Arguably the most impactful and widely referenced economic theory still used to this day is the Modern Portfolio Theory (MPT). Proposed in March of 1952 by American Economist Harry Markowitz in The Journal of Finance, his theory acted as a guide on how institutions and everyday Americans alike should invest their money to best ensure its growth. It was successful in part because it was straightforward fundamentally – a combination of stocks, bonds, and alternative assets was all you needed.
Advances in financial technology, however, have introduced a host of new investment categories. Without a doubt the most recent noteworthy innovation in this category is blockchain technology. It created the foundation for secure, peer-to-peer, and trustless transactions, all run on decentralized and transparent networks. This method of transacting generally speaking is referred to as Decentralized Finance or “DeFi”. In recent years, the subject of Decentralized Finance has taken center stage, creating a new solar system within the galaxy of options that exist for investors in search of alpha.
One of the planets orbiting the sun of Decentralized Finance is cryptocurrency and it has created a PR mess for DeFi. In the last year cryptocurrency dropped roughly 70% in capitalization, NFTs have lost billions in value, thereby threatening the credibility of decentralized finance which continues to be plagued by hacks. Despite their many setbacks, these new financial instruments still stand as a bastion of autonomy to the millions who wish to divorce government and money. The libertarian leaning web3 enthusiasts feel they put their foot in the freedom door just before it slammed shut and no amount of volatility will keep them from holding on for dear life while plugging their ears and touting their newly discovered decentralized economy.
Unfortunately, good ideas must be met with reality and when your favorite crypto wallet runs away with your money, reality hits hard. To say that DeFi has a PR problem wouldn’t be going far enough – it has a fundamentals problem.
Does this mean Web3 and DeFi are doomed? Will blockchain live out its dreams of becoming a mainstay on the world stage? We may need to look at this in a new way. Let’s discuss.
Before we get into what the sustainable growth of DeFi looks like, we’ll need to do a brief recap on the unique path blockchain took to get us where we are today.
There are many parallels to be drawn between the 1990s dotcom era and the blockchain boom. Pundits have used their similarities as a tale of caution for investors in the space. With that said, the difference with crypto is found in its perfect storm of new technology and an ideological community ready to support it. In fact, one could confidently argue blockchain came about as a direct response to the bailouts during the Great Recession. “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks” was the text contained in the code of the first block ever mined, presumably written by the creator of Bitcoin and therefore blockchain. Dreams were born of a decentralized and trustless economy where inflation and federal reserve cronyism are virtually coded out of existence. The taste of this utopia set the stage for millions of charged believers partaking in a new way of doing commerce and billions of dollars were invested into the space. This wasn’t just an exciting new technological breakthrough, this was seen as a new way of organizing how a society transacts. It was an answer to the out of reach macroeconomic problems that plagued our savings accounts – a final frontier for the financial freedom fighters!
The cryptocurrency sector alone saw $30B invested in 2021 – for comparison, all of Silicon Valley brought in just north of $100B in 2021. $30B invested into a space that would within months be hemorrhaging with its biggest players filing for bankruptcy.
Yes, the most recent PR problems in the space have been in large part because of FTX, but dozens of exchanges had already been shut down from not being able to weather the market’s volatility, leaving customer’s out to dry. It doesn’t take a seasoned analyst to know that the delta between the hopes and reality of this space are in need of a sobering trip to rehab.
The rehabilitation needed is both of the ideological and regulatory kind and both seem hard to come by. CEO of Coinbase Brian Armstrong recently noted, “Crypto regulation in the U.S. has been hard to navigate, and regulators have so far failed to provide a workable framework for how these services can be offered in a safe, transparent way.”
Senator Cynthia Lummis of Wyoming is one of the few leading lawmakers attempting to bring forth a regulatory framework to the space without limiting the potential for innovation. Her recently submitted crypto bill would ban entities like FTX from using customer assets like they would their own investments. It would also attempt to apply the howey test to crypto, which has proved to be a contentious topic thus far. “I hope [FTX’s collapse] highlighted with members of Congress who have not taken the time to learn more about this asset class, that it’s time for them to learn more about it so we can engage in proper regulation,” Lummis told the Financial Times Monday (Nov. 28).
All the while this goes on, blockchain has other assets and use cases that do not make the headlines likely because they don’t upset the fiat traditionalists and don’t excite the crypto-heads. To take a page out of the conservative playbook, sometimes you don’t need to throw out the whole gameplan, just make key tweaks to the existing system. Digital securities or “Security Tokens” (STOs) are a perfect example of just that: SEC compliant securities that are subject to the traditional regulations all securities abide by. These securities just so happen to be created through the process of tokenization and exist “on-chain.” Innovations like STOs are the poster children poised to survive and bring hope to the crypto winter. All the utopian DeFi dreams of cutting out the unnecessary middlemen with all of the legal framework to bring confidence to a broader market.
Thomas Carter, Founder of Deal Box, a digital securities issuance platform started in 2017, “All the while crypto figures out what it’s doing, security tokens will swoop in to steal the web3 spotlight by being easier to access, participate, settle, manage, and report than traditional securities done on paper. I predict by 2030 we will see security token issuance volumes in the trillions with a huge uptick coming after 2025 due to regulatory pressures.” Carter isn’t the only person who feels this way. DTCC, the largest clearing and settlement entity in the world, responsible for processing 2.3 Quadrillion in 2020 alone has embarked on its own journey into tokenized securities. In preparation for the inevitable expansion of the STO market, DTCC began work on two internal projects, “Whitney” and “Ion”. They are making developments in minting, distribution, chain-agnostic record keeping, STO marketplace compliance API calls, and settlement. These projects have now been in progress for one year and have made significant progress. With the premier post-trade market infrastructure for the global financial services industry being involved and actively investing into the space, analysts anticipate a new level of confidence from the SEC, issuers, and investors to follow suit.
Carter, also the CEO of STO funded Total Network Services (TNS), a blockchain infrastructure entity, noted “There have been a lot of people building shiny cars in the space but not many building the roads to drive on. The players that will last will be the ones solving real-world problems that bring next-level verification and security to new verticals.” TNS’ flagship service UCID is bringing the power of tokenization to IoT as the world’s first blockchain-enabled service for device management, software licensing, and equipment tracking.
Despite all of our grand imaginations for where web3 can go, it is still the case that we stand on the shoulders of web2. Let’s not ditch the system completely. Maybe it’s okay that we step out of the car, walk the white line one foot over the other, and make sure we’re driving the economy with sober minds.