Public Blockchains, Bitcoins and DeFi
The ARK Invest Best Ideas 2022 analysts team is optimistic in general, but the tone is definitely even more positive in the analysis of Blockchain, Bitcoin and DeFi, forecasting revolutionary changes with spectacular valuation gains to be had in less than ten years, with the belief that these technologies will free people from the restrictions imposed by government regulations while operating in a trusted, open decentralised network:
“Public blockchains are powering novel forms of coordination across money, finance, and the internet. By decentralizing institutions with open-source software, blockchain technology minimizes the need to trust centralized authorities”.
“We believe bitcoin is the most profound application of public blockchains, the foundation of “self-sovereign” digital money. The Bitcoin protocol has enabled two other revolutions: The Financial (DeFi) and Internet (Web3) Revolutions”.
The assertion that blockchain minimizes the need for trusted centralised authorities deserves scrutiny because the way trust is protected and sustain has an impact on the cost of transactions and the level of government interventions. Trust is always needed; without trust markets cannot function. Can trust be built without a central government authority? What about just authority or a small group of highly respected authorities in the field? Trust is built on the basis that system participants know implicitly the system works as expected and every participant receives the same outcome and treatment in identical circumstances and input.
Perhaps the real meaning of ideal decentralisation expressed in Best Ideas 2022 report is the absence of government control, which is not to be trusted because its power is susceptible to corruption and abuse resulting in the erosion of liberties, and ultimately in inefficient economics.
In reality, trust always needs some form of authority acting as a guarantor, but that authority doesn’t necessarily have to be the government. Trust requires unambiguous rules and capability to gather information about the system’s current state. This information is accessible, based on facts that inspire confidence the system works, and when it doesn’t, the authority (or authorities) have the ability to promptly rectify the errors. That is in itself an asymmetric distribution of power, due to the centralisation of influence. The key to a benign and impartial network is to have a transparent authority accessible to all participants that requires a small maintenance tax. That tax is the cost of doing business. The assertion of this report that these financial networks are trusted relies heavily on the technology component of the blockchain universe, as if that alone guarantees trust and thus there is no need for any dominant authority to control the system, especially not the government. This is illustrated in the diagram below, where the Bitcoin’s underlying blockchain technology is seen as the solution to the issue of transfer settlement and custody. Does that work in real life?
As public blockchains are adopted new functions need to be added to build security and trust that support end-to-end complex transactional contexts. These functions require access to system wide information, which implicitly will gradually lead to centralisation. These functions are carried by key network nodes which end up accumulating power of influence, and while their service is important to everyone, their services add to cost of doing business. What starts as a decentralised network in early stages, ends up as a network with centralised power at late stages of adoption. Trusted DeFi at scale is just not realistic. A fair balance can be achieved if the network is designed in such way that it prevents the dominant nodes to impose rules for their own benefit.
Back to the bitcoin. One of key rationale for its role as a storage of value is its designed scarcity, an attribute used to justify how the bitcoin is estimated to reach $1m by 2030.
There are several problems with this valuation.
First of all, it ignores the scale of changes in the structure of wealth allocation needed to achieve this sky high valuation. If the market capitalisation of bitcoin grows from $1.1t in 2021 to $28.5t in 2030, money would have to be redirected from other assets in large numbers. The increase of market capitalisation could also happen when governments print a lot more money, but that would inflate the value of most other assets too, making the gains in the value of the bitcoin relatively unremarkable.
As a side note, I am not sure how the bitcoin will reach a value of $28.5t at $1m valuation when the theoretical limit of the number of bitcoins is 21.1m. This must be based on an even more bullish forecast ($1.36m), or the forecast was calculated based on historical data assuming a variable supply of bitcoin.
Another reason to be sceptical is the fact that the value increase is also dependent on the use and the holding patterns of the bitcoin. The more the bitcoin is used and owned, the higher the valuation goes. Paradoxically, against the ethos of “central powers are evil” mantra, the suggested high level of holdings implies that institutional investors (who represent “central authorities”) become active participants. Many of these institutional investors manage money on behalf of large pension funds. Will they blindly, unconditionally, trust a “self-sovereign”, unregulated bitcoin?
Investors, users of bitcoin (for payments) will need to take funds from somewhere else to buy bitcoins. Which sectors will be downgraded, real estate, bonds, equities? Large reallocations need to occur to make funds available for pushing bitcoin’s valuation to this stratospheric height.
The second conceptual problem is the self-sovereignty hypothesis. The promise of anonymity attracts regulatory scrutiny because of the thorny issues related to money laundering, funding of criminal activities, theft, income tax evasion and environmental impact. The structural design of the bitcoin blockchain meant to create a secure domain distributed across a large network of computers has also another side effect. As the use of blockchain is rising exponentially, the bitcoin transaction costs become prohibitive as calculations are more complex and require larger amounts of energy. In response to the increasing demand for computational performance, in the US EPA is asked to investigate the environmental impact of crypto mining caused by the discharge of mining technology that becomes obsolete in short upgrade cycles. The demand for high energy led to the design of alternative coins, which is why the market has been invaded by a plethora of crypto currencies that have much lower transaction costs.
This is what ARK says:
“Public blockchains shift the distribution of trust, replacing institutions that rely on centralized authorities with decentralized, open- source software. The first profound application was self-sovereign, digital money (bitcoin). While centralized institutions must coordinate the functions of a financial system, Bitcoin operates as a single, decentralized institution. Instead of relying on accountants, regulators, and governments, Bitcoin relies on a global network of peers to enforce rules”.
What rules? Who decides what rules have to be followed? This aspect, critical to effective, reliable and trusted operation of the public blockchain, is missing in ARK Invest Best Ideas 2022 model.
Bitcoin transactions are facilitated through exchange layers and digital wallets. As the need for “trust” services increases (insurance, tax, guaranteed protection, legal, etc), the mounting expenses lead to consolidation in the industry, reducing the number of service providers to a small number of large players capable of operating at scale who act as private central authorities. Under public pressure, the regulatory agencies will have to catch up and impose regulations similar to those that exist today in the traditional financial industries. This evolutionary step is already happening in US and Europe.
Public Blockchains Have Unique Characteristics
“Public blockchain infrastructure serves as the backbone for new forms of economic coordination: it minimizes the need to trust centralized institutions. The decentralized, open, and permissionless characteristics of public blockchains lower the cost of coordination, among other advantages”.
The notion of lower coordination cost is almost amusing because the cost of transactions that use the main crypto currencies is very high. Economic efficiency analysis that compares the cost of doing business on blockchain to the traditional business way has been abundantly discussed. See some articles here(The Truth About Blockchain, Harvard Business Review), here(The Impact of Blockchain Technology on Business Models, Springer) and here (The Rise of Using Cryptocurrency in Business, Deloitte) where the high cost of doing business and high risks are key issues that need to be considered before adopting blockchain technology . The high cost still doesn’t diminish the attractiveness of the new blockchain technologies because of their perceived freedom from government regulations. See also CSIRO study (Risks and Opportunities for Systems Using Blockchain and Smart Contracts) and IBM web site.
Decentralisation, like functioning democracies, need central institutions that protect the freedom of participating public members. The crypto industry recognised that adding is necessary but cost additive. The current solutions attempt to address this issue by adding layers that orchestrate transactions with aggregating algorithms. However, the additional layers increase complexity and control risk. Here is a recent example of a $182m theft that took advantage of a recent DAO design.
The early adoption of the blockchain technology may not be deep and consistent but it is spreading across many industries. It will be interesting to see how it will evolve into practical and sustainable solutions once they reach the majority adoption stage. At the moment the crypto landscape is a bit confusing and intimidating, not in small measure due to the regulators still being behind the curve. We are still in early days, but there is no doubt that blockchain will have a massive impact.
ARK: Public Blockchains Are Stirring Several Revolutions
“In our view, the Bitcoin protocol created the most profound application of public blockchain infrastructure. In addition to the Money Revolution, public blockchains also have catalyzed Financial and Internet Revolutions”.
This is a nice diagram, but it needs to be expanded a lot. I am sceptical that it works as simple as it is shown here.
ARK: Each Revolution Involves A Different Level of Trust
“In our view, the Money Revolution requires predictable monetary assurances, maximum decentralization, and conservatism. The Financial and Internet Revolutions require some tradeoffs to achieve scalability, convenience, and innovation. Competing blockchains should recognize that too much trust in centralized authorities risks a reversion to the status quo”.
Is Bitcoin “Money”? The volatility defeats the “conservative” ethos, in the sense that even if everything remains unchanged, the fluctuations of bitcoin value vs traditional currencies make it everything but conservative.
“As bitcoin’s market capitalization hit an all-time high in 2021, ARK’s research indicated that its network fundamentals remained healthy. Bitcoin’s market capitalization still represents a fraction of global assets and is likely to scale as nation-states adopt as legal tender. According to our estimates, the price of one bitcoin could exceed $1 million by 2030”.
What is Bitcoin’s market capitalisation? If we agree it is money, market capitalisation doesn’t make sense. Does the dollar have market capitalisation? If we mean value, we can use the exchange rate to determine the value of Bitcoin. Note that bitcoin has a limit to its issuance. The market capitalisation term implies the use of business valuation method as if the bitcoin is a business that makes things or provides services. In reality people use mainly the bitcoin price, price history and price action to decide if it is worth buying it or not. The exchange rate is just a reflection of willingness to buy or sell purely on speculative basis. The use of market capitalisation term makes this speculation look somehow objective and legitimate.
This chart is both meaningless and deceptive. It gives the impression the bitcoin is an enterprise that produces valued output, when in reality the chart shows the history of value of the all coin holdings based on the daily average exchange rate. The bitcoin has no utility, even when compared with Ethereum.
Bitcoin’s Market Participants Are Maturing And Focused On The Long-Term
“Despite increased exuberance as bitcoin scaled to a record high price, on-chain data suggests that bitcoin holders are focused on long-term fundamentals”.
This is the most misleading statement, but in the same time the most revealing. It is difficult to conclude from these charts that people who bought bitcoin earlier still hold the same bitcoin today. It merely shows that an increasing number of people are buying bitcoin attracted by the prospect of appreciation and profit. Those who buy late are forced to wait for longer until the next wave of buyers lift the price up at which point those holders could sell. It is a pyramid scheme, admittedly one with a long life; the world’s population is so large. So far, the bitcoin has had seemingly an upward leaning trajectory. Let’s see what happens when it goes down over a longer period of time in testing economic conditions when bitcoin holders are compelled to sell their bitcoin holdings for a variety of reasons (margin calls, financial commitments, tax, market fears, etc).
The amount of BTC of long term holders barely moved while the number of accumulation addresses grew by 5 times. Somebody must sell BTC to be distributed among a larger number of “long term” BTC holders. This assumption correlates well with the chart below that shows a spike in trading in 2021. As the time goes by, an increased number of newcomers buying BTC in hope of realisable capital appreciation will own an increasingly thinner pie of BTC from the same amount (13-14m).
This chart proves that bitcoin owners are not necessarily long term holders; it proves that there is a lot more transactions. See the comments in the next sections below.
Bitcoin Could Continue To Scale In Response To Technological Breakthroughs
“Last year, Bitcoin made conservative, strategic enhancements at the base layer while encouraging experimentation “off-chain.”
As I mentioned earlier, the inherent high transaction costs raised the need to design technological solutions to address this problem. Bitcoin denominated DeFi is masking the Bitcoin network. It’s a little bit like financial derivatives. Small changes in the value of each underlying coin side could trigger unexpected changes in value of the denominations.
Bitcoin Is Attracting Institutional Holders
“Bitcoin’s institutional holder base appears to be broadening after the launch of more regulated products and the adoption by corporations and nation-states”.
The bitcoin valuation will likely pulse within range over time until the interest will diminishing as the traders looking for speculation overtake those who believe in the bitcoin as a long term value store. The supporters of bitcoin are very vocal and it is difficult to discuss pros and cons of the bitcoin as an investment asset class. Bitcoin marketing has been pervasive across many media platforms to convince the public and financial institutions to consider the bitcoin as a reliable asset class. Warren Buffet expressed his disbelief that Fidelity Investments intends to offer the option of buying bitcoins as part of their clients retirement plans. Peter Thiel is at the other extreme, vehemently attacking anyone who opposes the idea of investing in bitcoin. Aggressive passion is a red flag signalling the potential risk of irrational behaviour.
Ironically, the same funds who belatedly entered the bitcoin fray in search for alpha will be those who will bring the bitcoin down when they rush for the exit. The tipping point will be when after a long stagnation period characterised by range trading and failed attempts to hit new highs, the number of those who try to take profits begin seriously to outnumber those who want to buy. At that point the larger funds will be under pressure to change their allocation strategy to seek better investment opportunities elsewhere, reduce exposure or simply liquidating the bitcoin positions. That will trigger a wave of selling which will sharply depreciate the bitcoin due to its scarcity and which will damage its reputation as a “safe” investment for a long period. Scarcity was good on the way up, but devastating on the way down.
Concerns About Bitcoin’s Lack Of Sustainability Seem Ill-Informed
“Our research suggests that Bitcoin has the potential to transform monetary history by providing financial freedom and empowerment in a fair, global, and distributed way”.
No evidence presented to support this argument, and no reasoning, just a bunch of statements to “support” the statement.
Ethereum and DeFi
There are two reasons that motivate the search for a decentralised financial system: freedom and efficiency. The freedom means independence from central authorities, over-regulation, avoidance of large, quasi-monopolistic financial institutions, free to be innovative, flexible, capable to adapt to new situations. Efficiency means the cost of transactions is small, possibly free in certain situations, services can scale to respond to increased demand and the entire ecosystem is transparent, smooth, functional and well maintained with minimum expense of energy. The two reasons are interrelated. A system cannot be efficient if the participants are bogged down by complex regulations and over surveillance, and a system cannot be free if it is inefficient.
Blockchain based DeFi promises to meets these two requirements. ARK Invest is an enthusiastic supporter of this idea, but again it fails to place DeFi in a realistic light by not touching on potential challenges, risks and natural limitations. The two reasons that I mentioned earlier, are interdependent in ways that could be beneficial, but that could also pose certain risks. Freedom and efficiency support each other, but they also depend on functions that make them contradictory to each other. An efficient system must be able to perform at scale, be secure and reliable. This cannot be achieved without hierarchical architecture, which is the antithesis of freedom. A good design must create a balance that is satisfying for all parties with minimum sacrifices. This can be achieved, but only on a temporary basis because the societal and technological landscape changes continuously. These are natural limitations that we have to accept they exist and deal with them.
ARK Invest chooses to ignore the bigger picture and focus instead on one of the most recognised blockchain crypto platform (Ethereum) as being a technological solution capable of creating a true decentralised financial system.
“Decentralized Finance (DeFi) promises more interoperability, transparency, and financial services while minimizing intermediary fees and counterparty risk. After a turbulent 2018-2019, Ethereum emerged in 2021 as the predominant smart contracting platform for decentralized finance and non-fungible tokens (NFTs)”.
In ARK Invest’s view, Ethereum smart contracts function is the silver bullet that solves all the problems and gives us a true decentralised financial system.
“According to ARK’s research ether (ETH) is both the preferred collateral in DeFi and the unit of account in NFT marketplaces, suggesting that it is likely to capture a portion of the $123 trillion global money supply”.
As I mentioned earlier, Ethereum proved to be a costly way to execute transactions, and clearly a DeFi ecosystem based on Ethereum cannot scale at global level. The prediction that despite this drawback it will likely capture a portion of the $123t global money market is in a dire need for an explanation, which unfortunately is missing.
Smart Contracts Are Usurping Traditional Financial Functions At The Margin
“Smart contracting platforms like Ethereum are open and transparent. They do not rely on traditional financial intermediaries, thereby reducing counterparty risk”.
A reduced counterparty risk needs assumes that smart contracting platforms themselves carry little or no risk because they are automated and objective. Again, ARK Innovations makes favourable assumptions that support a headline view without self-critical analysis and no alternative ways of looking at risk. As good a software can be, you still need human infrastructure around it to make it work, and many of the old institutions are quite good at that (although there is always a risk that a human link may break inside the organisation). The human infrastructure is needed to handle design and execution errors that naturally occur as no one can ever design a perfect system in a changing world. The human infrastructure is also needed as a continuous mechanism to validate, adapt and detect errors in the framework that constitute the foundation on which the smart rules are operating (this is mainly about governance, key concepts, principles, data definitions, interoperability, etc.). As an example of a failure of smart contract platform, recently WSJ reported on a near record hack that resulted in the theft of $182m by exploiting a weakness in the Beanstalk smart contract algorithm.
Ether Hit New Highs In Response To DeFi and NFTs
“Built on Ethereum, DeFi, stablecoins, and NFTs pushed ether to an all time high in late 2021. Since the speculative ICO washout in 2018, Ethereum’s activity has evolved considerably”.
The more Ethereum is used to create smart contracts the more expensive it becomes – see below.
Crypto-Powered Finance Might Scale More Efficiently Than Traditional Finance
“Smart contract-based financial transactions settle in near real-time almost anywhere in the world. Revenue per employee illustrates DeFi’s efficiency relative to that of traditional finance (TradFi)”.
I am not sure this demonstrates the DeFi is more efficient in the context of the wider market. It may just show how expensive is to operate in the new DeFi.
Stablecoins Have Fuelled Crypto Trading, Lending, And Payments
Stablecoins as cryptoassets are anything but stable. How could ARK say they are stable based on a two year history in which stablecoins are transacted on platforms that lack clear regulatory guidance and standards is hard to understand.
“Stablecoins—cryptoassets pegged to fiat currency, often the USD—serve as fixed-value assets for crypto trading, lending, and payments in both centralized and decentralized markets. They increased nearly 5x in 2021”.
“On international crypto exchanges with limited access to US Bank accounts, like Binance, stablecoin-denominated trading pairs account for more than 70% of total trading volume on centralized crypto exchanges, well above USD- denominated trading at only 15%”.
“Used heavily in DeFi, stablecoins account for 95% of total outstanding debt on Compound and 22% of total liquidity on Uniswap”.
Is this realistic, safe?
Are the $160b valued stablecoins backed by US dollars? Isn’t there a risk that some (or worse, many) issuers of stablecoins are not able to remit stablecoins back into dollars at request?
The recent market volatility highlighted the high risks associated with the ownership of stablecoins. TerraUSD, perhaps the stablecoins with the highest “market capitalisation” had a dramatic drop in value because of an artificial pegging on the dollar that was relying on another crypto coin, Luna. The drop in value resulted in large losses for owners of the TerraUSD and those who use the coin in the debt market. The latter is a demonstration of the crypto DeFi risk. This has led to, predictably, … regulations, with the US Treasury Secretary Yellen calling for the Congress to act.
In all this crypto-currency enthusiastic picture there is little analysis on the asset backing mechanism. There is a real danger the collective optimism leads to the formation of a massive financial bubble because speculative nature of these operations propped up by stories of fast ultra-high return on investment. The US Treasury Secretary Yellen cautiously noted the turmoil in the stablecoins market hasn’t posed a substantial threat to the financial system, but if they keep growing, they could pose a systemic risk. This clearly points to regulations that will require changes in the DeFi design framework, changes that will make it less decentralised over time.
Ether’s Market Cap Could Exceed $20 Trillion In The Next 10 Years
“According to our research, Ethereum could displace many traditional financial services, and its native token, ether, could compete as global money. As financial services move on-chain, decentralized networks are likely to take share from existing financial intermediaries. The beneficiaries of this shift include Ethereum, the base protocol, and DeFi, the decentralized applications built on top of Ethereum. As the preferred collateral in DeFi and the unit of account in NFT marketplaces, ether (ETH) has the potential to capture a portion of the $123 trillion in global M2”.
This looks like an extract from a marketing brochure: always optimistic, all opportunities and no risk. lt is a controversial presentation of facts. On one hand the increased price of Ether is a big deterrent against its use, but on the other hand more people will use it because its appreciation. This push-pull didn’t prevent the analysts from predicting an exponential growth in the value of Ether. Perhaps this is because there is no clear distinction between the use of the crypto token as a currency, a ”value store”, or as a blockchain based transaction medium (this pattern of confusion is present in the media at large). The increasing price is potentially appealing to traders and investors, but at the same time the increase encourages innovators to look for an alternative that is far less expensive, less energy consuming and much faster. This renders little credibility to the prediction that Ether will reach $20t by 2030.
- Blockchain based DeFi is intrinsically trusted, not in need for too much regulation and central authority supervision because of the revolutionary underlying blockchain technology.
- Smart contracts are the engine of DeFi. ARK Invest is confident this technology alone will build the trust into the blockchain financial system (DeFi). Some of the recent events dispute this assertion (I gave one example).
- There are no risk worth mentioning here, according to ARK Invest, otherwise they would have been. I discussed this on each sub-topic as a potentially significant issue.
- Blockchain technology enabling three revolutions: Money (through the bitcoin), Financial (DeFi) and Internet (Web3). The Money revolution is confusing because the Bitcoin is not money: it can be used for conversion into main currencies, but the volatility associated with the crypto currency is way too high. This is a hotly debated topic: is bitcoin currency, value store or gold alternative?
- Ethereum seen as a key crypto currency underpinning the DeFi revolution.
- Ethereum will increase in value, which in turn will increase the transaction costs, but this is not seen as an issue to the dramatic gains of DeFi over the next ten years. The use of additional protocol layers add risk and costs, aspects that haven’t been discussed in the ARK Invest’s report.
- The Bitcoin will reach $1m by 2030, increasing its market cap 29.5x to reach a value of $28.5t. As the upper limit of bitcoin supply is 21.1m, it is not clear how ARK Invest arrived at the$28.5t market cap.
- Stablecoins are stable and reliable and predicted to continue growing, the report says. No risk has been discussed. The recent market volatility (described by many as a crash, given what happened to TerraUSD and Luna) demonstrates that these risks must be considered by investors and that regulators are just beginning to look at this area of the market as a potential systemic risk. This is an area in which the report falls way too short.
- Ethereum will increase in value 52x, reaching a market cap of $22.5t
- Bitcoin + Ethereum will have a market cap of $51t by 2030. This is a staggering value, which unfortunately hasn’t been explained how it was arrived at. As a point of reference, the total world market capitalisation was $121t in 2021 – assuming a healthy growth, it could double by 2030 to $240t. BTC and ETH would represent a quarter of that market cap.