Why this time is different — Crypto Usecases being built as the liquidity bubble pops
If you have been following me for a while, you might remember my most popular article from November 2017 when I said that the bubble of 2016/17 was an almost exact replay of the .com bubble. I said it was likely to be followed by an almost V-shaped recovery of high quality protocols and new, superior crypto applications (the Googles and Facebooks of crypto) were likely to emerge. I think it is fair to say this has happened and yet, we seem to be at a similar juncture again. As I laid out in a Twitter thread, bitcoin has entered a neutral market stance, after the bull market became exhausted.
The Everything Bubble
What happened to bitcoin was driven by the same force as all financial assets — the Fed. When the US Fed announced that it would support markets with the purchase of $120bn+ in assets each month, absolutely everything rallied. Whether it was old cars, real estate, rare watches, art, stocks or crypto — asset price inflation caught everything. At the same time, the real economy went through the worst short term contraction since the Great Depression, due to the measures governments implemented to battle Coronavirus. This separation of asset prices and reality has been dubbed “The Everything Bubble”.
Bitcoin was uniquely placed to benefit from the onslaught of liquidity, because it is easier to trade than Gold, has absolutely no fundamental value and can be hyped beyond belief. It functioned as the perfect “liquidity vacuum”. With it, all of crypto followed suit. It is fair to say that when dog meme coins without use or technological innovation are valued higher than businesses with multi-billion dollar cash flows and imitations of the same coin start becoming the most successful asset class, a bubble has reached epic proportions.
This bubble is now at a crossroads. Over the last 6–8 weeks it has become obvious that the US economy is on track to emerge from the Covid trough, while inflation has picked up across the board. The Fed and other pundits are making good points as to why that inflation may be transitory, but any way you slice it: the era of abundant and free liquidity is likely drawing to a close. Over the next few months, not only will Fed asset purchases no longer make up for treasury debt issuance (thereby no longer injecting liquidity on a net basis), but it also seems likely that asset purchases will be reduced and interest rates may even rise. 10 year yields have already risen more than 50% on a relative basis since their trough.
It is therefore sensible to assume that an asset with only one use in the “free” world, like bitcoin, is no longer going to be rising in perpetuity. As I laid out in my Twitter thread linked above, it is likely that bitcoin’s future path is much more difficult from here.
This Time is Different
It seems sensible then to assume that all of crypto is doomed and the house of cards will deflate as quickly as it inflated. While that is undoubtedly a possibility for the sheer $ value of these assets, just like I said in 2017 that the entire ICO space would collapse and no value would remain in these useless assets without any rights, I want to explain why I think ‘this time is different’.
The 2020/21 crypto boom was certainly driven by Fed liquidity and as I said above, bitcoin itself will have a hard time when the storm of reduced liquidity unleashes. However, just like after the tech bubble burst, the new technology has delivered a number of innovations and applications that will not go away and that will become a central part of our lives in my opinion. So outside of bitcoin, there is actual value in the space. I want to touch on a few of these:
DeFi — Decentralized Finance
While the finance world was busy with chasing tech stocks, crypto has built an entire separate financial system that is both decentralized, highly innovative and autonomous. It’s most important innovations are:
- “Be your own Bank”
With the advent of stablecoins that actually provide monthly attestations by a Top 5 auditor (such as USDC), it is now no longer necessary to expose yourself to the fluctuations of crypto prices in order to manage your own finances and keep your money secure. I have frequently explained why I think the largest stablecoin (Tether) is a scam and a dangerous place to hold money, but while I recognize the risks, I think that stablecoins such as USDC and Paxos do not carry the same amount of risk. When you have a company backed by the largest regulated crypto exchange (Coinbase) and the world’s most famous bank (Goldman Sachs) offering a stablecoin, you are much less likely to actually be scammed outright.
So while bank accounts frequently charge negative interest, often (though not always!) come with slow money transfers and generally impose restrictions on the use of your own assets, you can now hold your dollars in an ethereum wallet (or a Solana one for that matter) and you can even put it in a multisig (gnosis-safe.io) so it is more secure. Alongside you can download an app like crypto.com and order one of their debit cards. You are now able to store your money as a US Dollar equivalent on the blockchain and use a normal debit card to pay your expenses. Yes, the risks with this set up are still much, much higher than with normal banking, but the fact this is now possible is truly spectacular in my view. Once a federally issued digital currency comes around, this journey will be complete.
- Decentralized, trustless loans
With the possibility to “be your own bank”, comes the possibility to borrow and lend money on a decentralized marketplace. There are two main innovations here, namely the advent of trustless loans, as well as 30 second interest compounding. Both are remarkable.
In the crypto world, you cannot perform a creditworthiness check on your counterparty, so another mechanism had to take the place of it in order to ensure the lender does not face undue risk of losing their funds. This is solved by overcollateralization (similar to Lombard loans, but more aggressive), where the borrower will lock up 150% (typically) of the asset he wants to borrow and the lender contributes another 100%. Both sides’ assets are locked in a smart contract and the borrower can then use the entire sum (250%) to invest, thereby levering up substantially. If, at any time, the value of these assets falls below 120% of the lender’s principal, the investments are liquidated and the lender is paid back automatically. Therefore, the problem of creditworthiness is solved in a trustless manner.
The second innovation is more disruptive to traditional finance in my view. In a traditional setting, a lender receives interest on his investment every month or every quarter. On the blockchain it happens every block. This may not seem like much of an innovation, but it means that lenders are able to compound their interest every 30 seconds. This can add 20–30% to the interest rate received on a loan and represents a competitive advantage of decentralized finance that traditional banks will have a hard time competing with.
- Yield Farming
I have written about this topic in more detail here, but the simple story is that the described 30 second compounding needs an input from the user. In order to take advantage of it, every 30 seconds you would need to click and re-invest your interest received. As this isn’t possible, yield aggregators do this automatically. The lender pays their funds into another smart contract that will then select the best lending pool and compound the assets at an optimal time interval in exchange for a fee. This can further increase the yield, while the base rate the borrower pays remains unchanged. This is in the case of single asset staking.
Multi-asset yield farming takes this a step further. It involves putting up liquidity in two separate assets (like ETH and USDC) in proportion of the current market price of these assets and then letting other people trade “against” that liquidity. Ie, if the demand for ETH increases relative to USDC, traders will take some of your ETH in exchange for giving you more USDC. This is a highly risky use of your assets due to impermanent loss (the fact the value of the liquidity you put up goes down with every price change of the assets, positive or negative) and also the risk of putting up liquidity in a low quality asset which means you might be faced with a wipe out of your principal if things go south. As the risk is high, rewards are often outlandish. There are yield farming opportunities that offer >1M% APYs if the value of the assets you are rewarded with remains stable for a year (which it obviously won’t). These kind of returns make the risk of a wipeout attractive to some people and this process enables the next innovation.
- Decentralized Exchanges and Start-Up Financing
Decentralized exchanges are smart contracts that enable swapping any two assets using the liquidity pooling described above. It means that you can not only trade any asset decentrally at any time (which already includes some stocks), but it also enables start-ups to receive financing from 1000s of crypto users by putting up a small amount of liquidity for their token and then explaining their value proposition to potential investors. This kind of disintermediation (in this case, venture capital) is a key feature of crypto (and will be discussed further below).
- Decentralized Insurance
With the advent of yield aggregators and other smart contracts that hold a lot of value, insurance platforms have emerged. These are another set of smart contracts which enable you to insure your paid-in capital at other smart contracts for a relatively low fee. In the case of a smart contract hack (which is arguably the biggest risk of the loans and yield farming opportunities described above), you can reclaim your capital from the insurance.
- Decentralized Equity
Finally, the decentralized financial system would not be complete without the emergence equity token. Different from their 2017 ICO counterparts, many of today’s “governance token” come with unalienable rights (often documented in a smart contract) similar to equity rights. They come with the ability to vote on platform governance and use of funds and they receive a share or all of the platform income (such as trading fees). With this piece of the puzzle coming together, the financial system built on the blockchain is complete. And yes — they are all securities.
There is little doubt in my mind that the above innovations will outlast any bubble in crypto assets and change the way finance works.
Disintermediation of Industries
The main real world usecase crypto may be able to fulfill is disintermediating industries that are structured in an inefficient manner. The first example above is banking, where the middleman (the bank) becomes less and less relevant.
Another example is the art industry or that of rare collectibles. While the NFT craze may just be another aspect of the bubble (definitely), the use of NFTs goes far beyond that of interchangeable JPGs on the net being exchanged. Real world assets can be tied to non-fungible token and there are numerous start ups trying to enable this. I do not want this article to be a “shill fest”, so I am refraining from mentioning any token or companies here, but I have invested in or seen the work of firms making the transition of real world assets to the blockchain possible. The most advanced examples are real estate and art, while there are even promising approaches to make intellectual property tradeable on the blockchain.
This force should not be underestimated. At some point in the future, retail clients will not necessarily need a bank, brokers & banks will not need clearing houses, investment managers will not need a fund managing company, collectors will not need art dealers, artists will be participating in every subsequent sale of their art, provenance of art, food or even just money will be 100% clear and real estate agents will have a hard time defending their fee level. While I may lack imagination to come up with even more intermediated industries, trust me that founders of crypto businesses do not.
Proof of Anything
The more blockchain technology matures, the more services and vital applications of Democracy will become trustless. Two main items come to mind.
Firstly, in a world of fake news, deep fake videos and populist politics, it will become more important than ever to determine the outcome of events in a verifiable manner. This role is taken by so-called oracles in crypto. While their main application today is that of providing a price input to a smart contract, they will continue to grow and may become vital to telling the outcome of elections, something as trivial as soccer matches on a different continent or any other event that a real life contract is based on. As more and more media become politically-driven and tell a story that is inline with the owners’ beliefs, this is a highly underestimated application of crypto.
Next, it is absolutely clear to me that our identity will move on-chain. It makes no sense to have a passport with 50 different security features that needs to be held into a camera to take part in online services or even elections. Identity fraud is a major issue of today’s world and it can be ended by implementing a blockchain version of it. Numerous start ups are working with governments to make this a reality and I cannot wait for the day when I can finally ditch my passport and mobile phone contract “secret word” to access my accounts or to take part in basic Democratic governance.
Just like the above points, this application is extendable by people with more imagination. I am just scratching the surface.
The future is Crypto
So. While it is entirely possible that the valuation of all crypto assets takes a further hit from the withdrawal of central bank liquidity, the advances made in the space will not go away anymore. Similar to what happened after the tech bubble burst, an entire new world of real life applications has been built in its aftermath and it is here to stay. The current burst of the 2021 liquidity bubble looks more like the Financial Crisis of 2008 than another .com boom and bust. In both cases (ie in the real life crisis and in the crypto equivalent now) a liquidity “rug pull” caused havoc on asset prices, but the underlying fundamentals of business remained sound.
In the future, it looks likely that investors and, in fact, users will forego an investment in bitcoin in order to use some of the applications I describe above. It used to be the case that you could only participate in crypto by buying bitcoin and then flipping it for other assets. This step is no longer required today as most crypto assets are widely available in US Dollar on centralized, but also decentralized exchanges. Therefore, it is very possible that crypto’s “digital gold” (bitcoin) meets the same fate as its real world equivalent: once liquidity is reduced, non-yielding assets lose their favor. Of course, bitcoin could also innovate and build a whole DeFi infrastructure on top of the lightning network, but that is not currently the case (yes I am aware of the one project that is trying).
The applications above require highly scalable, but still decentralized layer one solutions. There are a handful of worthy chains that can offer this (with one standing above all in terms of current use and another in terms of potential) and I find it a logical conclusion that these will overtake bitcoin in value at some point (though this can happen by bitcoin falling more rapidly). Perhaps, we will see crypto assets starkly divert from the usual correlation of 1 across the board as the space matures. It would be a welcome development. Let me also be really explicit: this article is not to suggest prices have bottomed. I am merely saying this time around there is substance in crypto.
Lastly, the all important disclaimer: this is my personal opinion, not my professional advice. Most of all this is not investment advice in any way. Crypto assets can fluctuate widely in value and all of your capital can be lost. I have a 50/50 chance of being right. Any negative views expressed, if any, are solely aimed at the token in question, never at the development teams behind them for which I have utmost respect (if they are sincere).