Tulips, steam and decentralised finance

When we are thinking about where the worlds of Bitcoin and cryptocurrencies, “smart” “contracts” and decentralised finance (defi) 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 from 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 revolution that contributed to a Dutch golden age which meant that 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”.


with kind permission of TheOfficeMuse (CC-BY-ND 4.0)

As I am very interested in learning from a) history and b) smart people, 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!)

Cryptocurrencies are more like railway shares in Victorian Britain than tulips in the Dutch Golden Age. Click To Tweet

Aside from tulips, another well-known “bubble”, Britain’s 19th century railway mania, was the subject of some discussion in the room. This particular example is worth studying because 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 a detailed article about it a couple of years ago and, in fact, noted the incredible scale of the mania in Financial World magazine a decade back: 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 in turn led to a colossal crash in 1866, which then 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 that world of defi: The world of financial services, including lending, exchanges, investment and more that are built on shared ledgers and smart contracts. 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 view, that digital assets (“tokens”) are where the next generation of financial services will be forged, was reinforced in a new paper published in the Federal Reserve Bank of St. Louis Review. In it, Fabian Shar explores the evolution of markets based on tokens 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 already several examples of off-chain collateralised stablecoins. The most popular ones are USDT and USDC which both USD-backed* ERC-20 tokens on the Ethereum blockchain.
  • On-chain collateral means that the assets are locked on the blockchain (in a smart contract).
  • Algorithmic tokens that are not backed by collateral at all, but whose value is maintained by algorithmic market interaction. This was, incidentally,  the original meaning of the word “stablecoins” that has now been hijacked by imprecision)

The trading of these tokens, if it were to take place in the existing market infrastructures, would be interesting enough. But to Maya’s point, 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, will leave us in a new financial world. I strongly agree with the view of Jay Clayton (when chairman of the U.S. Securities and Exchange Commission) that “everything will be tokenised” and the obvious corollary to this that everything will be decentralised. It is not the underlying cryptocurrencies that will be the money of the future but the that they support. As the St. Louis Fed’s paper concludes, and as I wrote in Forbes back in January, defi may potentially contribute to a more robust and transparent financial infrastructure.

In the long run (and the lessons from history are clear), I think this will be much more important and lead to much greater structural change (and therefore opportunities) than cryptocurrencies. We can already see the world of tokens entering the mainstream: Dapper Labs (the company behind the famous token game CryptoKitties) is as I write raising $250 million at a $2 billion valuation and Celo, a defi alternative to Facebook’s Diem, has just raised $20 million from (amongst others) noted Silicon Valley investors Andreessen Horowitz.

There are good reasons to welcome these pointers to the emerging paradigm. While defi is now mainly used for speculation between tokens of many varieties, in the longer term it 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). It also, and most importantly (for reasons discussed before), offers a more transparent market with accountability as part of the infrastructure. Don’t be put off by the Wild West of defi as it stands now, begin your scenario planning for defi as it will (inevitably) become.

*Does not constitute financial advice.

[An edited version of this article was first posted at Forbes, 15th February 2021.]

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