When we are thinking about where the worlds of Bitcoin and cryptocurrencies, “smart” “contracts” and distributed ledgers will go, it can be helpful to find historical analogies that can provide a shared narrative to facilitate communications between stakeholders and provide foundations for strategic planning. But it’s important to find the right analogies and, even more importantly, to derive the right lessons for them. For example: people discussing Bitcoin will often refer to the famous “tulip bubble” in 17th century Holland. But if you study this episode, what you discover is not a mass market mania but speculation by a small group of rich people who could well afford to lose money. And you will also see the creation of a regulated futures market that played a role in the financial markets that created Dutch golden age which meant that within a few years, balances at the Bank of Amsterdam became a pan-European currency and as noted in an interesting paper from the Atlanta Fed last year, the florin (the unit of account for those balances) played a role “not unlike that of the U.S. dollar today”.
I am very interested in learning from a) history and b) smart people so I set up a room to discuss the topic on Clubhouse. (I have to say this transformed my view of Clubhouse, because I was blown away by the quality of the discussion that ensued and how much I learned in such a short time. Truly, arguing with smart people is by far and away the fastest way to acquire actual knowledge.)
A similar event, Britain’s 19th century railway mania, was the subject of some discussion in this room. I agree with Nouriel Roubini and Preston Byrne’s observation that that the cryptocurrency mania of today “is not unlike the railway mania at the dawn of the industrial revolution in the mid-19th century”.
(If you want to read more about this, I wrote this detailed article about it a couple of years ago and in fact noted a decade ago for Financial World magazine about the incredible scale of the mania. The first railway service in the world started running between Liverpool and Manchester in 1830 and less than twenty years later the London & North Western railway had become the Apple of its day, the biggest company in the world. This boom led to a colossal crash in 1866, which in turn led to a revolution in accounting and auditing.)
My good friend Maya Zahavi, drew the parallel between railway mania driving the introduction of accounting standards that led to new global capital markets in Victorian times (which in turn led to new kinds of regulation and institutions) and the world of decentralised finance, “defi”. I think she is right. I have long held the view that while cryptocurrencies themselves may or may not have a future as money, the evolution of digital assets that are secured by the underlying networks (“tokens”) points towards new services, markets and institutions that may well lead to a better financial sector. This general view, that digital assets (“tokens”) are where the future will be forged, was reinforced earlier by a new paper published in the Federal Reserve Bank of St. Louis Review in which Fabian Shar explores the evolution of markets based on these new instruments that sit on blockchains of one form or another. He looks at three models for “promise-based” tokens: off-chain collateral, on-chain collateral, and no collateral.
-
Off-chain collateral means that the underlying assets are stored with an escrow service, for example, a commercial bank. There are also several examples of off-chain collateralized stablecoins. The most popular ones are USDT and USDC, both USD-backed stablecoins. They are both available as ERC-20 tokens on the Ethereum blockchain. DGX is an ERC-20 based stablecoin backed by gold, and WBTC is a tokenized version of Bitcoin, making Bitcoin available on the Ethereum blockchain.
-
On-chain collateral means that the assets are locked on the blockchain (in a smart contract).
-
When there is no collateral, counterparty risk is at its highest. In this case, the promise is entirely trust-based.
On-chain collateral has several advantages. It is highly transparent, and claims can be secured by smart contracts, allowing processes to be executed in a semi-automatic way. A disadvantage of on-chain collateral is that this collateral is usually held in a native protocol asset (or a derivative thereof) and, therefore, will experience price fluctuations.
The trading of digital assets, if it were to take place in the existing market infrastructures, would be interesting enough. But this is not where we are going. We are heading into the defi era where there is an impending explosion of business models, institutional arrangements and transaction complexity which, when it settles, leave us with a new financial world. There are good reasons to welcome this: defi offers the promise of much reduced costs in financial intermediation by both removing middlemen and automating them, it opens up the possibilities for new financial instruments better suited to the new economy (instruments built for bots to trade, not for people to understand) and (and most importantly, as I wrote previously in Forbes) and more transparent market with accountability as part of the infrastructure.
This, I think, is the narrative that I find most plausible. But what are cryptocurrencies “paving the way” for? I think it is for cyryptomarkets that trade in cryptoassets: cryptocurrencies with an institutional link to real-world assets. These are markets made up from money-like digital bearer instruments or, for want of a better word, “tokens”. As I have written before, it is not the underlying cryptocurrencies that will be the money of the future but the “tokens” that they support. As the St. Louis Fed’s paper concludes, and as I wrote here in Forbes in January, defi may potentially contribute to a more robust and transparent financial infrastructure. In the long run, I think this is (and the lessons from history are clear) will be much more important and lead to much greater structural change (and therefore opportunities) than cryptocurrencies.
Snippings 