SPOILER: I Don't Have The Answer
I know a few people who have become very rich-- very, very rich-- by gambling on bitcoin, including Adam, the very first DWT art director. I'm more an investor than a gambler and I never quite grokked crypto, so I generally stayed away, although, for a lark, I made a small buy and got out of it when I quintupled by money. But that wasn't anything that's going to change my life.
Roland keeps moaning about having missed the huge opportunity and how he could be rich... if only he had... Well, the opportunity is knocking again. Bitcoin has sold off dramatically-- plunging from $70,000 a coin in November to $35,000 now, outpacing the stock market downturn significantly. It dropped 9% just yesterday. I think there's room to go down further. Yesterday, Tory Newman and Rachel Siegel reported that "The sell-off accelerated a two-month slide in the global cryptocurrency market that has vaporized $1.4 trillion in value: After reaching a high of roughly $3 trillion in early November, the total value of digital assets sat just above $1.6 trillion early Saturday afternoon, according to CoinMarketCap."
Vocal supporters of bitcoin and other cryptocurrencies suggest they have the potential to transform finance and are pushing for crypto to edge further into mainstream use as a store of value or a payment alternative. But many people are buying-- and, increasingly selling-- crypto as a speculative bet in hopes of turning a quick profit.
The latest crash is demonstrating the perils of the approach, just as millions of Americans have joined the digital gold rush in recent months.
Backers of bitcoin in particular argue its value lies in its limited supply-- the network behind it will only mint 21 million of the tokens-- suggesting it should serve as a safe place to park money during times of high inflation. But prices are rising across the economy at their fastest clip in 40 years, putting the thesis under strain. To combat this, the Fed is preparing to raise interest rates, leading many investors to pull back.
The stock market sell-off has been pronounced and attracted the most attention in recent days. The Dow Jones industrial average fell 3.9 percent for the week, while the broad-based S&P 500 shed 5.1 percent since Tuesday. The tech-heavy Nasdaq composite index fell 6.2 percent this week. But instead of investors pulling money out of the stock market and piling it into bitcoin, the pullback from crypto has been even faster.
“You’d think with the inflation we’re seeing, you’d see the opposite,” said Bob Fitzsimmons, the executive vice president for fixed income, commodities and stock lending at Wedbush Securities. “That’s been one of the selling points for bitcoin, so its correlation to stock prices has surprised me.”
Last week, Ming Zhao, an ex- Wall Street quant and cybersecurity whitehat, writing for Noah Smith's substack, gave a quick course in decentralized finance (DeFi) that you should read before even thinking about putting any money into crypto. Her post is a a short, fun history of how the crypto world has changed since the big bubble and crash of 2017. It even has a section explaining crypto memes! It also answers Noah's basic question about what DeFi is financing. Apparently it appears to be "the crypto sector itself"-- crypto startups, crypto trading, and crypto asset management. She offered, for those new to crypto or just playing catchup, <https://noahpinion.substack.com/p/a-defi-crash-course-for-normies-crypto>a 5 minute crash course on everything that's happened in DeFi<> since the great 2017 crash:
At First It Was Just A Pipedream
“DeFi” is Born: stablecoins & AMMs
Solving Scalability: L2s, proof-of-stake, Solana
Solving Liquidity: accelerating institutional adoption
DeFi Summer: lending, liquidity mining, liquid staking
IT’S ALL ABOUT THE DANK MEMES
Some Speculation on the Future of DeFi
1. Crypto Pipedream in 2017
Let’s start real OG. Here’s what the crypto landscape looked like in 2017: there was Bitcoin (“digital gold”), Bitcoin pizza, Ethereum (the platform on which people wrote logic to build apps like kittie-trading). And that was pretty much it.
“DeFi” wasn’t a thing yet 🤯. We had speculators, market makers, and centralized exchanges (Coinbase, Gemini, Mt. Gox… RIP). But we pretty much lacked every other practical ingredient to build a new financial system from scratch. Like: (a) scalability greater than 15 transactions per second, (b) reasonable transaction costs, (c) stable assets, (d) liquidity bridging, (e) lending markets, (f) institutional buy-in, (g) hedging markets… and the list goes on.
To quote @arjunblj, “It’s not worth reflecting on this bygone time further; thank you to the early builders who got us here.”
2. “DeFi” is Born: stablecoins & AMMs
What happened next? Barely four weeks went by in 2018 before BTC plunged 65%. “It’s the Chinese government’s fault!” said some people. “It’s the reflexivity of fear and greed!” said others. Well ya sure but the 800-lb gorilla in the room was still how f***ing useless the entire crypto ecosystem was, except to buy drugs & Bitcoin pizza. No wonder markets got paper hands 🙄 🧻🤲.
To become the new financial infrastructure of the future, at the very least it needed some functional money markets. And thus began the stablecoin race: a prolific epoch to create the default stable base currency.
Initially people thought, “Let’s just peg some coin to the dollar! For every $1 in as collateral, we’ll issue 1 stablecoin out.” 👋Tether. 👋USDC.
But this solution was not true to the OG ethos of decentralization because requiring reserve pools in dollars meant we’d be standing on the crutches of our broken existing system rather than ripping-and-replacing. Plus a single entity (read: single point of corruptibility) would have to manage that collateral.
As an alternative, Basis Protocol said “Let’s make an algorithmically-pegged stablecoin not tied to any collateral! The protocol will mimic a central bank: automatically mint more stablecoins when the price rallies above $1 and automatically burn supply when price dips below $1.” Unfortunately the Clayton administration killed Basis.
A year later, however, Clayton reversed his austerity, and many new decentralized stablecoins emerged: DAI, AMPL, UST, etc. In the wake of so many algorithmic stablecoins, people thought “Hm, centralized exchanges are not true to our ethos either! Let’s algorithmically run our exchanges too!” Unfortunately the first Dexs (decentralized exchanges) immediately ran into ETH scalability limits.
It was impossible to maintain full order book data on-chain so the traditional market-maker quoting setup just didn’t work. That’s when Uniswap (inspired by this Vitalik reddit post and this blog post) said, “Well since price is related to supply, let’s just make price literally a function of supply– i.e. automatically derivable– and get rid of the need for market maker quoting. We’ll tell people to inject funds into a two-sided swap pool (e.g. ETH-USDT) and when the market favors asset X over asset Y, they’ll remove more volume from X, driving up the relative price of X according to x*y=k.” And so the world’s first AMM (“automatic market maker”) was born.
It sounded so simple and great. No order books necessary.
But slippage was a huge issue, especially for huge orders, where ultimate fill-price often deviated >3% from displayed price. So execution-sensitive market makers across the board decided they would stick to “CLOBs” (centralized order book exchanges) for trading the major coins and use AMMs only to trade “altcoins” (like SHIB and OHM) not listed on CLOBs.
There was no viable workaround to the computationally heavy CLOBs problem, it seemed… until late 2019.
Enter L2s and Solana.
3. Solving Scalability: L2s, proof-of-stake, Solana
One way to solve scalability was to fix “ETH classic” (the original proof-of-work protocol) via performance-improving techniques like batching, sharding, and data compression. “Instead of running crazy CPU-frying mining algos on-chain, one transaction at a time, let’s aggregate orders off-chain, process them in batches, then only write summary data back on chain” said developers.
So they made several aggregator chains on top of ETH, collectively called “L2s” or “Layer-2s”. These L2s used two main methods of validation: (a) “Optimistic ETH” – where the system would initially trust all written transactions to be valid, then reward its users to constantly scalp around for fraudulent history, and (b) “Zero-knowledge/ZK Rollups”– where the system would ask its aggregators to generate proofs for each batch-write operation, then have to check the validity of the proofs rather than of the original transactions.
But regardless of method, a modification on proof-of-work was never going to reach the hundreds of thousands or even millions of TPS (transactions per second) necessary for the day full-fledged crypto adoption replaces traditional finance.
The second and only true solution was to rip and replace proof-of-work (PoW) with proof-of-stake (PoS). By mid 2019, Solana launched as the first “faster than Visa” PoS alternative to ETH. Suddenly execution costs dropped from $20-70 per transaction on ETH to $0.00025 per transaction on Solana, while network throughput expanded from 15 TPS to 65,000 TPS. Ultimately, on a 40GB link Solana TPS could reach 28.4 million. In other words, for the first time ever, DeFi markets now possessed a network infrastructure capable of processing a full fledged global exodus from traditional finance.
This was a major turning point in crypto history. Nay, in financial markets history. Finally DeFi was more than a pipedream. Finally it was institutionally accessible
4. Solving Liquidity: accelerating institutional adoption
Below is a graph showing institutional adoption through 2020, overlaid over the price of BTC.
At the last peak in Jan 2018 the total market cap of crypto – i.e. all the crypto money in circulation-- stood at $770 million. Today that number is $2.6 trillion! The most significant driver of this growth has been institutional onboarding. To highlight a few OG crypto-native market makers: Alameda Research now trades >$5B in cryptos daily, GSR trades >$4B daily, Genesis Trading’s institutional lending desk processed $36B loans in Q3 2021, etc… Their success caught the attention of “traditional” big market makers: Jump Trading, Tower, HRT, Susquehanna, Jane Street, and the latest addition as of Jan 11, 2022... Cita-last-straw-del.
“But why do we want institutions in DeFi?” you may wonder. “Isn’t the whole point to decentralize and give power to the people?”
Yes. Of course. But 1) markets need liquidity and 2) what does it actually mean to give power to the people? It was never the existence of hedge funds and banks in traditional markets that was the problem. It was that traditional markets rigged the game, giving hedge funds and banks hidden privileges and special access totally unknown to retail traders.
Like the fact that non-accredited investors <$1M net worth can’t invest in startups or buy secondaries in private deals. (Whereas, anyone can buy any crypto project’s token in DeFi.)
Like the fact that if retail traders wanted to buy options or oil futures, the minimum trade size is 100 shares’ worth and 1,000 barrels’ worth, respectively. (Whereas, assets trade in infinitely fractionable increments in DeFi.)
Like the fact that retail traders can’t directly market-make on the traditional exchanges: CME, NYSE, NASDAQ, etc. (Whereas, on crypto exchanges like FTX, Binance, Coinbase, etc. retail traders can quote and execute trades programmatically using the exact same APIs as professional firms.)
If DeFi is our second chance to build a new financial system free of structural biases and bureaucracy, then we need to massively accelerate institutional adoption to get there.
Three ways that institutional activity directly lifts crypto markets:
It increases liquidity, which means tighter spreads, lower slippage, and huge executional improvements.
Each new initiate injects huge chunks of capital into the system, many billions in lifetime value (e.g. when Microstrategy bought 125,000 BTC, now worth >$5B).
It creates memes and marketing (e.g. when SBF rekt Coinmamba over $SOL at $3; when Su Zhu pumped/pumps $AVAX).
Three ways that institutional activity indirectly lifts crypto markets:
Wild returns from market inefficiencies continue to lure the biggest IQs from TradFi to crypto (e.g. Jane Street = “HR department at FTX”?)
Market makers continue to be the biggest bootstrappers of new DeFi projects (e.g. Alameda is the biggest liquidity provider for Serum, QCP is the biggest liquidity provider for Ribbon Finance)
Funds trading market-neutral strategies (e.g. basis trade) must constantly borrow assets, pushing up lending rates which trickle down to retail in the form of “juicy yields.”
And speaking of juicy yield…
And that's where you need to go directly to Noah's blog and continue the learning experience-- including the fun part... like this:
My two cents: in the end, this is still gambling, not investing and unless you can afford to lose all of what you put into crypto... don't buy the tulip bulbs.