The Breakdown - Are Banks Getting Nervous About Competition From DeFi?

Episode Date: May 6, 2021

Today on the Brief: MercadoLibre has added bitcoin to its balance sheet Galaxy Digital buys BitGo  Debates around the new, improved, real economy  Our main discussion: While the last year has seen a massive amount of growth in decentralized finance, it has been mostly driven by enfranchised insiders and builders. In this bull market, that is starting to change. In today’s episode, NLW looks at a recent paper by the $1.1 trillion bank ING around where DeFi fits in the context of traditional finance. -- Earn up to 12% APY on Bitcoin, Ethereum, USD, EUR, GBP, Stablecoins & more. Get started at nexo.io -- Enjoying this content?   SUBSCRIBE to the Podcast Apple:  https://podcasts.apple.com/podcast/id1438693620?at=1000lSDb Spotify: https://open.spotify.com/show/538vuul1PuorUDwgkC8JWF?si=ddSvD-HST2e_E7wgxcjtfQ Google: https://podcasts.google.com/feed/aHR0cHM6Ly9ubHdjcnlwdG8ubGlic3luLmNvbS9yc3M=   Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW   The Breakdown is produced and distributed by CoinDesk.com

The real gist of this is that decentralized finance would do better if plugged into centralized financial rails. It seems to me that one of the central categories of inquiry and debate going forward is going to be around co-option of crypto finance ecosystems by traditional finance. How much adoption, i.e. assimilation by banks in traditional finance, is good. How much, if any, undermines the enterprise? I have a feeling this won't be the last report like this, this cycle, and so understanding where different projects and people stand on those questions, is going to become increasingly important.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.io, neer.org, and genesis trading, and produced and distributed by CoinDesk. What's going on, guys? It is Thursday, May 6th, and today we are asking whether banks are getting nervous about competition from D5. First up, however, let's do the brief.

First on the brief today, Mercado Libre is the latest company to add Bitcoin to its balance sheet. This is a massive Latin American e-commerce and fintech company. You may remember them from being one of the founding members of the Libra Association and then leaving that association a few months later. It's a company that is based in Argentina but listed on NASDAQ. They announced as part of their Q1 reporting that they had added $7.8 million worth of Bitcoin to their balance sheet. Now, in some ways, this isn't that surprising. Mercado Libre has a long history of interaction with Bitcoin.

In 2015, they integrated Bitcoin as a payment option on their Mercado Pago platform. Just last week, the company announced a real estate platform exclusively for properties available for sale in Bitcoin, launching with 75 initial properties. Some on Twitter pointed out that a Latin American company investing in Bitcoin to protect itself from currency devaluation was even more poignant than some of its American counterparts. given how frequently bouts of inflation have destroyed savers in places like Mercado Libre's home of Argentina. And speaking of Latin American unicorns, the Mexico-based crypto exchange Bitso has just raised a new round of funding that values it at $2.2 billion, making it the first Latin American crypto unicorn. Next up on the brief today, Galaxy Digital has bought BitGo for $1.2 billion.

One of the key themes we've been watching here at the breakdown is Crypto. M&A. M&A can tell us a lot about where an industry is. When times are tough, M&A is a survival strategy for companies that might otherwise go under. When times are good, M&A is often something very different. This time around, there are two broad categories I'm seeing. First, is a joining of forces not because one party is at risk of dying, but because together they see more chance to win an important category. The second type of M&A I'm seeing is a catching up of big external actors racing to join the space. Interestingly, BitGo has been on both sides of that coin over the last few months.

Last year, they were in advance talks with PayPal about a merger. Obviously, PayPal has been racing to catch up in this crypto space, and with now a booming business in this area, the need for the type of custody offered by BitGo was clear. The deal that actually happened, however, with Galaxy is something different. Galaxy is one of a number of firms trying to create a prime brokerage for institutional engagement with the crypto space. Custody is obviously a key part of that, and the deal brings about 400 new clients into Galaxy's orbit, getting them one step closer to that prime

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set prime brokerages. They are also the largest institutional digital asset lender. In Q1, Genesis facilitated over $30 billion in spot trading, over $10 billion in derivatives transactions, and over $20 billion in new loan originations. Check out the Genesis Q1 report on Genesistrading.com for insights from the firm gathered from across their spot trading, derivatives trading, lending, custody, treasury, and prime brokerage business lines. Visit genesistrading.com today to learn more. Third and finally today on the brief narrative competition around employment and the economy. So first, the good news. U.S. jobless claims have fallen more than expected to a new pandemic low of $498,000. Tomorrow we get the official April jobs report and that is expected to have more good news. So why are stocks falling?

Well, in short, it comes down to a perverse relationship between asset prices and market pain. Investors see the return of the real economy as a leading indicator of the Federal Reserve peeling back monetary support. That support is integral to sustaining the valuations of companies where they'd been trading. Hence, you get a situation where the real economy improving becomes bad news for stock market investors. There's another dimension, however, to the employment story that's also worth discussing. There's some intense narrative debate over labor shortages. The Fed has insisted that these shortages are all anecdotal. And to the extent that they exist are very transitory. There's that word again. Their claim is that if they were more than anecdotes, we'd be seeing a bigger increase in

wages. However, if it is just anecdotes, they are certainly growing in number. A Bloomberg headline reads, companies warn of U.S. labor shortages economists call temporary. Companies from MGM Grand to Chipotle have said that they can't find or entice enough workers to come back. On earnings calls, you've often heard the finger being pointed at stimulus checks and unemployment benefits, although that certainly is more anecdotal than data. Now, in terms of actual data to watch here, it's not just the unemployment rate, but the labor force participation rate that matters. Remember, unemployment doesn't consider people who aren't actively looking for jobs. Right now, unemployment is down under 6% again.

However, the labor force participation rate is still far less than pre-pandemic levels. This means that some meaningful number of people have stopped looking for jobs. There are tons of reasons for this. Continued health concerns, child care issues, post-pandemic structural adjustments in where and how work takes place. All of these could be contributing. It's one of the strange followouts of the unprecedented last year that we've had and certainly something to keep an eye on.

But with that, let's move on to our main topic about banks and D5. So this is a good moment to remind you guys about what I see is the raise on debt for the show. More than anything, I'm interested in shifts in power. In our world, power is wielded through many channels, cultural, political, military. All of these are expressions of power. The primary, although not exclusive focus of the show, however, is, of course, economic power. The reason I spend so much time on Bitcoin is that I don't think you can reasonably talk about shifts in economic power and not talk extensively about Bitcoin.

When it comes to other crypto assets, it's not that I have an a priori dismissal of their capacity to also be a part of this conversation. It's just that in many cases they haven't got there yet. Defi is perhaps the best example of this. On the one hand, Defi transparently offers benefits over the traditional financial system. It is in many ways more purely and ralely market capitalists than even the comparatively lightly regulated American system. On the other hand, Defi has largely been in an internal incubation period, where a furious array of tests and entrepreneurial experiments have been

undertaken by largely enfranchised insiders. And don't get me wrong, the ammunition is real and the growth in the industry is undeniable. From less than a billion in total value locked, almost exactly a year ago to more than $60 billion deployed to DeFi apps today. I will note before y'all get tribal that while Defy is undeniably connected to Ethereum right now, it seems pretty clear to me that what it represents isn't just limited to a single chain. Rapt Bitcoin is already used as a base asset for almost 20% of that total value locked. Binance smart chain and Solana are both seeing significant building as defy hubs, and we haven't even really seen the Cosmos and Pogo ecosystems get up to their full potential yet. Lastly, I will also note that I think that I think

it has been hugely to the benefit of Defi that this space has been comprised primarily of those enfranchised insiders. I think that it has reduced the risk and allowed for more powerful tests and trials with fewer people getting hurt. But as this bull market goes on, the composition of who is playing around in Defi is changing. It's changing in a bottoms-up way as the TikTokers use Dexas to access absolute rubbish like Safe Moon. Chow Wang tweeted yesterday, some of my Normie friends are trading shit coins in Dexes. They aren't technical. People think defy is too hard UxYs. Nope, this shit works. So that's one force-changing things. The second is some amount of growing attention from banks and financial institutions. As you heard yesterday with Robbie

Gutman of Nidig, it would be very easy to overstate this. By and large, the vast majority of institutions who are paying attention to anything in the crypto space are strictly and exclusively wading into Bitcoin. But that doesn't mean we're not seeing the early glimpses of a future in which defy is a part of that institutional power conversation as well. I want to point specifically to a paper release last month by ING or ING called Lessons Learned from Decentralized Finance. So this is a big Dutch financial institution that's one of the largest 30 or so banks in the world. It has 1.1 trillion in assets, and if you've ever flown through an airport like Amsterdam's, you've seen their orange ads absolutely everywhere.

The paper is a serious attempt to understand the defy space. And it does functionally two things for other bankers or interested parties from traditional finance. First, it gives an explanation of the basics around defy, including a case that he of AVE, and then it gives a slew of their conclusions. One quick note, the way that they define defy actually just straight up includes Bitcoin. They basically define it as any financial application on a blockchain and reference the Satoshi White Paper throughout. Let's briefly go through those 15 or so conclusions to see how banks are interpreting this new source of competition. The first is composability as innovation catalyst and risk. Composability is the idea that because

all of these protocols are built in an open source and permissionless platform, they can plug into one another and be built on top of one another. This has radically increased the rate of innovation. However, the bankers worry that it creates a very familiar type of systemic risk. Quote, financial contagion in defy can be best described as the potential damage that could be done to all protocols, relying on an underlying protocol, if the underlying protocol does not function as intended by the protocols that have built on top of it. Composability has the potential to undo all the innovation in defy as fast as it has accelerated it. Their second takeaway has to do with flexibility, and what they're really articulating is what they see as a trade-off.

On the one hand is convenience, 24-7-365 access. On the other is complexity, or at least what they're arguing is complexity and how people interface with defy. However, that interface word seems to me to be the most pertinent one. Complexity is often an issue of UI-U-X and highly solvable. Their third takeaway has to do with legislation. They say defy legislation may improve adoption. The most interesting thing to me here is that this isn't some generic regulatory fud.

They identify a specific question as central, where liability lies if a protocol doesn't work as intended. Their fourth takeaway is that centralized institutions can benefit from defy's borderlessness. On the one hand, this is a recognition that defy and Bitcoin are inherently global internet phenomenon, not restricted in the same way to national boundaries. But it's also the beginning of what you're going to see throughout the rest of this paper, which is a real idea that centralized finance and decentralized finance should be working together. With takeaway number five, you start to see them shifting away from all the good stuff to things that they don't like as much. Their fifth takeaway is that defy is a coin with two sides, and

here they draw a contrast between micro effects and macro effects, which are their terms. They call everything in defy currently, from stable coins to p-to-p lending, micro-effects. Then they have this weird word salad line. Quote, however, the macro effects of decentralization of financial services have been discussed before the introduction of blockchain in 2009. These effects are currently. currently lacking in the discussion on Defy and the literature. For example, decentralization may have dangers, pitfalls, and may be in need of rethinking. Although Defy may seem to offer many opportunities by improving existing or introducing new financial services, its macro effects

should be taken into account as well. Like I said, given how absolutely little that actually says, it reads to me like they're trying to dig up something to make this whole thing more dismissible or at least more co-optible. I think you'll see from the next set of takeaways that that continues to hold. Number six, defy properties are not always realized in practice. They talk about efficiency, transparency, decentralization, and finality not always being realized. They're discussing transaction costs. And they also make the bold claim that Bitcoin and Ethereum are less decentralized than envisioned without any explanation or justification of that logic. Number seven, there's no clear definition of defy yet. Number eight, defy literature requires a critical review.

Now, number nine, it gets interesting again. There is a tension between transaction, transparency and basic human rights. This is a good conversation to have, where we draw these lines, what the rights to privacy are in these new types of internet monies and financial applications. But then their main takeaway is that defy companies should take advantage of collaborations with existing corporations to plug into KYC AML regime. So even if we are having that conversation, I'm not sure where they're going to fit into it. Number 10, defy is not without risk. I mean, yeah. Number 11, there is currently no liability. This is a lot of goes back to the regulatory thing I was mentioning above. Number 12, full decentralization may be suboptimal,

and by this time, they've made it insanely crystal clear that the conclusion they're working to is, hey, there are some good things here. Us centralized folks and you decentralized folks should team up, with us in control. Number 13, they say tying real world assets to defy remains a challenge, so the Oracle issue in so many words. 14, more work on risk is needed, and 15 AML and defy could be assisted by centralized finance. Phew. So, like I said in number 12, the real gist of this is that decentralized finance would do better if plugged into centralized financial rails.

So why does this matter? Why is this worth the whole show? Well, it seems to me that one of the central categories of inquiry and debate going forward is going to be around co-option of crypto finance ecosystems by traditional finance. We're having this conversation right now in an accelerated way in the Bitcoin space. The dominant force in this bull market has been the introduction of institutions. Do they share the value of Bitcoiners?

Are they willing to throw aside censorship resistance and just keep the sound money thing? Ultimately, does the sound money thing even matter? Or is that just a nice narrative excuse for the true draw? NGU number go up technology. Based on this paper, it feels to me like DeFi builders are likely going to start having these conversations as well. How much adoption, i.e. assimilation by banks in traditional finance, is good. How much, if any, undermines the enterprise?

I have a feeling this won't be the last report like this, this cycle, and so understanding where different projects and people stand on those questions is going to become increasingly important. At least I think. But for now, guys, I appreciate you listening. I hope you're having a great week, getting excited about the weekend. We're almost there. Until tomorrow, be safe and take care of each other. Peace. We're witnessing the greatest paradigm shift in finance in modern history. Join thousands of newsmakers and influencers talking the future of money at Consensus by CoinDesk. A live virtual experience of leaders, change makers, virtual reality meetups, keynotes from Ray Dalio, Gary Vaynerchuk, and much more.

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