How Blockchain Cuts the Middleman

TL;DR

Blockchain is the technology behind cryptocurrencies, but overall it is a tool for decentralisation. Beyond speculation, the crypto ecosystem holds many promises because it can cut the middleman in most economic sectors starting with Banking and Financial Markets.

Users of decentralised exchange, stablecoins, crypto lending and non fungible token all have one thing in common, they put their trust in the code, not in a regulation entity. DeFi (Decentralised Finance) can speed up exchange of value, lower fees and create new markets while fostering pseudonymity and self-regulation. Nevertheless, there is a price to pay for financial sovereignty called self-responsibility.

DeFi is still too complex for the average Internet user and most of the naive investors lured into crypto by Bitcoin’s bull run are likely to suffer losses due to irrational bets or blatant scams. Virtual asset service providers are enjoying a loophole in financial regulation, but watchdogs have not said their last word as AML and KYC rules are being drafted. Rules are beneficial if they are not prohibitive.

Remember 2000 with the dot com bubble, remember 2017 with the ICO bubble. Ultimately, solid DeFi projects will survive, but this $40 bn unregulated market will not escape Darwinism.

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Here we go again. Another article on cryptocurrencies, but this time I will not be writing about Bitcoin. I would like to shed light on two hypes going on in the crypto ecosystem : DeFi and NFT. These are complex applications of Blockchain that I will try to explain with simple terms. This article is not an investment advice. You should due your own due diligence before investing, especially for highly volatile assets.

What is Decentralised Finance?

Let’s start with Decentralised Finance, DeFi in short. Much ink has been spilled about these four letters and for good reason. According to DeFi Pulse, the total value locked in DeFi projects jumped from $15 bn in January 2020 to $40bn in late March 2021. DeFi is open banking, an umbrella term for disruptive self-regulated financial applications on the Internet. It aligns with Blockchain technology’s original purpose: cutting the middleman to spur financial sovereignty and inclusion. This is not only more affordable, but also less intrusive and non-discriminatory.

Unlike centralised cryptocurrencies, such as Facebook’s former Libra Project, DeFi supports permissionless transfers of value. It is the purest expression of Classical economists’ “laissez-faire” because it requires no supervising body; supply and demand are the only two forces maintaining an equilibrium. It is accessible to anyone with a connected device and the code is fully transparent and open source. Even if you are not a programmer, you can be relatively (not entirely) sure that the most common DeFi platforms have been peer-reviewed by tech savvy users. Finally, DeFi platforms are interoperable, which means they can offer a wide variety of financial services, especially when they leverage the power of smart contracts. However, like any emerging technology, DeFi has its flaws and shenanigans. I will dwell on the limitations later in the article, but first of all, I would like to give some concrete use cases.

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DEX / Decentralised exchanges

A blockchain has an immutable code and is secured with private keys, which makes it very resistant to hacking (notwithstanding quantum computing). The reason why cryptocurrencies have such a bad press is not because of flaws in their underlying technology, but rather because centralised crypto exchanges constitute a central point of weakness with large potential gains for hackers.

Decentralised Exchanges, DEX in short, is one application of DeFi, which can mitigate such risk. DEX allow users to perform P2P (peer-to-peer) transactions with each other while keeping control of their funds independently (eg. Uniswap and Kyber Network). A DEX matches demand with supply, but never keeps funds under custody, and that is the power of decentralisation. The same smart contract-enabled system is used to develop decentralised insurances where a pool of investors share the risk with each other in exchange for the insurance premium. Defi platforms can offer insurance against many unforeseen events (a flight delay, a market crash, a hack, the failure of a smart contract) for a low premium (eg. Nexus Mutual). The issue for now is that most of them miss a user friendly interface, unlike decentralised exchanges.

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Stablecoins

Tether or USDC are examples of cryptocurrencies whose price is pegged to the USD with a ratio 1:1. This is handy for investors willing to hedge most of the volatility of their crypto portfolio without cashing out in fiat currencies. Even though these projects are audited, doubts are rising about dollar funds supposedly held to back the stablecoins. To mitigate this risk, DeFi systems such as Dai allow the creation of new tokens in exchange for a 150% crypto equivalent. This ensures the stability of the coin’s price. As showed on the follwoing price chart, volatility is relatively low compared to other cryptocurrencies, but it is non null.

Nevertheless, this model works as long as users view a stablecoin as a safe haven. In the unlikely, yet possible event, where all crypto enthusiasts lose faith in any crypto and stop creating new Dai, the value of collateral will plunge until margin calls make the scheme collapse.

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Crypto Lending & Yield Farming

In appearance, yield farming is like locking cryptos on a saving account to let a decentralised bank offer loans to other investors in exchange for interests, except yields can be several thousands of percentage points a year. This is very interesting for large crypto investors willing to generate a passive income. Nonetheless, as you know, there is no free lunch. The reason why some platforms offer such profitability is because it is far riskier than a classical saving account.

Source: Coinmarketcap

In a nutshell, yield farming is like liquidity farming : a LP (Liquity Provider) adds funds to a liquidity pool – smart contract containing cryptos – in return for a reward. It is a win win – borrowers can make a better use of the crypto funds they want to hold by using them as collateral to obtain a loan for their daily needs, while long-term holders can lend their fiat or crypto in exchange for some juicy interests, far greater than a saving account (though riskier). Some platforms also offer flash crypto loans, which makes room for arbitrage – taking advantage of market inefficiencies to secure a riskless profit.

Source : Ledger Academy

Unlike a bank or brokerage account, there is no KYC (Know Your Customer) involved in DeFi, so no need to prove your identity or solvability. There is no institution facilitating the transfer of funds, only a software-based middleman securing the loan via smart contracts with a collateral in excess of the loan’s amount. This system could help bank the unbanked and reduce discrimination. Nevertheless, as a coin has two sides, Open Banking opens up a way for terrorist financing and money laundering.

The liquidity pool powers an AMM (Automated Market Maker) - a marketplace - where users can lend, borrow, or exchange tokens. That reward may come from fees generated by the underlying DeFi platform, or some other source. Some liquidity pools pay their rewards in multiple tokens (whose acronym is often food-related), which can themselves be deposited to other liquidity pools to earn rewards there, and so on. Consequently, investors can build complex passive income strategies across platforms like Aave or Compound for example. Aggregators like Yearn.finance can also optimize token lending by algorithmically finding the most profitable lending services.

Yield Farming is generally considered to be high risk/high return as locked resources can be lost if there is a backdoor or loophole in the farm smart contract, while the generated resources could be useless. In addition, one of the biggest advantages of DeFi is also one of its greatest risks. DeFi protocols are permissionless and can seamlessly integrate with each other. This means that DeFi applications not only have a specific risk, but also a systemic risk since the ecosystem is heavily reliant on each of its building blocks.

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Non Fungible Tokens

The latest craze fits in three letters NFT (Non-Fungible Token). They are cryptographic assets on blockchain, but unlike cryptocurrencies they have a unique identification code and metadata that distinguish them from each other. NFTs are irreplaceable and can have many use cases such as tokenising real-world items and authenticating identities and property rights. NFTs can remove intermediaries between buyers and sellers of artworks and real estate, simplify transactions and create new markets.

The trend started with skins (graphic item changing the appearance of a character or an object) in video games like Counter Strike and were later officialised in 2017 with cryptokitties, a game where people trade digital representations of cats with unique identifications on Ethereum’s blockchain. Each kitty is unique and has a price in ether. They reproduce among themselves and produce new offspring, which have different attributes and valuations as compared to their parents. Within a few short weeks of being launched, the project racked up dozens of millions of dollars.

Source: cryptokitties.co

Remember about Pokemon and baseball cards? Blockchain made them digital. The NBA made good use of the hype and launched “NBA Top Shot”, an online collection of short video clips of its greatest game highlights. No need to go to your newsagent anymore, you can crack open a booster online right from your couch, for $9 to $229 dollar (only). But basket ball epic shots are not the only “thing” you can buy. With NFTs, pretty much anything can be put up for sale: a ten year old meme ($561,000), Twitter CEO’s first twit ($2.5 million), an online artwork ($69.3 million), etc. For this price, you do not get anything tangible, but it is a unique piece.

Some may advocate that paying millions to buy something already available on the net that you cannot even touch is pure madness, but it is a matter of perspective. Are shiny metals and stones, oily canvas and old grape juice legitimately worth millions just because most people agree they are rare AND they look good in a vault? Is someone willing to own an iconic piece of digital history more or less rational?

Sources: NBA Top Shot ; Nyan Cat meme ; Everydays—The First 5000 Days, Beeple (2021)

Cryptokitties is a trivial use case, but this is only one of the many possibilities of NFTs:

Identity management – converting passports into NFTs would streamline the entry and exit processes for jurisdictions, reduce identity thefts and improve international census;

Real estate trading – a real piece of RE could be parcelled out into multiple divisions with particular characteristics, and traded on an exchange, simplifying a complex bureaucratic process;

Art – a blockchain allows artists to sign their digital artwork in the metadata and can connect directly with their audiences since a blockchain replaces intermediaries.

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Nothing escapes Sauron's eye

The crypto ecosystem used to be an area of lawlessness, but watchdogs asserted their intention to retain control of their monetary policy and apply financial regulations. Decentralised exchanges are wrongly portrayed as businesses with legal obligations, but in fact they are software tools, which cannot be held responsible for its users’ actions. This loophole gave room for complacency, but now that DeFi projects handle dozens of billions of dollars, these will reach the top of regulators’ agenda. Just like in Tolkien’s masterpiece, nothing can be hidden from Sauron’s eye and DeFi makes no exception.

One black swan lurking in cyberspace is the inevitable clash between DeFi and Anti Money Laundering regulation. One fosters pseudonymity while the other wants to collect as many sensitive data as possible. The raid on DeFi The recommendation 10 and 16 of FATF draft guidance on a risk-based approach to virtual assets and virtual asset service providers (March 2021) made it clear that VASP (Virtual Asset Service Providers) need to conduct customer due diligence and obtain, hold and transmit originator and beneficiary information (name, ID, address, date of birth, account number) - the “travel rule” – when conducting virtual asset transfers of more than USD/EUR 1000. This is a complete violation of cypher punk's ideology.

Government interventionism may not be entirely negative, because the DeFi ecosystem is still riddled with infrastructural mishaps, hacks and “rug pull” scams and some set of rules could help protect investors’ hard-earned coins. It is also crucial to define an international legal supervision since DeFi’s transactions are not bounded by physical borders. However, regulators may not be content with “some” rules and clash with the concept of decentralisation and anonymity.

Self-regulating alternatives are emerging and should be considered by governments. For example, Confirm and Chainlink partnered to offer developers a plug and play solution to produce an AML risk score involving 270 indicators including blacklisted addresses checks, high-risk transaction pattern warnings, etc. In the end of the day, Code should be Law, nothing else.

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My takes on the hype around DeFi

To sum up, DeFi could toss many intermediaries from the financial industry onto the garbage heap of history: brokers/dealers, institutional lenders, insurers, and pretty much any middleman from other sectors of the economy. Decentralisation can streamline transfers – faster and cheaper – thanks to the power of Code. In my opinion, Blockchain is an actual game changer, but several pitfalls remain.

The biggest advantage and the worst drawback of decentralisation is that anyone can do anything. While some projects are truly promising, fair and well designed, some others are just doomed to fail or steal users’ money. The current bullrun of Bitcoin and altcoins nurtured the FOMO (Fear Of Missing Out), which brought many naive investors in the crypto ecosystem. Just like in 2017 with the ICO bubble, so-called DeFi projects are appearing everyday and luring neophyte investors into blatant scams.

I am very excited about DeFi, but I think it needs a tremendous amount of due diligence to understand the specific risk of each project together with the systemic risk of the ecosystem. Some regulation may help, but pseudonimity should be preserved. At this moment, in early 2021, I feel like decentralisation is being used as a buzzword, first it was .com, then Blockchain and now DeFi and NFT. The essence of this technology is ground-breaking, but not all related projects are worth a penny.

Sources used in the article: Cryptoast, Ledger Academy, Binance Academy, Medium, CNN Business.

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The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.

MT Finance - Mathias Talmant.