The next step in DeFi?

Where are we?

Here we are on the 17th of May 2022,

A number of reasons for which this day is memorable, as we wake to the biggest drop in equities since the pandemic, Bitcoin is below 30,000 for the first time in almost a year, and TerraUSD (UST) has lost its peg and dropped down to 0.1 US$.

Let’s focus on the last one for a minute.
Stable-coins are a necessary bridge into traditional finance when dealing with crypto products and hold a familiar store of cash value for all investors exiting and hedging positions against crypto. For anyone that’s been following me for any time at all, you may be aware that I’ve been a very vocal critic of stable-coins, especially during my time at CACHE. Admittedly our motives for uncovering the scammy nature of our stable(ish)-coin competitors was part of our mandate, but this didn’t stop us from bringing to light the fractional reserve nature of what was meant to be the go-to crypto to “store” fiat on-chain.

Enter the algorithmic stable-coin. Terra isn’t the first to attempt at building a stable-coin entirely backed by other crypto currencies; using a minting and burning mechanism as well as staking incentives to keep the value (more or less) pegged to one US$.

Bennett Tomlin had a great way of putting this: “Algorithmic stable-coins in general are all a well-coordinated game trying to convince a sufficient mass of people, that a thing that has no reason to be valuable is definitely valuable.”

For stable-coins like Terra that are governed by Luna, the concept is quite simple: you can exchange one US$ worth of the underlying Luna for Terra and vice versa. As simple as the idea sounds, the math doesn’t add up unless everyone believes the underlying asset is valuable. To quote one of my favourite classics: “the whole point […] is lost, if you keep it a secret!”

If any of this reminds you of how fiat currency works; you’re dead-on. In most countries, the value of their currency is represented by a basket of goods, also known as the Consumer Price Index (CPI) which fluctuates with inflation. The price of goods not being centrally set in our (mostly) post-communist world, supply and demand take care of true price discovery. Our Central Banks however do set interest rates; higher rates make borrowing expensive and encourage saving, lower rates encourage borrowing and spending.

Here’s where the incentive part comes in.
Mining for bitcoin incentivises processing power allocation and staking Ethereum incentivises holding; these are vital for the infrastructure of the protocols and incentivise productive behaviour. Algorithmic stable-coin stability relies on the belief that the tokens held in their treasury are worth something. Faith is good, but incentives have had a more trustworthy track record…

So:
· Terra’s Anchor Protocol offers up to 20% in savings/staking interest/returns.
· Olympus offers 467% staking returns (down from over 7000%).

The goal here is to build a system over time that is too big to fail and to hit the inflection point at which the governing token holds value out of mere adoption, similar to how Bitcoin and Ethereum’s tendencies to gravitate around a certain price over extended periods of time. These large incentives may seem attractive but are rarely feasible over time.

One of the main issues with inflection points of success in models like this one, is that they don’t tend to account for risk parameters outside of 3 standard deviations on each side of the mean. Once prices, demand, or supply fluctuate outside of 3 standard deviations, the model reaches uncharted territory, and breaks.

Bring in the Assets!

The USP for tokenising assets is quite simple: Bringing liquidity to illiquid markets. Now this isn’t a new Idea; as a matter of fact, ETFs were the first real attempt in 1990 and were considered a massive failure; raising a mere 11 million US$. 30 years later and globally, assets in ETFs and other exchange-traded products (ETPs) total more than 6.5 trillion US$, invested in more than 7,430 products. (Vanguard 2018)

Asset-backed tokens can broadly be categorised into 4 subsections:
· Equity
· Debt
· Utility
· Physical-assets

If these seem familiar, you likely weren’t living under a rock a couple years ago and remember ICOs… back in 2017/2018 Initial Coin Offerings took the nascent world of crypto for a spin. Giving anyone with a half-baked idea, a whitepaper, and a website the opportunity to access millions in investments. Ideas ranged from sustainability focused ventures to inventors and innovative ideas, all the way through to clearcut scams. It didn’t take long for regulators to step in and consider these kinds of tokens securities and dealing in securities requires licensing. Let’s remember how the Supreme court determines whether an investment is a security; the now famous Howey Test’s four criteria:
· The existence of an investment contract
· The formation of a common enterprise
· A promise of profits by the issuer
· The use of a third party to promote the offering

Enter STOs: Security Token Offerings; tokenised digital securities traded on token exchanges. Now this opens a few doors for DeFi and TradFi to find a common playground.

All the TradFi comforts of traditional assets (and new ones) given the modern infrastructure of DeFi products, with the new capabilities and efficiencies of blockchain products. The limits to what can be tokenised are endless. From gold and physical commodities (shoutout to CACHE), to private investments, such as funds, real-estate, and even digital assets (shoutout to InvestaX)

Now STOs may just seem like regulated ICOs, but they come with applications that far outweigh the volatile risk of traditional blockchain products. There are endless efficiency optimisation opportunities for traditional finance, and products with a trail of owners dating back to origination, KYC requirements built into tokens, true price discovery on continuously traded secondary markets, and of course complex structured products built directly on-chain. One of the core problems with structured products on-chain so far, has been the volatile nature of the governing tokens. With asset-backed tokens, 150% collateral for a loan would no longer be needed. What if your token was backed by real estate? Or a brick of gold held in a vault in Switzerland? Or a successful business?

Traditional finance already addresses these needs and builds these products through a simple centralised entity: a bank. Blockchain gives us the opportunity to democratise the access to capital. It gives us the opportunity to build financial products and granting access to any relevant parties, regardless of geographic location, without losing efficiencies to manual processing. A common infrastructure gives us the opportunity to build interconnected markets, allowing for true price discovery for otherwise illiquid markets such as carbon credits, real estate, cars, antiques and private company interests.

As we push forward into decentralised finance, we need to be willing to port existing needs and products on-chain to make room for new products more apt to our modern needs.

Special thanks to Michael Lints and Brian Hankey for sanity checking the draft

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