A Fork in the Road

With the exception of the UST de-peg event that initiated the present chain of events in digital asset markets, one common thread has been the vulnerability and abuse of centralized players. While the most recent down leg is yet to play out, I believe that the DCG / Grayscale / Genesis Trading triad, which appears to have sometimes included 3AC in the mix in a ménage à quatre worthy of the FTX management team, will probably land the most devastating blow yet given the multiple OTC deals originated by the Genesis Trading derivatives desk. I do not agree with Warren Buffet that derivatives are weapons of mass destruction in all instances, but there does seem to be one heck of a collection of primed tactical nukes under the bed here. These bilateral deals between various concentrated, centralized players could be highly damaging on two counts: by bankrupting even more buy-side institutional traders already in trouble due to positions stranded at FTX, and by wiping out remaining liquidity. The lack of transparency around counterparty risk that comes of these OTC deals means nobody really knows who is exposed, and absent information, most healthy traders and market makers will probably roll up the shutters until it’s over.

“Other than that, Mrs. Lincoln, how was the play?” Sigh.

In the last week or so I have been thinking a lot about the implications of all this, not just for Cloudwall’s specific work on digital asset risk, but more broadly for the industry. I think it is clear that centralization and large unregulated markets are fundamentally incompatible: to the degree that we have institutional risk-takers involved in complex, opaque deals and retail investors exposed to the consequences of fraud and contagion, eventually calls for investor protection from both politicians and regulators will lead to regulation. More broadly, regulation tends to follow market failure: it may not always do a good job at it — and sometimes makes matters much worse by encouraging rent-seeking and regulatory capture — but the idea at least is that when the market structure cannot self-correct, a finger on the scale may be necessary. That may take the shape of backstops like FDIC and SIPC or trade surveillance and bank exams, but I expect the calls for “something has to be done” will be answered with a “something” more like a hammer than a scalpel.

So it’s worth asking: who wins? Well, if you are wondering who is very well practiced at maneuvering in highly-regulated markets and you think the answer is a 30 year-old MIT wunderkind with questionable Excel skills and tragic hair care choices, try again. The established exchanges, broker-dealers and banks, including the FCM’s that Mr. Bankman-Fried was trying to punk not that many months ago, have spent almost 90 years (at least in the U.S.) learning how to navigate this. In my mind this means that to the extent centralized crypto survives, it will be dominated by traditional finance. Whether that means M&A or waiting for the centralized exchanges and crypto broker-dealers to go bust and scooping up the staff and the clients remains to be seen, but I just do not see a world where the crypto natives with giant holes in their balance sheets and credibility build the necessary compliance organizations, risk culture and technology quickly enough to compete with the incumbent regulatory land sharks.

Satoshi must be spinning in their grave right now. It was not supposed to end this way.

Over a year ago now I thought about what might happen if DeFi were to become institutionalized and ultimately replace the fabric of finance, and that chain of thinking eventually became Cloudwall. I know what you are thinking: “a band of degenerates aping into airdrops on protocols with TVL slightly less than the annual transaction volumes of an ATM in Times Square and the capital efficiency of a bonfire in a bank vault? These guys? Seriously? This is who we need to rely upon to save the day? Sweet Christ, I felt better when you were suggesting that the answer was a takeover by the banks. Can we all just install our retail CBDC wallets, put a gun in our mouths and go shopping?” But hear me out. It’s not like you have anything better to do while the courts process FTX’s bankruptcy claims.

Not long after the FTX crash, I spent part of a Sunday afternoon reading Vitalik Buterin’s paper on Soulbound Tokens (SBT’s) and Decentralized Society (DeSoc). If you missed it back in May because you were too busy following the FTX/CFTC debate referenced above, read it. It is absolutely bonkers: grand, Utopian, arcane and way more important than SBF and the FCM’s getting into a pissing match over real-time margining. This section keeps coming back to me:

Whereas DeSoc has possible dystopian scenarios to guard against, web2 and existing DeFi are falling into patterns that are inevitably dystopian, concentrating power among an elite who decide social outcomes or own most of the wealth. The direction of web2 is deterministically authoritarian, accelerating the capacity of top-down surveillance and behavior manipulation. The direction of today’s DeFi is nominally anarcho-capitalist, but is already falling into network effect and monopoly pressures that risk its medium-term path becoming authoritarian in much the same way.

It spoke to my own fears that technologies designed with a noble purpose will get used to make a more efficient & effective tyranny. What was radical about the ideas behind blockchain and then Web3 was that it tried to rethink trust in society. And counterparty risk and everything that has gone down in the last year at the end of the day is all about mis-placed and even blind trust. Sequoia must have done their due diligence on FTX, right? Grayscale is a money-spinner, I am sure those related-party transactions with Genesis Trading won’t come to a bad end, right? Those nice boys at 3AC need to get another hit from the leverage bong, why not make the next loan from Celsius un-collateralized? And on and on.

What if trust could be calibrated and conditional? What if we could set the dial on what we reveal vs. what we conceal, and make these choices visible to others so they could decide? In short, what if, rather than overcorrecting for the market failure by repeating the same regulatory patterns for centralized finance that we have been trying to make work for 90 years, we decided to change the market instead? This is why DeFi is important, and this is the fork in the road: from here on out, there will be two experiments in crypto. One will attempt to apply those same patterns, and this game will be played and won by traditional finance. Stablecoin issuers will get bank charters; the likes of Genesis Trading will get folded into investment bank trading desks, as will the prime brokers and lenders; the centralized exchanges will confront behemoths like ICE and LSEG, and lose. And because legislators and regulators are conservative and just got their fingers burnt by SBF, they will wave through only a limited number of tokens for listing and only a very narrow range of innovative models. Tokenized cash like USDC: OK, maybe; algostables: not a chance.

Where will the liquidity and lending for that long tail of tokens go? This will be the second experiment. As we have already seen, the less liquid tokens will transact primarily on the DEX’s, only more so: “less liquid” may encompass almost everything other than a handful of blessed tokens. Innovation will also happen here, in the second fork in the road. Algostables, on-chain exotic options, decentralized asset management and roboadvisors, new models for SBT-based under-collateralized lending: those experiments, already started, will continue on DeFi. And because it’s small and quite frankly weird, hard to understand and difficult to disrupt, and its transparency at least means everything going on is at least visible, it will probably continue to tick over in that way for quite some time. It will be tolerated. While conservative, no legislator or regulator is entirely immune to considerations of innovation and geopolitics: nobody wants the jobs of the future to happen somewhere else. So, just in case they are onto something, the Degens will get some small space.

And along the way, some interesting things are sure to happen. The challenges of on-chain institutional custody will get solved. Ways to represent off-chain and on-chain data for decentralized identity and trust will be worked through with soulbound tokens or something else, and this will start to draw in institutional traders who might have been concerned about KYC/AML issues in shared pools. There will likely be a robust debate about privacy on-chain and MEV, with some creative solutions employed to selectively disclose information while still making transactions private by default. Once this really gets rolling — and let’s be clear, this is not in 2023 — the buy-side is going to realize that this whole ecosystem has a really interesting property: not only does it lack cup-dipping intermediaries in the flow of capital, but it has a solution to the problem of trust that has not been seen before, and thus has a chance of having less systemic risk and being more stable and fair. In other words, denizens of an inevitably dystopian world will look over the wall at a possibly dystopian one and say what many a trader has said over the years: now that seems worth a punt.