Hi everybody!
Let’s hope the tech works with this newsletter send (for those of you new here, last week’s didn’t go as planned), and that you have had a good weekend. If you’re reading this, I’m assuming it did work, and so I’m going to ask you a favor: if you have colleagues or friends who might be interested, do please forward this to them. I’ll understand if you don’t forward it to your competitors.
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This week I get a little bit geeky on you with a hint of decentralized finance – but really, it’s about the evolution of traditional finance. You know you want to keep an eye on that. I also look at a regulatory proposal that is unlikely to be passed, but that doesn’t make it unimportant.
There is also a broad assortment of notable developments in the crypto asset sector from the past week, as well as why I think they’re significant.
With that, read on…
- Noelle Acheson
(The song in this week’s subline.)
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Any port in a storm
Earlier this month, SEC Commissioner Hester Peirce proposed a “safe harbor” for token issuers that would allow developers to develop and investors to invest without fear of regulatory reprisals. Needless to say, much of the sector’s initial reaction was one of excitement because THIS was obviously the regulatory solution everyone had been waiting for, a way to let innovation breathe while protecting investors to some extent.
The idea is to give crypto entrepreneurs a three-year grace period to launch and decentralize their projects before having to address whether their circulating tokens qualify as securities under federal law. They would be able to sell their tokens to a wider range of investors, provided they make sufficient public disclosures and submit to SEC oversight.
As always, questions soon started emerging about the details and the implementation – definitions, the bedrock of securities laws, were called into question, with lawyer Preston Byrne calling the SEC’s decentralization test “unquantifiable to the point of being unconstitutionally vague.”
Others take issue with the three year exemption, arguing that it grants unusual leniency to blockchain-based tokens that other securities innovations don’t enjoy, that it would encourage a free-for-all of meritless development based on copies and forks, and that it sidesteps the need for a more sweeping change to securities laws.
Some have pointed out that the rule focuses on networks rather than applications, it does not address mining centralization and, if approved, it could trigger another crazy and hype-fuelled issuance period like 2017, only this time with implicit regulatory support.
What does this mean for investors? Well, for now, nothing. It’s just a proposal, and one that’s unlikely to make it into an approved Rule – Peirce’s term is up in June of this year, and it’s not certain it will be renewed. Also, she would need unanimity from all the other Commissioners, which – given the nature of teams combined with the contentious status of cryytocurrencies in general within the organization – is unlikely.
So why are we even talking about it? Because that’s the point. No-one wants to go back to the crazy days of 2017, where we felt like we were watching a train wreck in slow motion. But no-one wants innovation to be stifled and the bright ideas to go offshore. No-one wants crypto assets to exacerbate inequality, either within U.S. borders or globally. And no-one wants retail investors to get duped and lose their hard-earned savings.
Peirce’s proposal has started a meaningful conversation that will have a material effect on portfolios and capital accumulation. Definitions may as yet be vague and not completely thought through, but at least they are being thought about. Inefficiencies and unreasonable blocks are being given the disinfecting treatment of sunlight. And the sector’s legal and economics experts are actively considering how to improve on the initial framework.
Maybe (probably) Rule 195 won’t come to pass in its current form. But eventually, something like it will. When that happens, new investment opportunities will appear, with both risks and potential. The nature of “assets” will change. And investors will have a chance to get in at the ground floor of a probably bumpy ride toward a new type of capital market. Profitable or not, it’s certainly going to be interesting.
Gone in a flash
Decentralized finance (DeFi) is not yet a “thing” in institutional crypto investing, which is why you hardly ever see me talk about it here. But we can’t not discuss what happened last week with DeFi platform bZx and its unfortunate flash loans, because:
1) It throws into stark relief the bumpy road of financial innovation,
2) It highlights how risky this is,
3) It points to how real innovation will emerge, and
4) It’s just damn interesting, in a scratch-your-head, hunh?-oh-wow kind of way.
I won’t go into the details of how flash loans work (is that a sigh of relief I hear?), but if you are interested, my colleague Will Foxley wrote up a good explanation, we have a video to go with it, and it was the CoinDesk podcast with Adam Levine and John Biggs that finally gave me my “ohhh” moment.
Basically, you borrow money on a flash loan platform, use it to buy a crypto asset on another platform, sell that asset at a higher price on a different exchange (arbitrage) and pay back the original loan, pocketing the profit – all in the space of seconds. No collateral is needed, because the sequence of transactions is inter-dependent, they are all part of the same transaction: if you don’t pay the loan back in the short window, you didn’t get it in the first place. (What happened with bZx is a bit more complicated than this and would require a whiteboard and a marker to do justice to, but you get the decentralized drift.)
One of the more intriguing aspects of the debate, familiar to those who were following the sector back in the times of the 2016 The DAO attack, was whether or not this was a "hack." Decentralized platforms don’t have a team of analysts verifying creditworthiness, nor compliance officers checking credentials. They run on code, which as we all know, can be hacked, and data and cryptocurrencies can be stolen. But in this case, the code allowed the manipulation.
However, the fact that no rules were broken does not make it right, and these twists give us an enhanced understanding of why we have securities and banking laws.
These twists also add fuel to the fire under the growing relevance of DeFi in traditional finance. The whole fintech movement has been about increased efficiency, lower costs and broader audience reach. DeFi takes that trend to a new level, removing middlemen and oversight, which is not only worrying for the middlemen and the watchdogs, but also for those that trust the middlemen and the watchdogs to make sure that nothing terrible happens.
That is the main issue: trust. In traditional finance, we trust the institutions we deal with. Decentralized finance wants to make that unnecessary – instead, we have to trust the computer code. Ah.
But here’s the thing: under the magnifying lens of open-source code and brilliant people looking for exploits, bugs will be found, and exploited. Some end up losing money, but on the whole, the sector benefits. These dramas should not break trust in DeFi platforms – they should enhance skepticism in the short-term, but increase trust in the long-term, as we collectively get better at this.
By that, I mean that we develop tools and expertise that can find bugs more easily (although the pesky things tend to evolve); we develop rules and oversight (yes, oversight) to protect the innovators on both sides of the client relationship; and we develop a deeper understanding of the new economic principles that these platforms give birth to.
With that, traditional finance is likely to evolve also. DeFi is unlikely to ever replace centralized finance, and nor do I think it should. But it will end up influencing it. This is a development worth watching.
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BIG IDEAS
Crypto researcher Hasu debunks the claim that bitcoin mining is becoming dangerously concentrated. TAKEAWAY: Techincal, perhaps, but important: the alleged concentration of bitcoin’s mining community does not make the system more vulnerable. This confusion stems from a much-misunderstood feature, which is that bitcoin’s design assumes that miners are rational, not that the system is distributed. Bitcoin is not impossible to attack, it is expensive to attack, and miners will opt for a course of action that brings them greater economic profit. Self-interest will convince them to support the network rather than attack it, no matter how many miners there are, where they are based or who they associate with.
Jeff Dorman reminds us that crypto markets won’t be “mature” until more general investors start playing the asset rotation game. TAKEAWAY: To those of us working in this sector, the case for portfolio diversification with crypto assets seems obvious: low correlation, compelling use cases outside the fiat system, an early bet on a promising new technology… But to most of those in the trenches of portfolio management, struggling to stay on top of macro shifts and find alpha in an increasingly atomized and untethered investment landscape, investing in crypto barely crosses their minds. Part of it is both lack of digestible information and time to do the necessary digging – at CoinDesk we are working to remedy both, framing this new asset class in terms traditional investors are familiar with while at the same time highlighting how fascinatingly different it is. (And, yes, consider this a shameless plug for our introductory reports on crypto investing.)
Institutional crypto exchange ErisX published an op-ed comparing gold markets to crypto markets. TAKEAWAY: This sheds helpful light on the development of the crypto sector’s market infrastructure, and shows how the existence of a futures market makes pricing in the spot market more reliable.
Galen Moore shows that demand for DeFi lending services built on ethereum tends to move inversely to the price of ETH. TAKEAWAY: DeFi lending hasn't yet shown a convincing ability to drive adoption beyond the existing population of ETH investors.
Benedict Evans, the master of simple but high-impact presentations, is mercifully still doing his big tech scene overviews even though he is no longer at Andreessen Horowitz. TAKEAWAY: Tech evolves. So does commerce. Tech and commerce together create new consumer habits and business models. Asking the right questions is a big step towards understanding where this is going. (And I know my colleagues will echo my helpless laughter at Slide 3, trying to imagine a day when crypto gets boring.)
The Bank of England published a working paper last week, that posits that speculation in bitcoin can depress its price, not the other way around as in “normal” economics. TAKEAWAY: This is because of the limited block size – a higher demand for speculation crowds out other use cases, which diminishes the potential value of bitcoin, which will reduce the demand for speculation. Got it? Circular, yes, and it overlooks that most speculation is in derivatives these days, which don’t settle on the blockchain and therefore don’t take up any block space. So, the theory is interesting, but not very applicable.
Crypto lending interest rates are all over the place for now – but as they converge along with greater lending and borrowing demand, they hold a possible key to asset valuation. TAKEAWAY: Analysts have long decried the lack of fundamentals in crypto assets – no cash flows, no tangible backing and no interest rates. With the growth of crypto lending, that might change, giving traditional analysts a valuation tool they are familiar with. This, combined with the relatively attractive returns crypto lending currently offers, could pave the way for greater involvement by general investment funds, which will boost market liquidity and sophistication, and further consolidate lending as a firm feature of the crypto landscape.
MARKETS
Crypto custodian BitGo has announced the acquisition of security token platform Harbor. TAKEAWAY: This is a big deal which has so many threads to pull on. Here I’ll focus on the fact that, with this acquisition, BitGo will have a broker-dealer license. Sure, this means that it can not only issue security tokens but also sell them and custody them. But the part I’m most interested in is the possible emergence of a prime broker in the traditional sense of the word (in other words, not just a platform that aggregates information and re-routes trades). Next step: watch BitGo get into lending.
London-based crypto custodian Copper has raised $8 million in a Series A financing round, to fund global expansion. TAKEAWAY: One of the cited potential uses for the funds raised is the expansion into crypto trading. If this doesn’t ring bells, check out the BitGo news above, and Fidelity’s custody ambitions.
Fidelity International, a spin-off from the U.S. financial services giant Fidelity Investments, has invested $14 million in the Hong Kong-based operator of crypto exchange OSL. TAKEAWAY: This feels less like crypto platform Fidelity Digital Assets branching into Asia than it does an incumbent institution dipping its toe into crypto asset businesses.
NEW PRODUCTS
Crypto exchange Bitfinex has increased maximum leverage on its most liquid spot pairs to 5x, from 3.33x. TAKEAWAY : Leverage is something that traders have been clamoring for – this should encourage more participation and more liquidity. Yes, it increases risk, but infrastructure is improving, risk management techniques have evolved and the extra volume should bolster exchanges’ insurance funds (which we fervently hope they have). A jump from 3.33x (for most pairs) to 5x might not seem like much (in FX some desks offer leverage of over 100x), but it is over 50%. Remember how excited we got when we reported last week that Coinbase had (re)introduced leverage of 3x?
Blocknox, a subsidiary of second-largest German stock exchange Boerse Stuttgart, is expanding its cryptocurrency custody service to institutional players. TAKEAWAY: Boerse Stuttgart was one of the early incumbent entrants into digital assets, launching a cryptocurrency trading app in January 2019, and a digital asset exchange last September. It will face stiff competition with this expansion into institutional-grade custody, as a German law came into effect at the beginning of this year allowing banks to enter this new area, without worrying about regulatory repercussions. According to reports , over 40 financial institutions have signaled their intention to do so. Borse Stuttgart is likely to be a significant player in this field, given its activities across the ecosystem. It also is setting a business model example for other incumbent financial institutions, both exchanges and banks, to potentially follow.
Panama-based cryptocurrency derivatives exchange Deribit has listed daily options on ether (ETH). TAKEAWAY: I don’t know how Deribit daily bitcoin options volume is doing since the product launched last month (anyone?), but I don’t see these products eclipsing the standard expirations, no matter how much more flexible they are. Monthly and quarterly expirations are easier to hedge with futures, as this insightful piece by data platform Kaiko explains. The open interest in ether options on Deribit has increased 60% over the past month, which is a hefty growth rate, but it’s unclear which options products this growth comes from.
Source: skew.com
Binance, the largest crypto exchange in the world in terms of volume, will soon launch a digital asset trading platform that can be rebranded by smaller exchanges for their local markets. Binance Cloud will offer local exchanges spot market and futures trading, as well as local bank API integrations and P2P fiat-to-cryptocurrency exchange services. TAKEAWAY : If you thought the crypto exchange ecosystem was fragmented, you ain’t seen nothing yet. But this will spread trading and possibly cryptocurrency use, as exchanges spring up in areas that don’t have a lot of market infrastructure built up. Sure, the back-end may still be Binance, but the front end could become more diversified. This is not a bad thing, assuming local laws are respected and retail investors are protected.
CRUNCHING NUMBERS
According to charts on crypto derivatives data platform skew.com, oil is again more volatile than bitcoin. TAKEAWAY: According to Goldman Sachs , the recent spike in oil volatility is largely due to supply chain concerns triggered by the spread of the coronavirus. Bitcoin is probably one of the few industries that doesn’t have to worry about supply chain disruption – except for manufacturers of bitcoin mining equipment, I suppose.
Source: skew.com
ADOPTION
At ETHDenver last week, my colleague Will Foxley spoke to ethereum’s creator Vitalik Buterin about some of the upcoming changes to the network’s protocol. TAKEAWAY: A lot of technical stuff in here, but the important part to know is that serious work is going on in the background to improve ethereum’s transaction speed, which will increase its potential throughput and use cases.
Travelers on Norwegian Air, one of the largest airlines in Europe, will soon be able to pay for flights using cryptocurrency. TAKEAWAY: I doubt that anyone really thinks that this will move the needle on bitcoin adoption, but it is interesting to see developments like this start to hint at growing interest in the payments use case.
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| Hot on the heels of our first Quarterly Review, we have just published our first Monthly Review. We want this series to be a short and sweet selection of charts to do with some of the themes we’re looking at. Our aim is to trigger conversations and push forward further enquiry – suggestions welcome! You can download the report for free here.
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