Crypto Will Thrive as it has Real-World Use Cases

Part 1: DeFi

There is no way to sugar-coat the fact that November was a terrible month for cryptocurrencies. The rapid collapse of billionaire-turned-scourge Sam Bankman-Fried’s crypto empire will likely be remembered for posterity as one of the blockchain industry’s worst-ever episodes, and nowhere was that more evident than in the negative performance of digital asset markets.

Whilst it was a tough month for digital assets, those of us with long memories will have seen similar collapses involving once-revered market participants in traditional financial markets before. The details may be different each time but, sooner or later, fundamentals reassert themselves and the sector recovers from the actions of these bad actors.

Nevertheless, this shocking crypto black swan event — very possibly involving fraud and lack of controls — has led to a renewed barrage of negative news regarding the demise of the whole industry.

“Crypto narratives sell tokens and make venture capitalists rich, but real-world utility is absent” is largely the crux of the argument.

Just a Ponzi Scheme?

You have probably already noticed that the crypto economy is regularly accused of being just a Ponzi scheme. The narrative goes that the sector’s growth has only come from inexperienced speculators hoping to find buyers even more irrational than themselves to sell to at a profit ….. until the bubble bursts, with the last buyers, the “greater fools,” being left with now useless and unsellable assets.

As recently as June 2022, Bill Gates opined that “Crypto and NFTs are 100 percent based on greater fool theory.” It’s important to remember that this comes from someone who in 1995 thought that the Internet would only be a passing fad. …well, it’s simply not possible that every smart person is right every time!

The truth is, the type of scam denounced by Bill Gates and others can be and has been set up in virtually every sector, from the traditional and highly regulated world of finance (as in the famous Madoff affair), to pyramid selling of diet products whose sellers are paid by the number of people they recruit.

Let’s for the sake of argument accept that a significant part of the returns in crypto relies on the growth in the number of users. Surely, that is exactly like any other new product or service coming to the market? Moreover, if the demand for crypto finance products is partly based on the hope of enrichment, then again that is exactly the same for mainstream financial products. Other similarities to existing financial products include the constant innovations aimed at creating new demand. The reality is that for any company or network to grow and therefore generate a return on investment, it largely hinges on an increase in demand by the end user. The key differentiator in terms of sustainable growth is whether there is a real problem the new product or service solves.

We probably all know by now why people in the blockchain sector are excited about its future: Blockchain technology allows for faster and cheaper transactions, and the existence of currencies that are not dependent on national policies and banking institutions, the prevention of inflationary risks, and better access to credit, especially in developing countries.

I suppose the crux of the argument comes down to whether there in fact are not just a few use cases but some very significant and wide-ranging real-world uses for blockchain technology, in which case it’s almost certainly not just a Ponzi scheme and it is rational to imagine the sector’s explosive growth and network effects continuing in the years ahead.

As regular readers know, I believe this technology has the power to transform virtually every industry. So what are the examples of real-world uses of crypto right now? In a series of articles I want to highlight a number of real-world cases where crypto is right now increasingly being used by real people and real companies simply because it’s better and solves a problem. Today I would like to start with decentralised finance (“Defi”).

Defi Solves Problems and Is Far from Dead

When I saw the FTX news in early November, my heart sank…A bank run was underway… Everyone was in full panic… Fear began to spread like wildfire that FTX, the world’s second-largest crypto exchange, was insolvent and there was the real prospect of widespread contagion.

This news came at the worst time. Following a worsening of the macroeconomic backdrop, crypto was already beaten and bruised in a bear market with savage price falls. This past Summer, two top crypto lending institutions, Celsius and Voyager, filed for bankruptcy. Combined, they had over 5 million users. And now it was the much larger FTX doing the same.

The fact is, these bad actors eroded trust in crypto amongst investors and the general public. And the mainstream media suddenly had even more ammunition to paint this industry as just a get-rich-quick Ponzi scheme.

But if you’re a regular reader, you know I don’t believe these recent bankruptcies had anything to do with the blockchain. The technology continued to work as intended. Companies outside of crypto have been going bankrupt for hundreds of years for the same reason as FTX, Celsius, and Voyager: Greed. These platforms were opaque private companies. There was no way of knowing how much leverage they’d been using. Or who they were exposed to… They were black boxes that drew in billions of dollars as a “safe” way to invest in the sector. But what happened at FTX could not have happened on a DeFi platform. This is because DeFi solves problems such as transparency and the human element.

Defi — A Real World Use Case that Helps to Prevent Fraud

Blockchain technology came to light with the invention of bitcoin in 2009. It laid the foundation for a financial system in which anyone can pull back the curtain and see what’s happening under the surface.

Since bitcoin’s inception, we’ve seen many different use cases for blockchain tech. But none are more promising than decentralised financial applications (also known as DeFi Apps). Today, you’ll find ‘dApps’ that enable you to lend, borrow, trade, etc… and the benefit is that anyone can see what’s happening under the surface. DeFi platforms now have over $63bn and transact $1bn a day, a mere blip compared to traditional financial markets but given that this use case has only really been around for less than two years, it’s pretty impressive.

DeFi platforms use “smart contracts” that automatically execute transactions when certain preconditions are met. And anyone can view these contracts online and in real time. Now, I won’t get too deep in the weeds, but here are a couple of examples of how decentralisation could have prevented what happened to Celsius, Voyager, and FTX. First, if you lend assets in DeFi, everyone can see the collateral that backs your loan. What is more, your collateral is ‘locked’ and cannot be used to borrow elsewhere. And loans are over-collateralized on most lending platforms to ensure safety.

As an example, that means for every $1 someone borrows, they might be required to put up $1.50 as collateral. On top of this, if a borrower’s collateral falls below a certain threshold, the DeFi platform will automatically liquidate it, no questions asked. Second, blockchain works strictly on computer code. So, the smart contracts only execute if preconditions are met. DeFi platforms don’t care about your net worth, credit score, or where you live… As long as you provide the collateral to back your loan, you’re good to go.

No favours are given to a select group because the lender has a good relationship with them. This removes any biases that could cause a lender to take on more risk than they should.

And despite the volatility and loan defaults we’ve seen from centralised financial lenders like FTX, no major DeFi protocol we know of has suffered a significant loss yet. The major DeFi lending platforms and exchanges have continued to operate without issues — mainly due to the robustness and innovations built upon blockchain technology.

This superior performance of DeFi protocols has not gone unnoticed by customers: they have started to vote with their dollars in favour of DeFi. According to CryptoQuant, since the demise of FTX, crypto users withdrew $2.5 billion Ethereum (ETH) from centralised crypto exchanges. And data shows it’s virtually all going into DeFi platforms.

Decentralised exchanges (DEXs) executed $32 billion in volume in the week following the FTX collapse — a roughly 150% increase from the week prior. One surprising thing that has become super apparent with the FTX meltdown is that DeFi is not dead. Far from it.

If you notice, all of the bankruptcies this year had one priority when they started to get into financial difficulties: it was to urgently try to pay back their DeFi loans. Because unlike a bank or hedge fund, you cannot negotiate with a smart contract. You either have the money or you don’t and if you don’t, you immediately lose your collateral. What’s more, the DeFi sector is continuing to innovate to better meet customer needs. The rise of perpetual swaps in DeFi is a promising development. Platforms like GMX, Gains, and Apex are all working to shake up how trading happens in crypto and give it the ease that is found in ‘Tradfi’ platforms.

Early-Stage Tech with Promise
Now, I won’t claim that DeFi is perfect. The technology is still new and needs to be battle-tested before it gains widespread trust… Just like it took years for the internet to gain that type of trust.

But the tools needed to create a better financial system are there. I think the growth in usage of these platforms right in the eye of the storm of the FTX collapse shows people are already recognising the benefits.

What is interesting to note after FTX — which may well turn out to be a massive fraud along the lines of the Madoff affair — is that the crypto industry, far from being just a tool for fraud, has instead built tools to help prevent fraud.

Hardly anyone uses these tools yet…..And I get it…Blockchain technology is clunky and slow. And it can be a headache to use… But we saw a similar learning curve for the internet. At first, it was slow and clunky, too. Remember how long it took for websites to load on old dial-up modems? And that’s if you were lucky enough not to get knocked off your modem by an incoming phone call. As time went on, and as the technology improved, the internet became more user-friendly. And today, more than 5 billion people worldwide use the web. I believe we’ll see the same happen with blockchain technology.

Final Thoughts

It’s clear that in the short term, the fall of FTX could very well be the most damaging event in crypto history. However, longer term, our conviction in the usefulness of decentralised and transparent public blockchains is as strong as ever.

The demise of FTX and others such as Celsius and Alameda actually demonstrate in practice that decentralisation and transparency are paramount as antidotes to the gross mismanagement that can be associated with centralised intermediaries, especially fraudulent ones. We are far from the only ones to see it this way: decentralised finance is proving to be a considerable beneficiary of what has happened. Some examples of the boost to Defi platforms this month include Uniswap overtaking Coinbase in ETH trading volume, MakerDAO increasing its user addresses by 33%, Aave experiencing a 70% increase in activity and Curve increasing volumes by 63%.

In a counterintuitive way, the shocking demise of FTX has it seems only hastened the growth of DeFi, the blockchain’s most successful real-world application to date.

The upshot is that DeFi as a real-world use case of blockchain technology is here to stay. Undoubtedly like anything new, it has growing pains and challenges, and this bear market may well see smaller start-ups run out of money and close up shop. But I think we will look back on the recent ‘Black November’ as the single event that in fact turbocharged the growth of DeFi and helped it to achieve mainstream adoption.

PTLIB is CIO of Dragonfly Asset Management.

DISCLAIMER: This content is for EDUCATIONAL AND ENTERTAINMENT PURPOSES ONLY and nothing contained in this blog should be construed as investment advice. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.