Decentralized Finance (DeFi)

The Future of Crypto-Powered Finance and How We Get There

Self-custody (non-custodial) crypto wallets will become the foundation of how individuals build wealth in crypto-powered finance.

Lately, I have received an increased number of requests asking me to explain Decentralized Finance (DeFi), how it differs from traditional crypto exchanges like Coinbase and Binance, and why someone needs a crypto wallet. This elevated interest in crypto-powered finance inspired me to write this long post to answer the following questions:

1. How are crypto assets different from other financial assets?
2. Why do you need a crypto wallet in the first place?
3. What the heck are the private keys and seed phrases?
4. Why would someone store crypto assets on an exchange instead of self-custody them?
5. What has changed in crypto self-custody since 2009?
6. How can you avoid writing down seed phrases and private keys?
7. How will self-custody wallets affect broader financial services and fintech?
8. The future for self-custody crypto wallets
9. Self-custody of crypto sounds great. What’s the catch?

Crypto-powered finance has really taken off in the past year. This includes earning interest on crypto dollars (stablecoins), borrowing against your cryptocurrency like Bitcoin or Ether, sending and receiving crypto dollars, and swapping one crypto for another. Companies like BlockFi and Coinbase allow their users the opportunity to buy crypto as well as earn interest or rewards on their crypto assets, including crypto dollars.

The emerging field of Decentralized Finance (DeFi) has also grown rapidly over the past year. At the end of September 2020, it had reached $10 billion of value held in various platforms, according to the leading analytics portal DeFi Pulse. The ability to earn yield on crypto dollars without taking on the risk of volatile crypto assets is what drew hundreds of thousands of investors to this industry. Some yield-earning opportunities are as high as 15% APY as reported by LoanScan, the portal that displays crypto interest rates.

Today, an investor may have accounts with multiple exchanges and service providers: Coinbase, Binance, BlockFi, Celsius, in addition to traditional brokerage and bank accounts. Since financial institutions are not linked into a common network, consumers need to open a new account with each service provider. Crypto-powered financial services are flipping this relationship. So instead, most consumers will have one account (wallet). The majority of crypto-powered investment and banking services will be either integrated into that wallet app, or consumers will have the ability to connect their account to other platforms and service providers without opening a new account.

In this article, I explain how this will be possible. But first, let me explain why this will be possible. The reason for this is the digital nature of crypto assets, which allows for self-custody. For those who already understand the power of self-custody of crypto assets, you can skip to the section, “What has changed in crypto self-custody since 2009?”

How are crypto assets different from other financial assets?

Most traditional financial assets are titled to your name. These include bank deposits, money market accounts, and brokerage accounts, and financial institutions hold these accounts. Because consumers entrust their savings and wealth with third parties, consumers need assurance that these financial institutions will not disappear. Therefore, financial institutions are regulated by national and local governments to protect their citizens.

Cash, in the form of banknotes, is the notable exception of titled financial assets. Whoever holds banknotes has the ability to spend them. If you hold cash in your pocket or store it under a mattress (not recommended), you are responsible for its safeguarding. You are only trusting yourself with your savings.

Like banknotes, crypto assets are inherently a bearer asset class, meaning whoever holds the private keys to the blockchain account owns the crypto assets. Therefore, consumers do not require oversight from regulators to hold crypto assets because consumers are not entrusting their funds with third parties.

Think of a private key as a unique password known only to you for your public account (wallet address) on the blockchain. Crypto assets issued on various blockchains have different addresses: one for Ethereum, another for Bitcoin, Cosmos blockchain, and so on. Private keys are stored in different kinds of wallets, and a wallet app may support multiple blockchains so that users can hold Bitcoin, Ether, and other crypto assets in the same wallet app.

We broadly use the term “crypto assets” to refer to any asset (item) issued on public blockchains that are secured by cryptography. Securities issued on blockchains are also crypto assets, but they are, for the most part, not bearer assets and are regulated in most jurisdictions by local finance authorities. Examples of bearer crypto assets include:

• Cryptocurrencies — Bitcoin, Ether
• Stablecoins or crypto dollars — USD Coin, Dai, Paxos Standard
• Application tokens, including governance, work, and rewards tokens — $COMP, $UNI, $LINK, $LEND
• Gaming and virtual worlds assets — Items from Cryptovoxels, Decentraland
• Collectibles, including various forms of art and trade cards — Items from Rarible, SuperRare
• Social and communities money — $ALEX, $HUE

There is no financial services company or governmental body that maintains a registry of who owns what crypto asset. Blockchains, such as the Bitcoin chain and Ethereum, are public ledgers and provide the ultimate sources of truth for account balances and all transaction records. Account balances, written to these public ledgers, are immutable, and transactions are irreversible.

Why do you need a crypto wallet in the first place?

A wallet is the main component of every crypto app or a service that deals with crypto assets. If you want to invest in crypto, earn interest on crypto, access Decentralized Finance (DeFi), or send payments to friends or family using crypto dollars, you must have a wallet. You may not be specifically looking for a wallet, but you will end up with one if you want to buy crypto or use crypto-powered financial services ;)

There have been many discussions about how and where to store cryptocurrencies. I break these down into five options, with some examples of each:

1. Crypto exchanges — Like Binance and Coinbase Pro
2. Third-party hosted wallet providers — Coinbase Consumer wallet
3. Self-custody wallet apps — Such as Blockchain.com, BRD, and MetaMask
4. Hardware wallets — Including Ledger and Trezor
5. Paper wallets — You just write down a private key or a recovery phrase

Some in crypto say, “not your keys, not your crypto,” meaning if you do not hold the private keys yourself, you don’t really own your crypto assets. To fully experience owning crypto assets and participating in DeFi, you must store your crypto in self-custody wallets yourself.

What the heck are the private keys and seed phrases?

Private key. Think of a private key as a password that allows you to access your blockchain-based account. A private key is usually a long string of alphanumeric characters, and it’s similar to how your email password provides access to your email. Anyone who knows your email password can read your emails and send emails on your behalf. Anyone who knows your private key from your blockchain account can withdraw your crypto assets, and no one can reverse this transaction. If you lose your private key, there is no one to reset it. It is gone.

Seed phrase. These are also called a mnemonic phrase, recovery phrase, or seed words. They are usually 12–24 words that allow anyone to derive a private key when put through a special algorithm. Most third-party wallets and blockchain interfaces allow you to import your seed phrase and sign transactions with your private key derived from that seed phrase. Anyone who has access to your seed phrase can access your crypto assets, the same as with your private key.

Signing a transaction with a private key. In other words, approving irreversible transactions. Storing your private key in a self-custody wallet allows you to sign a transaction and send it to the blockchain with a near real-time settlement. Self-custody wallets allow you to send crypto dollars to someone, deposit crypto to the Compound liquidity pool to earn interest, and swap one crypto for another on Uniswap among other things.

Why would someone store crypto assets on an exchange instead of self-custody them?

Historically, the most widespread use cases for crypto assets is to buy and hold and wait for price appreciation. Most consumers like the convenience of having a third-party trusted provider, such as an exchange, manage the private keys. The inconvenience of storing private keys yourself and using seed phrases as a backup and recovery is real.

Just to highlight, if you use a self-custody wallet that requires writing down a seed phrase and you lose your seed phrase, the wallet app developer cannot help you recover your wallet or reset your password. So, your funds will be lost forever. The developer has no access to your wallet, which is the entire point of self-custody and bearer assets. Therefore, some investors chose to hold crypto assets on exchanges or with third-party crypto custody providers.

Although, storing crypto assets on exchanges exposes users of exchanges to different types of risks — hacker attacks due to large amounts of crypto stored on exchanges and rogue exchange operators. Both these risks are real, with over a $1 billion of crypto stolen from crypto exchanges over the last couple of years.

Self-custody crypto wallet apps, such as Blockchain.com, BRD, and Trust Wallet opened over 54 million, 5 million, and 5 million wallets for their users, respectively. Billions of dollars worth of crypto assets are stored in those wallets, and their users made hundreds of billions of dollars in transaction volume. Clearly, there is a demand for self-custody of crypto for those who chose to own their assets or live in regions with no developed financial infrastructure. Owning your private keys allows you to use any third-party interfaces to the blockchain-based services and have access to your crypto funds at any time. It gives you peace of mind because you don’t have to worry that the developer will stop supporting the wallet app or go out of business, blocking access to your wallet. You really own your crypto this way.

What has changed in crypto self-custody since 2009?

I think of wallets like Blockchain.com and others, which require writing down seed phrases for wallet recovery, as the first generation of crypto wallets. They have been around since at least 2009 when the Bitcoin blockchain was launched. These wallets did a great job of popularizing crypto, especially in regions that do not have local exchange operators and users have to rely on peer-to-peer transactions to buy and sell crypto.

From 2009 to 2019 not much has changed in terms of crypto assets self-custody. At Linen, we have been building products in DeFi since 2018 — even before this space was named DeFi — and we recognized that it was too hard and impractical for most people to manage their own private keys using self-custody wallets. Furthermore, if someone wanted to interact with financial smart contracts, the MetaMask wallet web browser extension was pretty much the only game in town back in 2018.

Until recently, most crypto investors had to choose between the convenience of third-party providers, such as exchanges managing your private keys, and owning their private keys and investing in DeFi without intermediaries. But then the new generation of mobile self-custody crypto wallets came along. These do not rely on consumers writing down private keys and seed phrases for backup and recovery of their wallets. And in most cases, consumers do not have to rely on the wallet provider app for wallet recovery.

Argent and ZenGo pioneered the concept of crypto assets self-custody on mobile devices without writing down the seed phrases required for wallet recovery. Linen has followed suit and released a wallet that does not rely on writing down seed phrases. In future versions, it will also provide fully autonomous wallet recovery to access funds in the wallet, without relying on Linen Mobile, Inc. for assistance. Alex Bazhanau, the CTO of Linen, outlines his design thinking and security model of Linen Wallet in this post.

How can you avoid writing down seed phrases and private keys?

A combination of several technological advancements made it possible to design secure next-generation self-custody wallets, including:

• Smart contracts that live autonomously on a blockchain executing predefined code,
• Multi-party computation (MPC),
• Social recovery,
• Cloud storage, and
• Hardware security modules as a wallet recovery mechanism.

This next generation of wallets (accounts), which lives on blockchains, forms the foundation for new types of software companies (organizations) that do not touch user funds. They enable users to access crypto-powered financial services and applications, including investing, trading, earning yield in DeFi, and borrowing. These are the ones we know of today, but many more use cases will present themselves over time.

Users of these wallet apps do not bear the risk of the wallet software developer disappearing because users have access to wallet recovery mechanisms on their own. From the usability perspective, wallets that do not require writing down seed phrases for wallet recovery are much easier to use than traditional financial services apps.

How will self-custody wallets affect broader financial services and financial technologies?

The paradigm shift in how software companies provide access to crypto-based finance is a net positive for consumers, the emerging field of decentralized finance, and wallet app providers.

Benefits for consumers:

1. Access to the entire range of decentralized financial applications. For example, the ability to buy, sell, trade, hold cryptocurrencies, collectibles, digital art, and other crypto assets powered by public blockchains.
2. A direct relationship between users and blockchain-based applications where early users are rewarded for being customers. Ownership is in the form of a token (crypto asset), and it allows users to vote on how these platforms and applications are shaped. For example, Uniswap rewards its users with its $UNI token for providing exchange liquidity. The liquidity pool Compound rewards its users with the $COMP token for using the platform. All you need is to interact with these platforms using your private key.
3. Compromises no personal identifiable information. Self-custody wallet providers are not typically targets of hacker attacks aimed at stealing personal identifiable information because users do not provide personal identifiable information to wallet providers. If users purchase crypto with fiat, they usually provide this information to regulated financial institution partners who provide services that involve fiat exchange.
4. Unlikely to have crypto assets stolen. Since self-custody wallets do not contain user funds, self-custody wallet providers are not usually targets of hacker attacks looking to steal user funds.
5. Access to a variety of crypto-powered financial applications. Most self-custody wallets can be linked to numerous DeFi crypto services or accessed from multiple interfaces with no additional sign-up. This is a big deal since new investment platforms and crypto assets appear every day, and no single company can integrate even a fraction of them. Users can easily plug their wallet or export private keys from another interface and have all transaction records in place on a new interface.
6. Greater access and inclusivity. Residents of countries with less developed financial markets and less democratic governments have access to the global crypto markets, crypto dollars, and crypto savings. They can finally build liquid wealth, which does not exist in many parts of the world today.

Benefits for developers of decentralized applications:

1. Direct interaction with end-users via their self-custody wallets fosters decentralization, voting participation, and engagement with blockchain-based services and protocols.
2. Prevents the concentration of voting power on centralized exchanges, which can lead to voting manipulation and attacks on public protocols.
3. Mitigate the risks involving large quantities of tokens in circulation from being stolen from centralized exchanges due to hacks or rogue exchange operators.

Benefits for developers providing self-custody wallet apps:

1. Since wallet providers do not hold user funds, they are not regulated as financial services companies. Instead, wallet developers provide software to custody private keys for end-users. In a similar way, software companies, such as 1Password and LastPass, provide a secure environment to store and manage your passwords. Not being regulated as a financial services company drastically cuts costs, which can be passed on to end-users or reinvested in product improvements.
2. Building on the public blockchain infrastructure cuts operating costs since there is no need for building proprietary financial products or engines for transaction settlement. Everything is done on public blockchains and in DeFi protocols. This is a huge long-term competitive advantage compared to centralized crypto operators like exchanges or financial services companies.
3. Self-custody software wallet providers become global by definition because they do not have to rely on the traditional financial system or seek government approval. Regulated financial partners in the appropriate jurisdictions typically provide the fiat on-and-off ramps for users of self-custody wallets.

Companies that develop new-generation self-custody wallets and enable access to crypto finance essentially become security-first software companies, focusing on identifying threats and mitigating them.

The future for self-custody crypto wallets

The crypto industry has reached the point where there is much more clarity now than 1–2 years ago. Based on my own industry observations and by talking to founders of self-custody wallet apps, here is how I think crypto finance and DeFi will shape out:

1. Self-custody will become the primary method of custody of crypto assets. And by extension, it will be the primary method of interacting with crypto-powered finance and DeFi for consumers.
2. Self-custody wallets will work cross platforms and natively support mobile apps, desktop apps, and web platforms. Smart contract wallet design makes this possible. It is impractical for most consumers to manage multiple wallets, each with their own backup and recovery mechanisms. Hence, consumers will stick with one “main” wallet provider. However, it does not mean that individuals will be locked in one wallet provider since the wallet lives on the blockchain and consumers can always switch to alternative web interfaces.
3. Wallet apps will aggregate retail liquidity and channel it to various liquidity pools on layer 1 and layer 2 blockchains and scalability solutions. Fintechs like Credit Karma, Wealthfront, and Robinhood aggregate leads and liquidity and send it downstream. The same will happen in DeFi, but it can be done much easier because liquidity can be programmed and sent downstream without permission. While I was finalizing this post, the go-to DeFi wallet for the tech-savvy, MetaMask, announced getting into the supply side liquidity aggregation. In September 2020, MetaMask surpassed 1 million monthly active users, more than all the other DeFi protocols and aggregators combined. The majority of MetaMask users will be swapping tokens in the wallet without needing to go to individual platforms, while knowing that they will get a fair price. As a matter of fact, consumers value convenience and trust of their primary financial app and are ready to pay for this convenience.
4. Wallet apps will start moving down the stack, providing DeFi yield strategies and forming their own liquidity pools to capture greater economics. This will be the result of the liquidity aggregation I outlined above.
5. There is a good chance that yield strategies and liquidity pool smart contracts, which the wallet app is integrated with, will be heavily managed by the wallet app users. And the same for exchange liquidity pools. Imagine MetaMask issuing tokens and its users have a say in how the fees should be set, what new use cases should be supported, and may be even how treasury should be spent. This will increasingly look like a coop or union.
6. As long as the wallet can connect to decentralized protocols, either natively in the app or using third-party connectivity solutions, it will be easy to entertain novel use cases and have fewer reasons for users to switch wallets.
7. Wallet apps will provide authentication or/and identity services to third-party apps. This is the hardest task to achieve, and I am less certain how this will happen, but it will happen. It’s just a matter of time.

Self-custody of crypto sounds great. What’s the catch?

Today, blockchain-based applications are still in the experimental phase. But DeFi is growing rapidly with more than $10 billion of crypto assets supplied to various smart contracts, according to DeFi Pulse as of the end of September 2020. Examples of some of the issues that crypto finance is facing today:

1. Scalability. Ethereum, the leading smart-contract platform where most DeFi financial activities occur, has reached its capacity and transactions are expensive, pricing out retail investors. Sooner or later, scalability issues will be solved by the Ethereum core developers, dedicated Ethereum scalability teams, and developers of other blockchains that aim to provide similar services on other blockchains.
2. Privacy. Most transactions on public blockchains, such as Ethereum and Bitcoin, are traceable to the wallet that originated the first transaction. If someone sends you crypto assets or you send crypto assets to someone, the other party can view your wallet balance and all transactions coming in and out of the wallet. This is viewable by anyone using blockchain explorers like Etherscan. However, there is no name attached to your address on the blockchain. It is expected that privacy solutions will be implemented, and senders and receivers will have the option to send private transactions.
3. Technical Risks. Technical risks should not be underestimated in DeFi. There is no assurance or guarantee that something will not be hacked or exploited. Time is needed to test the systems. These technical risks possess a systematic risk for the entire crypto industry. Users of centralized exchanges and hosted wallet operators are exposed to this type of risk as well. This is either directly, through purchasing yield sourced through DeFi smart-contracts, or indirectly, by holding DeFi crypto assets.

Conclusion

At the end of the day, consumers need to find the utility in what crypto-powered finance offers, be it earning yield, accessing crypto dollars in countries with unstable banking systems, sending crypto dollars to a friend for last night’s pizza, swapping one crypto asset for another, or simply safely storing your crypto wealth. Decentralization, new applications, and self-custody are means to get to that utility and value.

The new generation of self-custody crypto wallets, which do not require writing down seed phrases for wallet backup and recovery, lay the foundation for how consumers will have relationships with the emerging crypto-powered finance. These wallets provide a secure way of storing various crypto assets and can be used with multiple DeFi investment platforms and applications. Crypto finance truly enables a customer-centric approach because users are not locked into one platform and can exit at any time by switching to a new interface, while preserving all their transaction records. Linen’s goal is to empower individuals to build wealth with DeFi and have alternatives to traditional investment options, regardless of where they live.

Linen is making this a reality by starting with a simple use case: deposit the stablecoin USDC to the Compound liquidity pool to earn interest. We aim to provide the easiest onboarding experience for those who are new to DeFi and crypto finance. We will expand our use cases from here by providing a multi-asset wallet for all your crypto assets with native integrations of DeFi yield and exchange pools. Linen Wallet is in private beta testing now, and from time to time, we invite additional testers. If you are an iOS user, download the app (U.S. App store only at the moment) to get on the waiting list so that we can invite you to our beta test.

A bonus for those who read the entire article: We are also running a Community Program on Republic for early members of the Linen community. All the details about the program are on Republic. Due to certain legal infrastructure constraints of our partners, the Community Program is open to U.S. residents only.

Jon Kol, thanks for providing feedback. A lot of credit for this story goes to my co-founder Alex Bazhanau for his autonomous wallet concept and the ability to explain complex distributed systems and security threat models to me in simple words.