Reminiscences of a Coin Operator — Part II
I have referenced before one of my favorite books on markets & trading; “Reminiscences of a Stock Operator”. It chronicles the ups and downs of Jesse Livermore’s life as a trader in an era where bucketshops were the norm for ordinary folk and only very few had access to major exchanges/institutions and actual price discovery.
A lot has obviously changed since those times but, to me, the key take-away is how little of that change has really benefited the retail market participant. I would even argue that what has been gained in increased market efficiency and market access has been more than offset by the regulatory and administrative overhead of the financial services system as a whole, whether that be in trading, lending, custody, clearing, or ancillary fields such as accounting, rating, administration, etc.
Where software and automation have transformed most industries, in TradFi the change has been mainly on the front end (the user interface) as opposed to at the middleware & settlement layers. Users can pay for stuff and swipe left or right to buy their favorite memes/securities using convenient apps such as Robinhood, Venmo & Paypall right from their smartphone, but the settlement of these transactions is still a legacy system (FedWire, centralized clearing houses, COBOL mainframe databases, and CUSIP numbers). And in many cases, the big institutions are the ones profiting the most from these apps and the data they produce. Just as Jesse Livermore discovered long before, being a market maker and custodian for the average Joe is where the real money is at.
Similarly, bank intermediation of credit creation results in unequal access to credit favouring those credits that suit the bank’s capital adequacy ratios and regulatory preferences. The relationship between the yield on the banks’ credit portfolio to interest rates on savings/deposits remains opaque at best and that’s before you factor in the leverage that the average bank uses to boost the returns on their lending book… Most of which is spoken for by regulatory & compliance costs, bankers’ remuneration, and dividends to shareholders.
Today, stablecoins offer a largely dollar-denominated, non-yield-bearing base asset for the crypto ecosystem. Stablecoins in other currencies (EUR, JPY, GBP & CHF) are being experimented with, but their liquidity remains relatively low for a multitude of reasons, and we are also slowly seeing the introduction of yield-bearing variants. We have long believed that although the Digital Asset Ecosystem (DAE) has many use cases, decentralized & permissionless money is the “Killer App.”. “Solving” the many issues that decentralized & permissions money represents to the traditional system will be the determining factor in crypto adoption.
The lack of regulatory clarity and difficulty in integrating stablecoins with TradFi has resulted in structural usage limitations for the existing variants. These headwinds notwithstanding, their adoption has been nothing less than stellar. Showing just how keen the world is on permissionless & decentralized money, US dollars in particular!
From the pioneering steps by companies/projects such as Tether, Circle and MakerDAO, I believe we are on the verge of step-change in the adoption of stablecoins as a new generation of projects addresses the structural limitations of the past and regulators & industry participants work together to forge a way forward that works for all. Listening to some of the thought leaders in the space such as Jeremy Alair of Circle and Luca Prosperi of M^O, I think the trade-offs are starting to become more clear and this enhanced clarity makes me very exited about what lies ahead.
Fully collateralized vs. Fractionally reserved. Todays stablecoins mostly portray to be fully and/or over-collateralized. Besides this being relatively capital ineffiecent, there has also been persistent regulatory pushback to fully reserved banks/initiatives in the US, hence a lot of stables choosing other jurisdictions. That said, it is becoming increasingly clear that fractionally reserved bank deposits pose increasing risks in the digital age (where they can be moved at the touch of a button 24/7/365), as was recently seen in Silicon Valley Bank collapse. Separation of high-velocity, fully collateralized “money” from fractionally reserved credit creation appears to be a logical answer, however difficult that is for TradFi to accept.
Centralized vs. Decentralized. Money creation is facilitated by commercial banks in today’s world. Banks are mostly private institutions that subject themselves to centralized regulatory oversight for the privilege of being allowed to borrow money into existence. That said, the whole idea is for banks to provide an “airgap” between the public’s financial affairs and the Government. Given the way bank regulation (KYC & AML) is progressing, I would argue that “airgap” function has ceased to exist and/or has become somewhat perverted. And that’s before I get started about CBDC’s…Clearly, the TradFi pendulum has swung too far in the direction of centralization, and some grassroots decentralizing countertrend is urgently needed to reduce systemic risk and regulatory overreach.
KYC, AML & Blacklisting. The Tether and Circle on/of ramps are centralized and only available to institutional and/or fully KYC/AML vetted parties but the stablecoins they issue can be sent/received/stored permissionlessly by anybody with a wallet…There are however backdoors that allow Tether and Circle to freeze and/or blacklist tokens/wallets and even though these functions have only been put to “good use” to fight actual criminal activity (justifying their existence), it would appear to be preferable if we could do something a little more decentralized / democratic than a centralized “kill switch” without governance or accountability regarding its use.
Yield bearing. The two largest stablecoin issuers currently retain all the yield generated on the collateral they hold against the stabelcoins they issue. Although this makes for great business and minimized regulatory attack surface historically, there are now numerous yield-bearing alternatives, and it is our contention that stablecoin regulation will unleash competitive dynamics that will force issuers to “share” the underlying yield with users.
Public vs. Private. Just like most money is created by private commercial banks today, we believe that decentralized money should also not be issued/distributed by centralized authorities and/or Governments. As China’s CBDC project (probably the most advanced in terms of roll-out) is already showing, people have a strong preference for non-centralized and more private money on Tencent’s or AliPay’s apps/wallets than eRMB in a Government controlled wallet/app. The power of digital ledger technology should be used to build better alternatives to opaque bank balance sheets, not to police usage and/or subvert privacy.
If you squint your eyes and step over the obvious hurdles some of the above conclusions pose for the existing TradFi system and/or weaker currency-issuing countries, you can see a bright future where fully collateralized, yield-bearing, high-velocity money can be issued against eligible collateral in a compliant, transparent and verifiable manner by either private parties or decentralized protocols. Given where we now are with block-chain scaling solutions and what will come in the near future, this can easily and much more efficiently facilitate global transactional flows and obviate the completely opaque “offshore” or “eurodollar” market in favour of something completely transparent. It would end the need to keep liquid reserves in the form of bank deposits in highly levered fractionally reserved local banks, it would end the Balkanisation through different monetary networks (SWIFT, SEPA, Credit Card networks) and would allow seamless/permissionless global access & payments for all.
Stablecoins thus have the power to revolutionize global payments, savings and credit creation. As competition forces stablecoin issuers to share the yield on the underlying asset portfolios and they find innovative, regulator approved/compliant and transparent (non-fractional reserve dependent) ways to generate and share such yields with their respective stablecoin holders, their economic attractiveness will increase, which in turn will drive adoption. We saw this in practice when MakerDAO began to explore sharing the interest from their RWA activities with DAI holders, once this trend is confirmed and regulators provide necessary clarity the competitive nature of the industry will force others to follow suit and attract more competition.
Ultimately it will be the denomination ($ vs other currencies) and the yield on the assets backing the stablecoins will set them apart from CBDCs (if they ever come). CBDCs will have to choose between being un-backed, so they are useable & transferable but without inherent value or yield (like FIAT cash), or linked/backed in an algorithmic manner to government debt securities thus curtailing endless QE going forward. The latter could compete with stablecoins as transferable and composable money-market instruments but my guess is they will fail to put a hard algorithmic cap on QE.
The composability of stablecoins lets their owners be their own bank in making their own decisions on how to use their stablecoin balances to generate additional yield (over and above the underlying yield on the assets backing it) through liquidity mining, providing leverage to others via lending protocols or other on-chain activities. What’s more, as there is no fractional reserve in a stablecoin issuer like Circle or Tether and the liability side of the balance sheet is fully on-chain, there remains only the asset side of the balance sheet that needs monitoring/regulating. When you hear Jamie Dimon reeling against cryptocurrencies (coping), just know that he understands what a game-changer this would be in terms of ending regulatory capture and the banks’ hegemony.
Lending protocols will perform the function of banks in a fully automated and transparent fashion with minimal rent-seeking or overhead and real-world assets whether already securitized or private will be brought on-chain through intermediaries such as Florence Finance, GoldFinch, TrueFi, Maple, and many others, thus decentralizing the actual creation of credit.
Lastly a word on regulation. The on-chain world was expressly built to be “permissionless” and it is imperative it remains so (shout-out to Erik Voorhees and his thinking on this topic). I believe “permissionless” is often misunderstood as “without rules” or “ungovernable” but in fact, it is quite the opposite. It poses no limit on setting “rules of engagement” as long as they are the same for all and enshrined in code as opposed to arbitrarily determined by centralized institutions and regulators. What is important, is that people are treated equally and free to come and go as they please, whereby the ability to leave (i.e. opt-out without permission) is as important as the ability to join and participate.
It should be very apparent that the ability to monitor and regulate is obviously vastly improved through most digital ledger / blockchain technology. Rather than this being directly dystopian, I believe the permissionless aspect will force a more nuanced discussion as to the balance between the “art of the possible” and what is necessary/desirable from a regulatory oversight perspective. Indeed it will also force a re-evaluation as to who is responsible for such regulatory oversight (self-custody vs. custodial services). This ongoing journey of discovery that is the DAE today and the ability to implement/experiment with it incrementally and transparently will be a vast improvement over banks and government regulators debating these matters behind closed doors in the absence of either the tools for implementation and the public’s ability to opt-out to keep them honest.
The future is bright, the future is on-chain!
