Looking back, 2022 was probably the biggest year of upheaval in crypto history. Multiple times throughout the year, I found myself saying, “this feels bigger than Mt. Gox.” Back when Mt. Gox was hacked, it kicked off the next phase of significant development within the crypto space: transitioning to a more global architecture of trust minimization and removing intermediaries beyond just within payments.
In practice, self-custody solutions like Ledger and Trezor took off in the early days. They made it so individual retail crypto holders could store their funds in something more secure than just their computer, while not having to trust a centralized exchange to hold their assets. On the institutional side, firms like BitGo made it so institutions could also store funds using secure multi-sig solutions, again removing any need to “trust” exchanges. These shifts seem small/evident in hindsight, but they were meaningful — enabling people to hold their crypto more securely.
A more significant shift happened with the build-out of Ethereum and smart contracts. This technology would make it possible to engage in a wide range of value transfer transactions (whether financial or otherwise), globally, and without having to trust any person or entity. The vision also included making the financial system more efficient, more accessible, and dropping the cost of financial intermediation.
However, many of those benefits still depend on the further build-out and integration of scalability improvements. At the time, there were a handful of people talking about the idea of being able to trade crypto without using exchanges, whether via atomic swaps — a sort of glorified OTC transaction doable in a way that doesn’t require trusting the counterparty — or via the advent of full-fledged Ethereum smart contract-based decentralized exchanges (DEXs). If you fast-forward to today, it’s easy to make crypto-to-crypto trades via DEXs like Uniswap and 0x. And back in 2013 and 2014, those ideas were just mere twinkles in the eyes of developers who had but written a handful of early thoughts on forums.
History Doesn’t Repeat, It Rhymes :: DeFi Is The Foundation For The Next Crypto Cycle
2022 felt quite similar to the late 2014 era in crypto. Many projects and companies that exemplified the antithesis of crypto’s fundamental principles blew up. People were saying, “crypto is dead,” yet I I believe it was one of the best times to get in the space, start building serious things, and a great time to deploy capital into crypto. It really is darkest before dawn.
And while there’s a temptation to say “this time is different because…”, things are rarely that different. While the exact cause of destruction was different, the theme of centralized entities failing because they were either hacked or became greedy and started doing sketchy/illegal things is a tale as old as financial markets. Actual crypto — like on-chain, smart contract, protocol-based crypto — really mitigates these problems because you don’t need to hand all your money over to one entity that claims, “trust us.”
One exception/caveat to this is that smart contracts are just code — code is dumb and computers generally do exactly what you tell them to do (ignoring the possibility of solar flares). So, writing a smart contract that creates a risky financial product is still risky, even if you no longer need to trust some centralized exchange, legal system, or whatever to execute that product. If I make a smart contract that lets you do uncollateralized lending, it’s not the computer program’s fault if your loan doesn’t get paid back.
With that disclaimer out of the way, the short version of “what was different” about the centralized finance (CeFi) blow-ups in 2022 was the exuberant crypto credit market. Three Arrows Capital, TerraLUNA, BlockFi, Celsius, Voyager, FTX, and Genesis have a pervasive thread: effectively lending vast amounts of capital to relatively risky counterparties, either without sufficient collateral posted or sufficient risk limits on that collateral, if any collateral was posted at all.
What’s interesting to note here, on the other hand, is that decentralized finance protocols, which lent to largely unknown counterparties, didn’t blow up. The reasoning behind why DeFi protocols managed to succeed has a couple of levels to it. The surface level is that these protocols (e.g., Compound, Aave, and Maker) force people to post collateral and enforce aggressive risk controls. The great irony is that those risk controls are the same kind of controls centralized entities often anecdotally said were “too tight, just inefficient”. They’d tell us, “these protocols can’t monitor risk like we do”. Mere months later, one of my closest friends told me about the favorable borrowing terms one of these companies gave him — the company was taking on absurd amounts of blow-up risk. I told him something along the lines of, “the next cycle will likely blow up due to these centralized lender entities. They’re picking up pennies in front of a steamroller.”
In software, there’s a common phrase: “worse is better,” meaning simpler systems that “just work” are better than highly intricate designs that increase the risk of failure. DeFi’s risk controls are, in my view, a great example of the worse is better philosophy, but for finance. Those centralized lenders that we spoke with sure had “elegant” systems, but none of their systems worked. Many of the hottest, “best” growth rounds of the prior cycle are zeroes. Some because their businesses weren’t real businesses — they were just akin to betting against downside volatility —and others because they were outright scams.
The second level of why DeFi protocols worked well in 2022 is the more critical, higher-level reason. Decentralized protocols can’t just say, “trust me, I went to MIT and want to donate everything to charity”. DeFi protocols are more of a “you don’t have to trust us” nature or, as Google put it so well before they dropped it: DeFi protocols “can’t be evil.” The only option at the protocol layer is to build something that works, something from first principles, in the open, against a pseudonymous playing field of rational economic actors, where your code is public, and anyone can scrutinize and read it.
Nick Szabo put it best: “trusted third-parties are security holes.” 2022 crypto in a nutshell.
Looking Towards 2023
Looking forward, I think it seems fairly evident that the historical arc of the world’s financial rails will end up as blockchain-based systems using smart contracts. The real questions are how we get there and what needs to happen to get there.
Despite lower prices, I think the space is clearly in a much better position than ever. We finally have scalability solutions that enable transactions with sub-ten cent transaction fees. With a couple more upgrades to Ethereum and Layer-2s (protocol extensions), it’s hard not to see transaction fees down to about a penny. That’s important because decentralized exchanges can’t compete with centralized exchanges if fees are too high.
The other significant paradigm shift — versus 2017 — is that developer infrastructure was practically non-existent back then. It’s just so much easier to write smart contract-based systems now than in the previous cycle. In 2017, I was the first primary user of Alchemy and everyone was messing around with janky node infrastructure on AWS or DigitalOcean. That and other problems have already been solved for new developers as they enter the space. And it’s not just nodes. Every other area of the stack has improved, whether test suites or automated tools to catch common bugs in smart contracts, to having IDE support for Solidity.
If we look towards what’s next, I believe there are two interesting questions:
1. What does the end state look like?
2. What enabling innovations and companies/protocols need to be built to let that happen?
Of course, I believe both areas are interesting to invest in.
The end state, in my view, is one where decentralized finance protocols and apps essentially solve many of the problems discussed above. The average person will have apps on their phone that give them access to DeFi, where they’ll be able to engage in financial transactions without banks/brokers, with lower fees, global liquidity, and markets operating 24/7. The internet, but for finance. The problem with fintech is that it’s mostly lipstick on a pig, and the pig is the existing financial system. To enable the true vision of crypto, we need to create a new economic infrastructure from the ground up. The good news is that many of the primitives of a new financial system exist today.
For instance, we already have currencies (both dollar-pegged and free-floating), exchanges, lending markets, etc. The world in this universe looks like one where when you want to trade an asset, you use a decentralized exchange where you can access a global liquidity pool to trade without first depositing your assets to an exchange. Even things like OTC trading — typically used by HNWIs (high net-worth individuals) or institutions — could take place in DeFi. Why send money to an OTC desk and hope that they send the other trading pair back to you? Instead, the OTC desk should be able to automatically send you a link that contains their quote, which only you can fill.
When you want to lend or borrow an asset, I believe the most logical place to do so is on one of the DeFi lending protocols. Currently, DeFi lending protocols are some of the few venues where it’s possible to borrow or lend in crypto at all, especially given that, with a few exceptions, many of the larger centralized lending businesses in the space have become insolvent.
There’s also an exciting innovation in financial markets that originated within crypto called “perpetual contracts”. These enable traders to get leveraged exposure like what one can get with futures contracts but without expiration dates. Instead, interest is paid continuously to the side with less demand (i.e., if there’s more demand to go long, it’s paid to shorts, and vice versa).
There are a handful of decentralized perpetual exchanges with traction. While the failure of FTX is undoubtedly a catalyst for “perpetual exchanges” to take off at scale, I believe we need to first build some enabling innovations. Long-term, that’ll happen within apps that are easy to use, where end-users may not even know they’re using DeFi. And very long-term, real-world assets will exist and be tokenized on chain. So, the steady end-state looks like a new, parallel financial system that enables everything you can do in the legacy system and much more. Similar to what the internet did with content creation, crypto enables the creation of an endless suite of custom financial markets on anything.
The Path To Success
To enable all of this, I believe there are a handful of problems that must be solved for adoption to take off further. The issues fall into two categories:
1. Increasing liquidity within and for the DeFi ecosystem
2. Making DeFi as easy as possible to use
Liquidity-wise, to get more institutional capital using DeFi, there needs to be more asset custodians that support using Ethereum directly. While there are great solutions like Fireblocks, the major issue is that most, if not all, of these solutions are not regulated custodians from an SEC standpoint. Some custodians that have received charters from federal or state agencies to operate as regulated custodians in the crypto space, like BitGo, support using DeFi protocols through a partnership with MetaMask Institutional, but still other regulated custodians must also add support for using DeFi protocols. This should bring much more liquidity and capital into DeFi.
Another way of increasing liquidity is to aggregate liquidity across multiple chains, Layer-2s, and liquidity pools on those chains. These aggregators will enable users to submit a trade and apps will source liquidity across multiple venues, across multiple chains, to get users the best price and best execution. To build that, we’ll need fast and secure cross-chain bridges. Many of the cross-chain bridges constructed to-date strike me as hacky — not in a cool “hacking the PlayStation” sort of way but more “slapping some stuff together that really only works if you trust (insert trusted third-parties here)”. The kind of trust, as we’ve seen, that is a “security hole”. The bridging problem has always been a software problem and should be solved with software in my view — not oracles, trusted multi-sigs, etc. The ideal way to solve this is to use zero-knowledge proofs, which, once Ethereum ships “single-slot finality”, should enable the ability to bridge to other chains exceptionally quickly. At that point, pooling liquidity becomes much more feasible.
The second set of issues — the usability issues of DeFi — is just as crucial as the liquidity part. While usability has improved a lot over the years, a common retort is, “the web was super hard to use in the early days, usability shouldn’t be a barrier”. Since the early of days of the web however, user expectations for usability have risen orders of magnitude. People expect things to be easy to use. I believe three usability problems need to be addressed. If addressed, DeFi adoption may grow more rapidly:
1. The first is the problem of the user experience (UX) surrounding wallets. I love MetaMask and what it’s done for the space as much as the next person, but there’s just something about the UX there that leaves me wanting. It’s a simple browser extension that users download, rather than a robust application with a carefully designed UX. It has a confusing layout, can be overwhelming if you don’t know much about crypto, and there’s way too much going on in the UI (user interface). It reminds me of those old-school Palm or Windows handheld devices that existed before the iPhone (i.e., they may work, but they are clunky and confusing, even if you know what you’re doing). Maybe the long-term answer here looks like a sort of MPC-based wallet for retail.
2. The second problem is the issue of having to pay transaction fees in ETH. This makes it so that you need ETH in addition to whatever asset you’re sending/trading/transacting. The idea of economic abstraction solves this issue. That’ll be a protocol-level native upgrade to Ethereum that makes it so you can pay transaction fees in tokens other than ETH. One can easily envision how this makes it so that if you want to swap USDC for ETH, you can send USDC to your wallet and then trade for ETH without paradoxically needing to acquire ETH first. It sounds simple but it’s a vast UX advantage centralized exchanges currently have over decentralized ones. It’s also useful for a whole swathe of other apps with more mainstream users who aren’t familiar with ETH or the concept of why they’d need it to do a transaction.
3. The third problem — one of the more pernicious ones — is getting better fiat on-ramps that can integrate natively within decentralized apps (dApps). A mass-market, Stripe-like integration, — where dApps can add a fiat on-ramp to allow users to buy crypto in a few clicks and where the fees aren’t exorbitant — doesn’t exist yet. It needs to be embeddable as a widget within a UI, where no one controls the UI (i.e., dApps). While cool, Stripe’s new crypto on-ramp product doesn’t solve the problem here.
The solutions to this current suite of problems will take another two to three years to be solved and built out. Many of them, and the future innovations they enable, will provide excellent investment opportunities. As they do get solved, they create an exciting groundwork for the next cycle of crypto being driven by DeFi. To me, the most exciting thing about that is DeFi’s enablement of a new open, global, and more efficient financial system.
