’s journey. Not only has the value of the Currency wildly changed over time, but the ability to conduct simple transactions still represents significant hurdles. I spoke about this in a presentation I did on the future of BitCoin, where I discussed the velocity of BitCoin and, more specifically, how it is orders of magnitude slower and capacity constrained than all other forms of transactions.
While we can overcome these technical issues, the question is, is the juice worth the squeeze.
To expand on this idea, what is the platform worth building on which transactions can take place that is an inherent improvement in velocity, cost, or some other metric that will speak to a core value? While stakeholders and visionaries alike may argue, you could also add privacy and security to this list.
DeFi – What Ride Am I On?
If we start with the premise that financial transactions come in the form of an agreement, we might be able to shake loose some of the issues.
In its simplest form, I agree to give you something, and you give me something in exchange. How we both value the transaction is the most basic form of capitalism. Again to the market analogy, we both crave inequities on the micro side and require stability on the macro side.
The core values are velocity, cost, privacy, and security at this level.
This is the inherent value in Crypto Currencies. It isn’t in the value against fiat but in the ability to model and conduct transactions. This is especially true if the transaction requires complexity because these agreements can be codified into the transaction itself.
The promise of Decentralized Finance (DeFi) is in the ability to create discrete financial functions which can be combined into larger transactions. Like computer code, contracts are often collections of reusable ideas and agreements that in combination, represent the unique conditions they are meant to transact.
Buying a house becomes a transaction with a bank with hundreds of minor stipulations and agreements. These mortgages are bundled and resold with specific risk characteristics. The more extensive portfolio is broken into risk tranches and sold to investors.
At the macro level, there is no visibility into how the underlying instrument is performing, but it is considered normative if it stays within limits. These assumptions are inherent and necessary without the ability to have more detailed transparency and analysis. As such, the risk is priced in and a function of the transactional cost or friction that the portfolio must produce to be of good value to an investor.
As a capitalist, the value here is in driving down cost by raising efficiency and being able to create new vehicles that represent improved value or reduced risk. DeFi offers this vision.
By codifying all aspects of the complete transaction chain, DeFi can provide visibility into the performance of every part of a portfolio. In the same way, it can rebalance based on perceived or projected value using underlying analysis.
There be dragons over there.
This complexity, and I would say exuberance, to create these contracts that we can demonstrably be seen as bringing instability to the market.
In the mortgage resale market, creating tranches of risk to package investments meant that investors could buy a portfolio where they may have felt that the approach allowed them to price in the risk.
However, we learned that the underlying financial instruments were inherently misunderstood or misrepresented in a way that obscured the true risk and therefore the true value. Once these instruments were no longer in their predicted range of performance, there were tremendous losses.
In the same way, there is an exuberance to create DeFi contracts. We have seen examples where a lack of financial or technical controls results in these losing or leaking value. A simple change in code that is ill-advised or malicious can cause cascading disruptions.
Companies like OpenZepplin approach this issue by creating a framework in order to audit and understand the complexity of Ethereum Contracts, but the issue goes further.
Visionaries innovate by creating new ideas. Organizations innovate and profit by taking existing ideas and combining them in ways that haven’t been done. This concept is critical in terms of the earlier example of markets craving instability. By combining common tools in uncommon ways, organizations extract new value. What is not always known is the risk associated with that combination. Key to this is the level of exposure the organization undergoes in the face of that risk.
Poking The Bear – The Best Opportunities are in a Down Market
Smart money is always working, and the best opportunities for this come when there is an execution gap. These gaps allow for market instability to turn into market gains.
We already see momentum in DeFi and can project a drop in M2 which indicates additional pressure on the market to maintain returns. If the market accelerates how it prices efficiency to return value, DeFi will be highlighted as a methodology to do so because it inherently reduces friction and improves efficiency.
Companies seeking solutions will invest without understanding risk.
Therefore smart money will understand the risk associated with DeFi and how to extract value from this instability.
With the instability of a technology startup, Block Chain has gained both a place in the Financial Industry and in the aspirations of investors for its speculative ride. As smart money seeks to understand this instability, it must move toward those aspects of the technology which represent undervalued opportunity. In doing so, it must also understand risk and how to avoid unnecessary pitfalls.
The future of DeFi offers many opportunities for those willing to make the investment in both understanding the technology and in mitigating its weaknesses.
About the Author
Bill Weber is the founder of Crypto Foundry, a Cyber Security and DeFi consultancy located in the Washington DC market. With over 30 years in Cyber Security, Crypto Economics, and Information Technology, Bill has worked with organizations like MIT’s Lincoln Laboratory, New York University, Hewlett-Packard, and Microsoft.