2022: The Year of Defi

Trust in the banks and brokerages that handle critical social and economic processes is at a historical low point. While volatility in the markets has been the new norm for the past two years, our infrastructure is beginning to crack under the pressure, revealing critical weak points in the process. Crippling economic sanctions against the Russian ruble has devastated the purchasing power of millions of Russian citizens. A few weeks prior to the war, the Canadian Government froze the accounts of hundreds of truckers protesting against COVID-19 mandates. This is not an argument about whether weaponizing the financial system is justified; rather, it is meant to highlight the ways in which the traditional financial system is failing everyday people. Moments like these are when the value of cryptocurrencies shines brightest. 

As stated by naval Ravikant, “Bitcoin is a tool for freeing humanity from oligarchs and tyrants, dressed up as a get-rich-quick scheme.” Bitcoin was created in response to the controversial big bank bailouts of 2009. At the time, big banks inflated a housing bubble by selling fraudulent mortgage-backed securities and profited from the crash by colluding with hedge funds (Collins 2015). Because these banks were too big to fail without causing a worldwide depression, the government committed 700 billion dollars to bailing out the culprits of the recession (Penn 2019). This effectively shredded the veneer of laissez faire capitalism: “The gains, it turned out, were privatized—the losses were socialized” (Penn 2019).

In the 13 years since the advent of Bitcoin, an entire decentralized financial ecosystem, called DeFi, has emerged. For the first time in history, it is possible to go “bankless” thanks to the range of innovative financial products that run on decentralized execution environments such as Ethereum, Avalanche, and Solana. These environments enable players to have full custody of their assets, which means they can trade and earn interest on their assets without middlemen. 

DeFi is a parallel financial system minus traditional finance antics. The past two years have demonstrated that traditional markets break down under volatile market conditions. In 2020, Robinhood infamously halted new purchases of AMC and GameStop (GME) stock after retail investors triggered a short squeeze of these assets. This created unfair market conditions for holders because buying was halted and only selling was allowed. Naturally, AMC and GME lost momentum after Robinhood’s controversial moves. More recently, the London Metal Exchange (LME) halted trading after a large firm struggled to meet margin calls after a nickel short squeeze (Farchy and Cang 2022). Market manipulation of this magnitude goes against the idea of free markets and reduces trust in banks and brokers.  Earlier this year, the Canadian government ordered banks to freeze the assets of Freedom Convoy protestors. When users create a savings account, there is an implicit trust agreement between a bank and the user that guarantees access to funds at any time. Public breaches of this trust agreement highlights the need for self custody alternatives that remove the risk of losing access to funds. This breakdown of trust is more evident under extreme market conditions, such as those faced by civilians in Russia and Ukraine. Due to economic sanctions, Russia’s central bank lost access to over 600 billion dollars worth of foreign reserves (Sindreu 2022). In times of crisis, foreign countries sell foreign reserves and buy their domestic currency in order to maintain price stability. Without access to foreign reserves, Russia’s central bank cannot prop up the price of the Russian ruble. As a result, the ruble has lost nearly 40% of its value relative to the dollar since the invasion began. Panicked Russian and Ukrainian citizens are rushing to withdraw cash from ATMs, but withdrawal limits in both countries stand in the way of these efforts (Gunerigok 2022; Cunningham 2022). Although it is beneficial to trust banks with custody of assets, loss of access disproportionally affects regular users.  These recent events highlight how traditional markets only operate efficiently under narrow market conditions. As trust continues to erode in traditional assets, alternative assets such as Bitcoin and Defi will attract more capital. One could envision a scenario where central banks around the world acquire exposure to digital assets as trust in traditional assets takes a hit. 

 Crypto is still a relatively niche asset class, and it has struggled to attract traditional investors partly because of volatility and perceived risks. The Financial Stability Board (FSB), an international body that works with governments to come up with new regulations, released a report highlighting crypto assets as a risk to the stability of the global financial system. According to the FSB, stablecoins, which are crypto assets that are pegged to the dollar, are a point of failure that could constrain crypto liquidity and spill over to traditional markets. Stablecoins are undeniably a source of risk; however, their argument ignores the fact that stablecoins compete with each other for liquidity. When a major stablecoin protocol provides superior transparency about reserves and governance, it triggers a transparency race between stablecoins that is good for users (Koning 2021). In this way, DeFi is subject to improvement by the rules of competition. Moreover, the risk of a stablecoin failing encourages diversification and risk management, which is a must in a space where composability between assets within a network is a main source of innovation.

Now for the crypto investment case: despite all the noise about crypto risk, bitcoin has a mean annual return of 93.9%. This was before questionable global monetary policy drove real rates into negative territory. It is important to keep in mind that previous price history does not guarantee similar price action in the future. However, one has to wonder what crypto’s price action will look like once it gets a chance to showcase its store of value proposition in the face of runaway inflation. One scenario that could trigger an exodus into the alternative asset class is the loss of faith in the yield of traditional assets, which may be driven by the central bank’s decision to end its quantitative easing program in March 2022. Quantitative easing intensified as a response to the pandemic, which arguably has led to an overvaluation of stocks and bonds. Once the Federal bank is no longer a buyer in the market, it is hard to argue the prices of bonds and stocks are justified in a rising rate environment. As rates go up, cash flows decrease and earnings go down, which may reduce investor confidence in stocks with high price-to-earnings ratios. This begs the following question: If investor confidence in stocks, bonds, and real estate is low due to rising rates and negative yields, why would they migrate to crypto? The answer is that although crypto has boomed in a low rate environment, it has not been overbought to the extent that traditional assets have. The central bank’s quantitative easing policy does not include crypto purchases. Because of this, the crypto market has priced in rising rates and the war in Ukraine more than traditional markets have. This means that moving forward, capital may rotate from heavily overbought traditional assets into heavily oversold Crypto assets. 

Another major catalyst for crypto markets this year is that DeFi 2.0 is set to emerge in 2022. Much like the first iteration of the internet, DeFi 1.0 suffered from a lack of user friendly applications which hindered its growth (Ahmadi et al. 2022). Moreover, liquidity in DeFi was constrained by the lack of customizable bridges between different blockchains. Chainlink, a major infrastructure provider for blockchains, is seeking to address these issues with the release of CCIP, the Cross Chain Interoperability Protocol. According to Chainlink, CCIP is analogous to the TCP-IP protocol that underpins the world wide web. CCIP will allow decentralized application (dApp) developers to utilize different blockchains as storefronts, while their actual code runs on the most efficient execution environment. This is a game changer because dApps will now be able to tap into liquidity and apps across all chains, not just the chain they are running on. 

This allows for innovative new use cases like self paying loans (Ahmadi et al. 2022). Borrowing in DeFi is overcollateralized. This means that if Tom wants to take out a 2000 dollar loan, he must provide collateral that exceeds that amount in order to protect the original lender’s funds. With DeFi 2.0, Tom’s collateral will not stay idle while he repays the original loan; instead, the collateral can be redeployed into various passive income strategies across chains that gradually pays off the initial loan.

DeFi and bitcoin are emerging as unbiased tools for economic activity with an additional layer of cryptographic guarantees. We are at a point in history where economic actors see cryptocurrencies as safer bets than government backed currencies. At the same time, DeFi is receiving a huge upgrade that will increase capital efficiency by several orders of magnitude. Although the world is in disarray, the Web 3.0 space is continuing to provide platforms for fair economic activity that are resilient and isolated from the uncertainties of traditional finance. 

References

Abelsky, Paul. 2022. “Russia Says Sanctions Determine If Foreign Bondholders Get Paid.” Bloomberg. March 6. https://www.bloomberg.com/news/articles/2022-03-06/russia-says-sanctions-determine-if-foreign-bondholders-get-paid.

Ahmadi, Aaron, Brianna Beckford, Sebastian Sinclair, Michael Bodley, and Ben Strack. 2022. “The Investor's Guide to DeFi 2.0.” Blockworks. January 6. https://blockworks.co/the-investors-guide-to-DeFi-2-0/.

Collins, Mike. 2015. “The Big Bank Bailout.” Forbes. July 14. https://www.forbes.com/sites/mikecollins/2015/07/14/the-big-bank-bailout/?sh=39bcf7ef2d83.

Farchy, Jack, and Alfred Cang. 2022. “Nickel Tycoon Covered Part of His Big Short Position This Week.” Bloomberg. March 24. https://www.bloomberg.com/news/articles/2022-03-24/nickel-tycoon-covered-part-of-his-big-short-position-this-week.

Koning, JP. 2021. “The Race for Stablecoin Transparency.” CoinDesk. August 16. https://www.coindesk.com/markets/2021/08/16/the-race-for-stablecoin-transparency/.

Penn, Amanda. 2019. “2008 Bank Bailout: Its True Cost, and Who Paid It.” Shortform. October 27. https://www.shortform.com/blog/2008-bank-bailout/.

Sindreu, Jon. 2022. “If Russian Currency Reserves Aren't Really Money, the World Is in for a Shock.” Wall Street Journal. March 3. https://www.wsj.com/articles/if-currency-reserves-arent-really-money-the-world-is-in-for-a-shock-11646311306.

Wan, Samuel. 2022. “Russians are paying up to $20000 above market rate to buy Bitcoin.” CryptoSlate. March 1. https://cryptoslate.com/russians-are-paying-up-to-20000-above-market-rate-to-buy-bitcoin/.