By Aaron Filbeck, CFA, CAIA, CIPM, FDP, Director of Global Content Development at CAIA Association.
“I once had strings, but now I’m free…there are no strings on me!”
– Pinocchio
What happens when central banks and centralized financial services no longer hold the strings? Prior to the 2021 Global Absolute Return Congress (GlobalARC) in Boston, MA, CAIA Association was thrilled to host our first in-person CAIA Allocator Advisory Council (CAAC) of the calendar year. The CAAC represents a group of some of most influential asset owners, and presents an open forum for all its members, under Chatham House Rule, to share ideas and discuss current issues with one another. The group helps guide and influence CAIA Association’s thought leadership agenda and curricula to ensure their relevancy and applicability.
In this meeting, represented by almost three quarters of a-trillion dollars in assets under management, the topic was decentralized finance (DeFi). This meeting’s keynote speaker and discussant was an early adopter, and cryptocurrency expert, Dr. Campbell Harvey of Duke University, and co-author of newly-released DeFi and the Future of Finance. The discussion covered the important and exciting topic of Decentralized Finance (DeFi), a world exploding with innovation.
Back to the Bartering Table
In the beginning… the way we exchanged goods and created value for one another was through a bartering system: I have a cow and need two goats – now I need to find someone with two goats, willing to sell them, and willing to accept a cow in return. It was one of the purest forms of peer-to-peer transaction, but one that came with one major flaw: it had a matching problem. Money was introduced, and largely solved the matching problem. Money introduced a common medium of exchange that provided a way of comparing the value of different goods.
So, what’s wrong with the current model? Well, despite impressive technological advancements, the way we interact with our money hasn’t really changed all that much in almost a century. On the list of frustrations include two-day stock settlements, 3% credit card transaction fees, two-day money transfers, and low savings rates.
To address many of these problems, DeFi moves us back towards a new and improved and efficient bartering system. In the future, imagine we no longer exchange fiat currency for goods and services and instead, go back to exchanging goods directly, but without the matching problem. Let’s try our bartering example again. Imagine walking into your local grocery store with a wallet of digital assets, hoping to buy ingredients to bake a pie. You want to pay for your ingredients with digital gold bars. However, this grocery only accepts digital artwork. At this point, all you need to do go through a decentralized exchange on your phone and anonymously exchange your gold for artwork in a matter of seconds.
Revolutionary or Evolutionary?
One of the biggest challenges to the incumbent financial services model is what Dr. Harvey refers to as the “Speed of Innovation.” Take a protocol like Uniswap, a DeFi protocol that is used to exchange cryptocurrencies known as an automated market maker (AMM). Uniswap, like most protocols is open source and transparent, meaning anyone can look at the underlying source code.
While this is great for transparency, it also incentivizes competition and innovation from other protocols. Rather than trying to build an entirely new protocol from the ground up, however, computer engineers can copy the entire source code from an incumbent protocol, edit it slightly, and launch a set of entirely new protocols that hopefully improves upon the original.
Think about how different this is from traditional, or centralized finance (CeFi). How hard is it for a bank to change something as simple as its user interface, let alone how they do business? The current business model is focused on supporting the legacy firm (equivalent to the original code) – improvements would be considered patches to software. Conversely, start-ups in DeFi have little to lose and it’s much easier to innovate, suggesting these incumbents have a limited and finite time horizon.
Regulation in the Interim
On the topic of interim regulation, the group believed that while most regulators support the reduction of transaction costs and the increased efficiency of those transactions, most are still so behind the curve on understanding the technology and are unable to hire the talented people that might, due to a lack of attractive incentives. Therefore, any potential balanced regulation is still relatively unknown and may be for some time. On one hand, agencies need to develop a kind of regulatory framework that protects the end consumer but, on the other, too much regulation could squash potential technological innovation in this space (see: incumbent financial institutions).
However, in the interim, the United States Securities and Exchange Commission (SEC) has opted for a few selective battles to fight. In September, the SEC sent notice to Coinbase that they would sue them if they launched an upcoming cryptocurrency lending program, Coinbase Lend. Lend would have allowed users to stake their holdings in USDC, a stablecoin, to the Coinbase exchange and earn a starting rate of 4%. According to the SEC, this process constituted USDC as a security, drawing confusion from Coinbase and prompting a tweet storm from its founder and CEO. What’s interesting about this move is that staking (lending) is common across other centralized cryptocurrency exchanges.
Why would the SEC go after Coinbase and why do they adamantly oppose a Bitcoin ETF that holds “physical” Bitcoin even if it might be better for the end investor? In Cam’s view, “it’s because they can.” Sure, there are plenty of other opportunities to earn attractive returns from staking Stablecoins elsewhere, but Coinbase is one of the largest centralized players in cryptocurrencies. Coinbase, unlike most DeFi applications, is a centralized corporation, with a board of directors. “How would they even begin to go after a decentralized protocol? It’s an algorithm! You could argue that they go after the users directly – but that goes against the mandate of the SEC. Therefore, most of the regulatory action will likely be on the centralized exchanges.”
Hashing Out the Issue of ESG
The largest cryptocurrency in terms of market capitalization, Bitcoin follows a “proof of work” concept, which requires miners to validate transactions by solving highly complex mathematical equations. Since the total number of Bitcoin will remain constant at 21,000,000 coins (currently at 18,000,000), these equations’ difficulty increases or decreases based on the number of miners trying to solve them. In other words, the greater the number of miners trying to solve the equation, the more complex the equation becomes.
This validation model requires an enormous amount of computer power today. In fact, a report from Cambridge University in February 2021 suggested that Bitcoin mining uses more energy than the whole country of Argentina and, if it were a country, it would be a top 30 energy user worldwide. Around that time, China began to crackdown on mining activity (before outlawing it entirely) due to its reliance on coal. I guess, when it comes to climate change, the phrase “Bitcoin solves this” isn’t very applicable.
So, this begs the question – is cryptocurrency ESG compliant? When asked by an allocator about the climate implications of Bitcoin mining, Dr. Harvey told the group that he estimates the carbon cost of mining a new Bitcoin to be about $4,000 per coin, a relatively significant amount. Additionally, the marginal cost of a new coin is significantly higher today relative to history due to the difficulty, and subsequent required computer power, to mint them. To combat Bitcoin’s negative impact on climate change, some have discussed somehow levying a carbon tax on transactions.
However, levying a carbon tax is easier said than done – if the goal is to levy a carbon tax, how do we assign a carbon value to transactions with new coins vs. old coins if they’re all fungible? In his view, the evolution of other protocols from a Proof of Work model to a Proof of Stake model (your ability to validate corresponds to how much you stake) to be more sustainable and environmentally friendly. While Bitcoin’s blockchain will not be able to make this transition, the Ethereum blockchain will do so in 2022.
Beyond the Environmental (E) issues, there are Social (S) implications for DeFi as well. One allocator pointed out that perhaps one of the greatest benefits of DeFi is the ability to foster broader participation in financial services and banking.
The Future of DeFi: Central Bank or Treasury Participation?
Keeping with the theme of social factors, one of the most interesting things to watch will be how central banks tackle the technology. The Chinese and U.S. governments have already taken a hard look at the viability of issuing their own stablecoins. At one point, the allocators were exploring some of the implications of a central bank digital currency (CBDC), including:
- Instant monetary policy
- Targeted stimulus checks
- Targeted taxation
- Negative interest rates on certain users
Perhaps a CBDC would make things far more efficient, but it does come with some drawbacks. Whereas “traditional DeFi” relies on anonymity, a government centralized ledger would likely remove some anonymity and allow insight into all users’ transactions. At the same time, cash would no longer be/need to be in circulation, which means the potential for government overreach could heighten.
If You’re Not Long, You’re Probably Short
“You could have purchased Amazon in 2005 and made a lot of money, rather than buying in 1998. How should we think about entry point and sizing?”
A great question from one of the allocators in the room, with the more explicit question – how should we, an institution, try to take advantage of this theme? Dr. Harvey believes that we are merely 1% into this revolution…but a good decision at a bad time is merely a bad decision.
Here are some potential ways to access these markets, ranked from least to most attractive for institutional investors, according to the group:
Bitcoin Spot vs. Futures Prices ETFs: In October, ProShares won the competitive race to launch the first Bitcoin Futures exchange-traded fund (ETF), and broke records in terms of inflows and trading volume. However, these ETFs are not direct investments in Bitcoin, a product of which is not expected to be approved any time this year. Investing in a Bitcoin Futures ETF brings about its own risks – not only is the management fee which, at the moment, at 0.95%, but also the futures curve currently sits in contango which, according to a Morningstar article on October 22, sits at a negative roll yield of 11.8%. As Ben Johnson, CFA at Morningstar says…investors have better options with the real thing.
Direct Investing: Direct ownership provides the cheapest and most customizable option for investors but, for most institutions, executing a cryptocurrency program is a difficult task and requires enormous operational and custodial due diligence. Beyond operational issues, the universe of cryptocurrencies sits at $2.6 trillion, with just north of 13,000 tokens available for investment. There’s so much happening on a daily (or hourly) basis – how does one know what to buy? Not everything works well in a DeFi setting.
Venture Capital: For institutions, perhaps the best way to access this space is through high quality venture capital GPs. Of course, every VC fund accesses the market differently. Some take a more diversified approach (where they hold cryptocurrencies, private equity stakes in some of the companies behind the protocols, and governance tokens), while others may focus on a particular area. Agnostic to approach, many well-known VC firms are investing in this space.
Finally, from a sizing standpoint, the group discussed what an optimal allocation might look like. It probably comes as no surprise to hear that “it depends” based upon the objectives of the capital pool. However, the group went a step further – what exposures do you currently have in traditional finance and FinTech that are likely to be disrupted? Even if you don’t have direct exposure to DeFi, you may be implicitly shorting it by owning legacy technologies and business models. In other words, if you’re not long, you’re probably short.
Putting It All Together
“I've got no strings, so I have fun…I'm not tied up to anyone”
The promises of DeFi are enormous, but there’s still a long way to go in terms of widespread adoption. More importantly, there are some major drawbacks to the technology that should be addressed even before there’s widespread adoption, such as the large environmental issues surrounding Proof of Work or small personal issues like password recovery or transaction errors where a centralized exchange or clearinghouse may display their worth.
When it comes to investing in cryptocurrencies, retail investors have fewer strings attached to their portfolios…they invest (or gamble) for themselves and often answer to fewer stakeholders. While institutional allocators often answer to a board of trustees, they are fiduciaries and tasked with being proper stewards of long-term capital for their end clients and, understandably, will be far more skeptical. In other words, they’d rather be smart than an actor.
Seek education, diversity of both your portfolio and people, and know your risk tolerance. Investing is for the long term.
About the Author:
Aaron Filbeck, CFA, CAIA, CIPM, FDP is Director of Global Content Development at CAIA Association. You can follow him on LinkedIn and Twitter.