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Sunday, September 20, 2020

A (Flawed?) Ethereum Thesis

Here's a theory I cooked up earlier this month:

 

Quick glossary for above:

  • ETH = Ethereum
  • Defi = Decentralized Finance
  • "reflexive credit cycle". A positive feedback loop between home prices and lending. Banks typically lend based on some loan-to-value ratio. Higher home values means banks are more willing to lend. More lending means more buying power, which increase housing prices, which then enables more lending, and the loop goes on.

For more information on reflexivity and credit cycles, Soros has a whole chapter on these dynamics in his "Alchemy of Finance". 


Anyways, when I heard that there's now a way to lend and borrow Ethereum (ETH), I immediately came up with the analogy. Ethereum prices can keep going up and up, because of this feedback loop!


Unfortunately there's 2 flaws to this thesis:

1) Can the Ethereum blockchain really scale?  The ethereum system is prone to congestion and result in high transaction fees. This is a well known critique of the ethereum ecosystem, with several solutions being worked on. But implementation risks remain.

Ethereum is the first smart-contract blockchain. It has overwhelming first mover advantage, and the vast majority of DeFi apps are built on top of Ethereum. 

Think of it like the Microsoft Windows operating system, on top of which you can have unlimited number of applications. There were other challenger operating systems that might be faster, more efficient, more secure than MS Windows, but having all the best apps / developers gave MS Windows an insurmountable network effect that outweighed its flaws.

Whenever Ethereum has scalability/congestion issues, newer blockchains will try to take apps and developers away from its ecosystem - perhaps through compatibility tactics. For example, Binance is launching BSC, "an Ethereum Virtual Machine-compatible blockchain ".

So there's a strategic chess game going on in crypto, much like there is among big tech platforms like Google and Apple. Ethereum has to solve its scalability issues to ensure its dominance.

 

2) DeFi lending is not real lending as argued here. 

and this thread below (sorry I keep linking to myself but as far as I know, no one else is talking about these things.)


It get's very technical if you dig deeper. The short story is that there's no unsecured borrowing and there's no maturity date. The latter means you cannot develop a yield curve that serves as a critical reference point for pricing assets.

In short, I believe the way DeFi operations are currently set up encourages speculation and scams instead of the development of a real credit market. If I'm right, then the current "lending" in crypto is not a sustainable.

If DeFi is not sustainable, then it cannot be the necessary part of the positive feedback loop that drives ETH prices higher. 


All is not lost. Innovation and progress require several waves of boom and bust. People are driven and entrepreneurial - I'm seeing new coins and new crypto systems comes up every week.

So I'm pretty sure someone will get it right one day, and crypto will have a real credit market. The feedback loop then completes itself.


Crypto 2.0:  Crypto as Collateral

And let's not overlook how big a step forward DeFi already is. 

Here's what I posted in Reddit's r/MakerDAO forum (lightly edited to provide context here):

What attracted me to Maker is its game changing paradigm of using ethereum as collateral and issue US dollar pegged money. In doing so it accomplish 2 things:

1. ethereum replaces reserves at the Fed as monetary base. That money base is now out of government control!

2. Maker moved us from crypto 1.0 ( unrealistic dream of crypto being used as money in every day transactions) to crypto 2.0 (crypto as collateral that anchors a credit system much like Fed reserves or US Treasury bonds currently do).

This is a big step up for crypto! Serving as collateral is a more feasible and more central role than money (currently there's a multitude of fiat currencies but one ultimate collateral - US treasury bonds. It also means crypto is now a cash flow generating asset - providing theoretical foundation for valuation frameworks.


Just to elaborate. Crypto 1.0 (my own terminology for the era that ended in 2017-2018 boom/bust) envisions a crypto asset such as Bitcoin or Ethereum as money - as in when you go buy a Coke at 7-Eleven, you're supposed to pay in Bitcoin instead of US dollars. That turns out to be bunk, as crypto turns out to be too slow and too volatile for transactions. 

So Crypto 2.0 evolved to have stablecoins such as USDT, DAI, USDC...etc. All these are pegged to the USD and thus can easier be adopted as money for transactions. The original crypto assets such as Bitcoin and Ethereum then can serve as collateral that generate those stablecoins. 

This is a big step forward and in fact better mirrors the real world monetary system. (footnote 1)


Does DeFi become the new eurodollar system?

Here's another question that drew me to Ethereum:  does crypto lending/borrowing create money supply, and become the "new eurodollar"? 

In the 60/70's, foreign banks began lending in US dollars and that created USD denominated deposits ("eurodollars"). Since those banks are not subject to the same regulation as US banks, the eurodollar system inadvertently created huge new supplies of USD, and that lifted all asset markets. 

The Soros "Alchemy of Finance" book I mentioned above also discussed the impact of the eurodollar market.

DeFi, with its USD pegged stablecoins, has that same potential. 


Footnote:

1. What we know as "money" are really bank deposits ("Citibank owes you $xx, you can draw that anytime"), and is separate from the "base money" that Federal Reserve creates (which is liabilities on Fed's balance sheet, but assets on Citibank/JPM..etc's balance sheets; this "base money" is in effect collateral that backs bank deposits that you and I call "money").




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