Will Governments Kill DeFi?

Date: 07/26/2021
Author: Mr. X

After almost being declared dead, cryptocurrency is in a rapid recovery. Bitcoin, “digital gold,” is once again moving towards $40,000. However, the recovery is not evenly spread across the market. Bitcoin has surged more than 11% over the last 24 hours. Yet the market generally is up less than 2%.

If Elon Musk can be blamed for sparking the initial crypto collapse, he can also be given some credit for renewing faith in Bitcoin. He recently gave an interview where he said he wanted Bitcoin to succeed. Twitter [TWTR] and Square [SQ] head Jack Dorsey is also a major booster.

Yet the real action in cryptocurrency – and the real transformative promise of the technology – lies in decentralized finance, or “DeFi.” In theory, and in its most extreme form, DeFi promises to cut banks entirely out of the financial system. Needless to say, there are a lot of people who don’t want to this to happen.

Senator Elizabeth Warren of Massachusetts has already written a letter asking the SEC to further regulate DeFi. Dan Berkovitz, commissioner at the Commodities Futures Trading Commission (CFTC), called the market “Hobbesian” and bemoaned its ability to dodge certain requirements. Of course, to many DeFi boosters, this is a feature, not a bug. However, when ransomware, cybersecurity, money laundering, and the potential to execute illegal activity or transfer funds to extremists or terrorists are major public concerns, it isn’t something that Washington is going to ignore. This isn’t simply “the Man” opposing the next big thing.

Nonetheless, as we saw with Bitcoin, the most likely scenario is that after some ground rules are laid down, we will see some minor institutional support for DeFi. This will be driven by the banks themselves. DeFi has the ability to make financial transfers more efficient, more accessible, and, by allowing the underprivileged access to banking services, more just.

There’s also a simple question of jurisdiction. Washington does not have the power to command the world crypto market. The SEC recently sued Ripple, arguing that it was using its convertible digital currency, XRP, as a security. As you might expect, you can’t simply issue securities without SEC approval. Initially, this sent XRP tumbling and put the entire cryptocurrency industry potentially in jeopardy.  However, the simple fact is that XRP is often used for cross border payments and much of it is held outside the United States. Even if the SEC’s lawsuit is successful, it might simply drive XRP underground.

There’s also some tentative movement towards accepting Bitcoin, Ethereum, and Cardano as payments by the e-commerce giant Amazon [AMZN]. Though this report is by no means confirmed, this would have a dramatically bigger impact than Tesla [TSLA] accepting Bitcoin.

Still, there is going to be a winnowing process. Bitcoin’s position appears to be safe, at least for now. Ethereum is more functional and allows applications to be built on top of it, which seems to make it the future. Put simply, Ether is a virtual currency and a store of value but Ethereum itself is a decentralized blockchain that can be used to verify smart contracts and perform other tasks.

Unfortunately, nothing is free. Ethereum suffers from relatively high transaction fees on occasion – which defeats the point of avoiding banks. These “gas fees” are one of the biggest obstacles to widespread adaptation of the network. In theory, Ethereum 2.0, which should be emerging relatively soon, will help solve this problem by switching to a “proof of stake” model. Those who have a certain amount of ETH will essentially make a financial commitment that will prevent high transaction costs.

Let’s make it simple. Ethereum, and decentralized finance more generally, could cut banks out of financial transactions and make things more efficient for everyone. However, without cutting down on high transaction costs, it’s completely pointless. The various coins simply become vehicles for speculation.

Therefore, there’s a lot of theorizing about what will be the “Ethereum Killer,” the digital currency that will be more efficient than ETH and take the #2 spot in cryptocurrency. The most likely winner may simply be Ethereum 2.0, whenever that is developed. Yet there are other candidates.

One that has received a lot of attention in the past week is Polkadot [DOT]. Through the use of what is called “relay chains,” it ensures security and is specifically designed to be more efficiently than ETH.

Cardano [ADA] is also built upon “proof of stake” mechanisms. However, it has another advantage. Because it is already set up on proof of stake, rather than proof of work, its energy usage is much lower. It’s more sustainable than Ethereum or Bitcoin. Remember, it was Elon Musk’s warning about Bitcoin’s carbon footprint that initially led him to back off from the currency.

Finally, one I’m very interested in from this standpoint is Algorand. It is carbon-negative, giving it an important ESG (Environmental, Social, Governance) advantage. It also boasts faster transaction speeds, a good research team, and more efficiency. I think it is far too often overlooked and am very excited about it. The question is whether it is simply too small to compete.

Of course, aside from Washington, there’s the other shark in the crypto pond – China. As I’ve written before, China’s state backed digital currency, the “digital yuan,” is far ahead of similar projects in the European Union and the United States. Crypto-boosters often talk about the “separation of currency and state,” but it’s hard to imagine the Chinese Communist Party being happy about that prospect. After all, one of the major factors in the recent Bitcoin collapse was the country’s sudden act against Bitcoin miners.

Still, as the American and Chinese economic orders increasingly decouple, there may be a bright side for Americans. Cryptocurrency might be the “rogue” investment in China and the more efficient choice in the West. More than anything, it’s a question of how Washington is going to handle it. My guess is what corporate America will make the choice for the politicians, getting in front of the technology and forcing the parties to play catch up.

How should investors play it? Bluntly put, there is no single way to pick which “altcoin,” if any, will be an Ethereum Killer.

However, what should be clear at this point is that the era of the “meme coin” is over. Some of these coins may gain some utility if businesses start using them as a gag (witness Dogecoin and the Dallas Mavericks). Yet ultimately, even if you just start a random token online, you run into the problem of transmission costs and gas fees.

Consider holding Bitcoin and Ethereum. From there, think about investing with what I call a “spare change” approach – a set amount of a few dollars a week in a few smaller altcoins. The key factor to look for is which coin has the best combination of efficiency and corporate adaptation.

DeFi’s potential is incredibly exciting, even revolutionary. However, for now, we are still in the speculative stage. It will take another year or two before we really start seeing this used for transactions and microlending.

The difficulties now are technical. Unfortunately, investors can’t rule out the possibility that even if the technical difficulties are solved, Washington (or Beijing) will impose political difficulties that will make using this exciting method of financing far more difficult. Keep an eye on the practical benefits to come, but don’t kid yourself that this is any different than investing in a promising small cap stock right now. There’s nothing inevitable in stocks, and there’s nothing inevitable in crypto, even when it comes to the seemingly unlimited frontiers of DeFi.

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