#3 The Context 25.01.22

Crypto crashes, Crypto obsessions and CBDCs?

Feb 03, 2022

Hey there, hope you’re well. Here’s your weekly dose of DeFi and crypto, offering what we hope is a grounded perspective on what’s happening in decentralised finance (Web3, crypto and DeFi) for those interested in the space but not necessarily following every twist and turn. (No technicalities or jargon, we promise.)

Our plan is to keep things short and concise, and try to pull together strands that might shed light on deeper trends, or angles that might otherwise have got lost. We’re not here to evangelise or criticise, but hopefully to add perspective, context and a bit of insight about the week’s moves within crypto and DeFi, as well as on its fringes.

tl;dr

Cryptumble - everyone took a bath in the past week, but what is really behind the crypto crash? We look at some of the discussion from within and without the DeFi space;
CBDCs - the Fed’s much-anticipated paper is out. It sits carefully on the fence, but a closer look reveals some interesting nuggets, and implications for DeFi;
Crypto obsession: great that everyone can get into crypto, but beware the pitfalls.

Your feedback is welcome, and if there’s anything we can help more on, don’t hesitate to ping us at thecontext@yapglobal.com.

Thanks for reading.

[Cryptumble]

The past week saw some major losses to cryptocurrencies. Several reasons have been given, such as:

the Fed’s warning of rate hikes to slow inflation as the pandemic-driven boom of fiscal and monetary stimulus comes to an end, and
a bearish attitude towards riskier assets caused by the tension over Ukraine.

That might not be the whole story: The two big coins, Bitcoin and Ethereum, were both 50% off their November peaks, exceeding the relative falls in stocks, according to Fortune’s Jacob Carpenter. Are we headed for another crypto winter, or is now the time has for other coins to take the vanguard role?

It’s also worth placing this in a broader context. Many DeFi protocols have been falling since at least November. The cascading effect of liquidation orders in DeFi has added to the woes of major cryptocurrencies. Non-fungible tokens, or NFTs, have held up well, possibly because of their links to big crypto since they are usually denominated in Ethereum. (See Mr Fox)

Protocol’s Owen Thomas points out that all markets, including crypto, have been flooded with cash as the global pool of money has swollen. The pandemic only increased already high savings, some of which has gone into crypto. While these asset classes may all be bubbles, it might be wrong to think of them all having to burst. As fear of inflation eroding the value of savings pushes money to seek ever higher returns, crypto, DeFi, NFT, Web3, may all benefit, he argues. (See: Protocol — The people, power and politics of tech)

Some don’t buy any ‘real market’ interpretations, saying the problem lies within. David Gerard, author of “Attack of the 50 Foot Blockchain” and long a stern crypto critic, believes there’s no longer significant retail demand for crypto. What is left to prop up prices are big players, he says: both miners who don’t want to crash the markets so they’re sitting tight on the coin they’ve earned, and whales who, also fearing a further fall, are trying to borrow real dollars using their BTC as collateral. (This view is not necessarily one held elsewhere.)

Sources

Bitcoin down 50% amid fear of Fed’s hawkish rate hikes | CryptoSlate

5 of the Biggest Bitcoin Crashes—And How This One Compares - Decrypt

Bitcoin goes down — and time bombs are waiting in the market.

[CBDCs again]

As we mentioned a couple of weeks ago, central bank digital currencies (CBDCs) are now more a thing than not. China is top of the list, and Chinese New Year and the Winter Olympics are going to be key tests of the digital yuan’s mettle. This is one reason why the U.S. Federal Reserve is taking the idea of CDBCs seriously. It’s one of some 90 countries pondering the matter; their consultation paper was published last week (link below).

The paper is long on research, short on action points. It says that any CBDC should, among other things, complement rather than replace current forms of money and methods of providing financial services, while protecting consumer privacy and protecting against criminal activity.

Easier said than done of course, but the Fed does lean towards a model it feels is the best bet: an intermediated model, where it doesn’t actually manage the accounts of individuals, despite the CBDC being a liability of the central bank (like cash). Instead it sees existing banks, and other regulated non-bank service providers, competing in an open market to hold and manage customers CBDCs. (Visa and others are already building for this world.)

Here are some reasons why it might appeal, combining both interpretations of a CBDC (as a retail currency, like paper and coin, and institutional or wholesale money, available only to banks) :

easier payments to foreign allies (improving ties)
support the dollar’s status as a global reserve currency (fearing a CBDC from, say, China, may prove appealing)
easier and faster distribution of money, aiding monetary policy (think handouts, employment checks, tax rebates)
retain control of the money supply and interest rates (a defensive move against crypto)
reduce transaction and other costs of physical cash
promote financial inclusion, giving the unbanked easier and safer access to money on their phone

The downsides? (of course, these are only downsides depending on where you sit)

undermining financial stability by depriving banks of access to deposits. A CBDC might divert money away from banks (since even if the bank is managing a customer’s CBDC wallet, they have no specific claim to using that money to make loans), which in turn might reduce a bank’s ability to lend. The Fed’s solution: limit CBDCs by, eg, not allowing them to earn interest, or limiting the amount of CBDC an end user should hold. (In a footnote the Fed acknowledges that this could also be true of stablecoins and other “nonbank money” whether or not there is any CBDC, a tacit acknowledgement of DeFi’s threat to banks.)
violating Americans' privacy? This has the potential to be more of an issue than any other bullet point, with China the proverbial canary. Economist journalist Simon Rabinovitch recently wrote on Twitter: "Just heard about a Chinese central bank official who was removed from his post after police found his name in tracing digital payments to a prostitute. And as it turns out, one of his last public speeches was on how policymakers should handle the challenges of digital finance." (more on privacy below)
limiting government “ability to combat illicit finance.” The other side of the privacy coin.
a run on banks, where citizens pull too much money out of banks at once and purchase CBDCs, triggering a stampede.
centralizing a system designed to be private may produce backlash from users and create cybersecurity risks (a recognition that private innovation in finance is not only popular but more secure?)
regulatory processes not getting updated to deal with the new forms of money and needing to be made more robust before adopting this technology.

All of this has implications for DeFi, some of which seem to have been passed over by other folks. A few points to ponder:

stablecoins are the most likely victim of CBDCs but the discussion about them also highlights the significance of the role they (could) play in the absence of CBDCs
CBDCs would likely be better bedfellows with fintech rather than crypto. The Fed’s vision of an intermediated world could well attract DeFi players, but it’ll be easier for fintech players which have already been regulated to quickly switch.
the Fed is explicit in saying that CBDCs could mitigate some of the risks of mechanisms that stablecoins and other cryptocurrencies use to reduce liquidity and credit risks.
but at same time the Fed believes a CBDC might make it easier for smaller companies to innovate because they no longer have to worry about “issuing a safe and robust form of private money”. While it doesn’t mention cryptocurrencies in the sentence, that seems to be what it’s referring to.
it also talks about programming money – what DeFi thinks of as smart contracts – to “deliver transactions at certain times”. Whether this is a positive or negative for DeFi will depend on a lot of things, but if nothing else, emulation is the sincerest form of flattery.
it also talks about a CBDC enabling micropayments, another focus of DeFi, and the Fed pointedly highlights it’s an innovation “which traditional payment systems are not necessarily designed to facilitate.” Ouch.
by its very definition, a CBDC is a national instrument, one that is run by a government, and therefore requires “significant international coordination to address issues such as common standards and infrastructure.” In short, CBDCs would be the opposite of crypto, in that the latter doesn’t know what borders are, while CBDCs were born with borders baked in.
The Fed acknowledges that threats to existing financial services – operational, cybersecurity – would equally apply to CBDCs (perhaps more so). So it would need to be “extremely resilient to such threats.” DeFi’s supporters could point out that DeFi has already been wrestling with these problems – not always well – for some time now, innovating and updating where necessary, and so might be several steps ahead.

Perhaps the biggest issue for CBDCs is privacy. Governments will find it hard to persuade users to shift from cash to CBDC if they feel this digital money carries with it the eyes and ears of others. The Fed acknowledges the issue, but says, “[i]n the intermediated CBDC model that the Federal Reserve would consider, intermediaries would address privacy concerns by leveraging existing tools.” That doesn’t sound as comforting as perhaps it should. Google and other “surveillance economy” heavyweights have secured forms of banking licences in Europe and elsewhere in the wake of open banking regulations. Perversely, the more CBDCs emulate DeFi in building similar infrastructure around them, the more they will educate users in the underlying process, including the desirability of privacy-preferring and pseudonymous transactions.

What is clear from the report is that the Fed isn’t going to do anything without clear support from both executive and legislative branch, “ideally in the form of a specific authorising law”. This is partly because among the seven Fed governors there are differences. But readers might be forgiven for feeling there’s still plenty of work to be done to understand the nuts and bolts of DeFi (Staking, for example.)

The bottom line for crypto? The Fed, like other central banks, is trying to get ahead of a rapidly innovating world, some of it aligned with existing institutions (banks, payment services, fintechs, neobanks etc) and some of it not (DeFi). While the report is in itself a small step, it sets in stone that DeFi has already helped changed the discussion from a theoretical one to a, dare we say it, an existential one. Governments need to respond to ‘private money’, whatever you want to call it, and the report clearly acknowledges that DeFi is a part of this new financial landscape. That’s probaly the biggest takeaway.

Sources/further reading

[Cryptobsession]

For all the exalted discussion and promises about the future of finance, spare a thought for those hit hard by the pandemic who see cryptocurrency as a way to make a living. Take India, for example: Interest in cryptocurrency trading has spread beyond the big cities. That should be good news, but it is also exposing consumers to addiction and scammers. In India, WazirX, one of the country’s earliest exchanges, reported that 55% of its users were from tier 2 and tier 3 cities in 2021. Indonesia has seen crypto asset trading rise from $4.5 billion in 2020 to $50 billion last year. Much of the country’s trading is done by those under 35, hard-hit by the pandemic or disillusioned by conventional investments. The recent steep declines must have left many in deep water.

And around the promise of crypto riches circle numerous scams, most of them ponzi schemes with a DeFi flavour. The danger is not just to the unschooled from straightforward scammers, but increasingly sophisticated attacks on those more savvy investors. Check Point Research published a report this week (link to PDF**)** showing how smart contracts are deliberately misconfigured to create fraudulent tokens, hiding either 99% fees – both buying and selling – or which give the owner special powers (maintaining the sole right to sell, for example, or allowing them to create more coins in his wallet). Chainalysis found that $14 billion of cryptocurrency had been stolen last year, a 79% rise on 2020, the most common being cryptojacking — where malware hijacks a victim’s computer to mine cryptocurrency.

Sources

Other tidbits:

Putin: Russia has “competitive advantages” in crypto mining. The Russian president’s comments follow those from the country’s central bank, which, last week, called for a ban on crypto mining. According to Putin, Russia’s advantages include the country’s surplus electricity and the number of trained personnel available. That Putin says this is likely to end the debate.
El Salvador rejects IMF calls over bitcoin. The International Monetary Fund has called for El Salvador to remove bitcoin’s legal tender status because of the risks associated with it. The country’s president Nayib Bukele responded on Twitter with a Simpsons gif with the bitcoin and IMF logos superimposed. El Salvador has doubled down, buying its cheapest 410 BTC as prices reach $36k. The country has accumulated 1,801 BTC over the past four months especially when the market sees a momentary price fall.
- Indeed, there is a case to be made that crypto is a refuge for those in countries facing economic instability. Turks have flocked to cryptocurrencies as authorities look to regulate the crypto sector. Amid soaring inflation, there is a growing trend and relationship between lira devaluation and lira trading on crypto exchanges as people in emerging markets look to preserve their savings against currency devaluation. For better or worse, this is a bone fide movement, say some.
The U.S. is still on the fence, though the Biden administration is set to issue an executive order on crypto as early as February. Federal agencies will be asked to weigh the risks and opportunities of crypto, so the order itself effectively kicks the can down the road to at least the second half of the year. Which is a long time in crypto.
Crypto giant Binance kept weak money-laundering checks even as it promised tougher compliance, documents show The report shows that Binance has operated outside rules that govern traditional financial firms and many crypto rivals. Binance has also repeatedly declined to specify in which its main online exchange is based, complicating regulators’ efforts to oversee its activities
Intel wants to be a Bitcoin player Intel is to launch a chip for Bitcoin mining. The Bonanza Mine is an “ultra-low voltage energy-efficient Bitcoin mining AISC". Intel could bring some competition to the chip mining industry. Bitmain Technology has a 75% share of the market for chips; however, chips have become pricey with increased demand, leading to long lead times. Intel’s step into the market could help reduce import charges while also improving power consumption by around 15%, reducing the electricity and power costs for mining companies.
Traders are complaining about Solana’s performance, raising questions about its status Solana blamed problems with the network on “high levels of network congestion” linked to “excessive duplicate transactions.” It raises the question as to whether Solana is the ideal choice for Wall Street when it comes to moving large amounts of money. Heavy liquidations made things even more painful for those taking out loans.
Lots of VC money still flowing in to crypto: Crypto exchange FTX US was valued at $8 bln after its first fundraise drew SoftBank and Temasek. FTX see the fundraise as statement of their rising to the big stage

This newsletter is pulled together by a team led by Jeremy Wagstaff, formerly of the WSJ, BBC and Reuters and Samantha Yap, founder of YAP Global. Other members involved include, Farhan Musa, Rebecca Campbell and Ruby Wu. Many thanks to Joey Woo for production. Any views expressed here are not necessarily those of the writers, YAP Global or its clients.

#3 The Context 25.01.22

Crypto crashes, Crypto obsessions and CBDCs?

[Cryptumble]

[CBDCs again]

[Cryptobsession]

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