Summer Vacation
I thought this would be a good time to get some thoughts down since we’re back in the neighborhood of the price levels that were seen around my last post in late May (well, at least ETH is). Quite a bit of drama has transpired since then as leverage continues to get wrung out of the system, in part due to CeFi retail lenders not appreciating the degree of their asset-liability mismatch and the Three Arrows Capital debacle.
Fat Tails
That brings me back to an observation that I made in May: DeFi protocols have pretty much worked as designed through the deleveraging process. In some ways, that’s a bit of a red herring because most DeFi uses overcollateralized lending methods which have allowed for more orderly liquidations, whereas the CeFi-related blowups we’ve seen largely have involved under (or “UN”!) collateralized arrangements. Leaving that aside for a moment and assuming under collateralization generally is figured out by leading protocols, there is a fun thought experiment somewhere in here that involves TradFi businesses running on composable and transparent DeFi rails.
Despite the casino, bad actors and how over-hyped crypto is/was, would DeFi protocols, perhaps counterintuitively, actually reduce the tail risk and speculation inherent in financial markets? Would that be a good thing for capitalism? If Three Arrows’ lending was on-chain, would things have turned out different for them? What about the 2007-08 GFC?
Experiments in running a sustainable crypto business
Novel idea, I know, but we may be seeing glimpses of this from the more established DeFi protocols. Two quick examples:
Uniswap is experimenting with turning on their “Fee Switch” feature for a period of six months, which will take a small slice of the fees already being paid to liquidity providers. TBD on how the DAO would utilize the money if it were to be flipped on permanently. The proposal is here and take note of the comment from Jeff Amico of a16z on potential regulatory implications - revenue, decentralized protocols and tokens add up to another hurdle to clear on top of defending your business model.
MakerDAO, which may be the most successful and longest running DeFi experiment of them all, is trying to figure out new revenue streams now that stablecoin lending has hit a brick wall (MakerDAO treasury data via Dune). One avenue that is being explored is onboarding real world assets to their balance sheet. Huntingdon Valley Bank recently announced their intention to open a $100m line and, just the other week, the crypto-native investment firm BlockTower Capital, submitted a proposal for a $150m facility to fund short duration credit assets, such as trade financing securitizations. I’m still trying to wrap my head around what’s in it for these real-world lenders - lower cost of capital? Operational efficiency? Fun?
Both experiments have the potential to establish business model patterns for other protocols to leverage in the future. Maker, for example, could become a “money center” bank for crypto protocols that are looking to diversify DAO treasury assets.
As if this couldn’t get any harder
Yesterday, the US Treasury sanctioned Tornado Cash because of its use by hackers in various heists. This essentially boils down to the decades-long tension between digital privacy rights and law enforcement, but for DeFi, it could be a landmark event. Literally overnight, businesses and protocols started blacklisting Tornado Cash addresses:
The US regulatory environment has been undefined for some time so perhaps this starts to draw some lines in the sand that indicate what the government will be working towards. For real world use cases, it probably means that AML/KYC eventually becomes requirement, which ironically could give more comfort to institutions who have been waiting to get involved.
Do the decentralization maxis lose here? To some extent their worst fears have come true, but anyone pushing for mass-adoption and crossover applications in the real world have been kidding themselves if they thought governments would simply look on as hundreds of millions of dollars were laundered through Tornado. One thing is certain: cypherpunks will always have a place in the digital world, innovating in privacy and decentralization technology.