#20 The Context: Does DeFi have TradFi problems?

Life goes on after Terra's collapse, including a possible rebirth for Terra

May 26, 2022

Hi there, life goes on, and while there continues to be fallout from Terra, other issues have arisen: two mainstream media pieces worth a mention look at whether last year's Indexed attack constituted a crime, and if so was it black hat or market manipulation? Talking of the latter, does crypto have an insider trading problem? Asking for a friend.

The usual disclaimer: This newsletter collates the main themes and headlines of the week in DeFi/crypto/metaverse/web3/NFT land and tries to provide unbiased context. It’s aimed at anyone who wants to keep an eye on the space but isn’t following it too closely, or is on the hunt for story ideas and angles. It’s put together by a team at YAP (shoutout to Roslyn Tear for her contributions), and doesn’t contain any promotion of our clients (if one is mentioned, we’ll flag that).

Your feedback is as always welcome. Ping us at thecontext@yapglobal.com. Old newsletters can be found here.

[tl;dr]

As DeFi starts to quack more and more like the sort of market any TradFi trader might recognise, is it inheriting some of the more salacious features of the latter?
What has happened in the wake of Terra's collapse, and what does that tell us about the appetite for prosecution, regulation and picking oneself up, dusting oneself off, and Carrying On?
While DeFi still feels like a 'first world' thing, it's worth noticing there's a lot more interesting blockchain stuff going down in Bangui, San Salvador, Shanghai and Jakarta.

[Rules? What rules? And whose rules?]

Bloomberg explores the Indexed attack of last October, when some $16 million worth of assets went missing, and how the complex interplay of DeFi's protocols leaves it vulnerable to those who have spotted a weakness. But it also highlights an issue that may in the longer term prove more important: when is it a hack (illegal) market manipulation or just a clever application of the rules? And when is an individual responsible for manipulating a token's value or the algorithm? And above that: is a court the place to determine the outcome of something that happened on an unregulated, decentralised platform, deliberately built to operate outside traditional, centralised, regulated markets?

Raising some of those same questions, The Wall Street Journal reports that crypto might have an insider trading problem, where tokens were bought in the run-up to a official announcement that the cryptocurrency in question was to be listed on big exchanges such as Coinbase. Those tokens were then sold shortly after the announcement had boosted the token's price. (The story mentions, among others, Gnosis, a YAP Global client.) Once again, while such practices would be illegal in regulated markets if it was found inside information had motivated the trades, it's unclear whether the same laws can, or should, be applied to crypto. Exchanges say they have clear rules barring their employees from engaging in insider trading; leaks may occur when exchanges test a token before an announcement, Coinbase's chief legal officer wrote in a blog post.

(Stories: Christopher Beam of Bloomberg; Ben Foldy and Caitlin Ostroff of The Wall Street Journal)

[Terra: the lawsuits, the investigations, the contagion ... the resilience?]

Fallout from the Terraform Labs collapse may play a significant role in determining how applicable old-world law is to new-world DeFi. The losses are very real: Terra victims' statements show just how badly affected customers have been, and that for many of them, investing in a stablecoin was not a speculative punt but a safe harbour for their savings. And it's not just those owning UST: A yield generation app called Stablegains faces a class lawsuit from users after losing $44 million on the Terra stablecoin, UST. Stablegains had allegedly posted misleading statements about its exposure to UST. Even Binance, the world's biggest crypto exchange, has not escaped scrutiny: the Financial Times wrote that Binance had been promoting UST as a "safe and happy" opportunity as late as April 6.

Then there's the question of how far prosecutors can, and want, to go in investigating possible wrongdoing. The South Korean police have asked exchanges to freeze assets linked to the Luna Foundation Guard, the non-profit which said it had spent more than 80,000 bitcoin vainly trying to prop up UST. Crypto Briefing said it had requested details of LFG's transaction history but had not received a response. The Seoul police said that it was investigating possible embezzlement by an employee of Terraform Labs. This may well not be the last that Terraform Labs founder Do Kwon hears of the matter. His plan to revive the company, after clearing the rubble, has been approved; it will involve creating a new blockchain, forking Terra without the UST token.

Terra may provide fertile ground for exploring the interconnectedness of DeFi, whether that risk is properly understood and how it can amplify systemic risk. Goldman Sachs explored in a note how apparently unrelated tokens, in this case Lido, a liquid staking protocol, could be affected by UST's collapse. A counter-view was offered by the Bank of America, which argued in a note that concerns about contagion risk and Crypto Winters were overdone.

How DeFi and its followers react to the Terra collapse may end up being the most important factor in whether there's a Winter, and if so how long it lasts. Binance's CEO Changpeng Zhao said he was pleased by the resilience of the crypto industry although he acknowledged there were "many lessons" to be learned. Coinbase, another giant, is not faring so well, although its prospects have been dimming for a while. After six months of falling stock price, it has imposed a hiring freeze and pausing new business projects, according to The Information.

(Stories: Timothy Craig and Chris Williams of Crypto Briefing; Kevin Helms of Bitcoin News; Will Canny of CoinDesk; Adam Samson and Joshua Oliver of the Financial Times; Ruholamin Haqshanas of CryptoNews; Samuel Wan of CryptoSlate; Arijit Sarkar of Cointelegraph; Pawan Nahar of The Economic Times; Mark Matousek and Aidan Ryan of The Information; Vishal Chawla of The Block)

[Who, exactly, is using crypto - and for what?]

It's probably not even worth noting, but the European Central Bank chief thinks crypto "is worth nothing. It is based on nothing. There is no underlying asset to act as an anchor of safety," Christine Lagarde told Dutch TV. We've heard this before, but what, perhaps, is remarkable is not that the crypto-devout would disagree, but a lot of other folk too. As noted above, many of those hardest hit by the Terrapocalypse were ordinary folk - single mothers, Ukrainians under siege or on the run. Investors, in other words, or simply those trying to find a place to park their savings. Indeed, even the U.S. Fed would have to agree: a survey it conducted in 2021 found that 12% of adults held crypto, and have little interest in it as a currency. They’re by and large investors, not transactors, and most of those were "high-income". But of the 3% who actually used crypto for payments or transfers, 13% did not have a bank account. (You can find the original survey here (PDF). Many of these might be crypto devotees who eschew any relationship with banks, but it may also include some of the country's 14 million unbanked. If true, it means acknowledging that DeFi is not (just) a financial playground, but an accessible haven for those unable or unwilling to commit their savings to more traditional institutions.

The signals are mixed, but there are indicators that it is this kind of adoption of DeFi that may prove more rewarding. Charles Hoskinson, founder of Cardano, told a crypto summit hosted by the FT that there was "more demand than supply" for the blockchain platform within the world's developing nations. This has been refrain of crypto for a while, and the more high-profile efforts have not always been well thought-through: El Salvador's adoption of Bitcoin as legal tender has not gone well, attracting the ire of the IMF (although the fund says it is still working with President Nayib Bukele) while the World Bank is anxious about the Central African Republic's plan for a crypto hub.

Perhaps more encouraging are companies like Jakarta-based Xendit, a payments infrastructure company operating in Indonesia and the Philippines, which has just raised a $300 million Series D round. Xendit is an example of a developing world company that initially focused on crypto but then focused on fintech as it realised how poor the financial infrastructure is for payments. Among its customers now are companies in both TradFi and DeFi, suggesting the two worlds are not mutually exclusive.

There's long been talk that the blockchain, with its immutable ledger, offers not only the promise of decentralised transactions, but also resistance to censorship. What that means in practice is not always clear, but its edges are being tested in China, where frustrated lockdowners are venting their frustration about inadequate food and censorship of their complaints on social media by creating digital artwork and minting them as Non-Fungible Tokens on a blockchain - making it nearly impossible to delete. This is unlikely to phase the censors much, since their concern is spread rather than permanence. But it will leave a paper trail for those hardy enough to look.

(Stories: Sergio Goschenko of Bitcoin News; Eleanor Olcott and Gloria Li of the FT; Gené Teare of Crunchbase News; Katarina Hoije of Bloomberg)

[Tidbits]

‘Move-to-earn’: You all know about 'play-to-earn' but now there's 'move to earn': buy a pair of digital sneakers and move around, earning tokens and leveling up. It's just another form of game, though whether it's a real game, or a running app, or something else entirely, isn't yet clear. Are these types of use cases the key to driving mainstream adoption - rather than DeFi protocols which present more technical barriers to entry?
Apollo Capital looks at the number of developers active in the main protocols between December 2020 and December 2021. "The developer engagement and its organic growth are some of the most essential fundamental metrics crypto asset investors will use when making investment decisions. The importance of these metrics is heightened in periods of downward and sideways price action in assets across the industry as it is these periods when the market is fearful when fragile ecosystems tend to decline in developer activity, whilst the strongest developer ecosystems remain robust through periods of uncertainty." Although the data is a few months old, it's still worth a dig.
Terra may have triggered anxiety about the immediate future of crypto, but the funding hasn't stopped: news items this week included these: Common Raises $20M to Build DAO Management Platform, Launch Token, StarkWare Reaches $8B Valuation Following Latest $100M Funding Round, Crypto asset manager Babel Finance reaches $2B valuation, and Andreessen Horowitz bets on crypto ‘golden era’ with new $4.5bn fund.