Long Take: DeFi should take the middle road between the extremes of QAnon and J.P. Morgan

Sep 28, 2020

Hi Fintech futurists --

This week, we look at:

How the music industry needed The Pirate Bay and Napster
Why J.P.Morgan is paying $1B in fines for allegedly manipulating the precious metals market
Whether DeFi is flirting with self-dealing and veering towards apathy
Why QAnon and 8chan are a bad example for global governance
And how the European Commission’s proposed crypto-market rules are highly productive for blockchain-based capital markets infrastructure

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Long Take

You needed The Pirate Bay to burn the media industry to the ground. You needed Megaupload, and Napster, and Kazaa, and LimeWire and of course BitTorrent. Decentralized, broadly-distributed peer-to-peer protocols that re-imagined an industry with the sharp edge of a blade. Torches of ingenuity and innovation that, like the Internet, showed that you can give almost anything to everyone for free, across the world.

Here's an ethically unambiguous example: A free physics textbook for every student in India, rather than bought by Harvard undergrads for $250 per copy paid to the academic press and the tenured professor. We say this as once indebted American undergrads.

Someone has to do this dirty work -- of showing how the world could be if we just didn't play by the rules of the industry and the government. A single Promethean figure brings forth the flame -- some technology that cannot be put in the box. This Prometheus is ordained in the sense that technological and economic forces would cultivate and generate this flame regardless. But our history attaches to the Sean Parkers and Satoshi Nakomotos. And it is often the generational young that pick up the revolutionary flag. It does not take an army, but a community.

For the Internet Age, Alan Moore's 1982 graphic novel V for Vendetta has become a bible of hacktivism, a re-interpretation of the Promethean myth. Dig even a little bit, and you can see this weird cultural root that has taken hold. See the below panels for an interpretation of this creative/destructive fire caused by the anarchic character V, donning the mask you may now associate with the Internet hacker collective Anonymous. And see the collective in the flesh today, in our world.

Alan Moore is an amazing story teller, and one of the greatest comic book authors of all time. His work is beautiful, philosophical, and mystical. But it is not ethical per se -- or rather, it reflects on a subset of ethics. As Ayn Rand caricatures her own positions on the capitalist right, so does Moore for the anarchic left.

In other words, if we had to pick Ruth Bader Ginsburg or Alan Moore as it relates to being fair to the lived experience of millions of people, RBG would win hands down by being grounded in the reality of our society and a legal education that connects problems to systems that can solve those problems. One is a bard, giving voice to the crowd, and the other is a doctor of law.

An Incumbent's $1 Billion Fine

Corruption is a human trait. We can't help ourselves. Insiders pursue insider trading. Market makers turn into market fixers. Dealers get caught self-dealing. It is hard to ask for more from our DNA and lizard brain, wrapping dopamine hits around our self interest. And yet, evolution has shepherded the Homo Sapien ahead of all other primates and apex predators through the ability to socially cooperate on a massive scale. This advantage looks down at our base needs, and attempts to weed them out through enforced shared agreements (i.e., the law).

The closer you are to the conduits of power and money, the worse it seems to be -- a trite observation. Take for example the news that J.P.Morgan will pay $1 billion in what appears to be a fine for market manipulation practices in the precious metals market. The trading desk generated lots of false trading orders in order to move prices. Investigations from the Justice Department, the CFTC, and the SEC created the pressure on JPM to settle. In the context of about $4-5 billion in quarterly profits, this amount is fairly chunky.

Do we live in a world where it is good that regulators are able to punish malfeasance? Or would we want to give JPM, a key pillar of our economic infrastructure, a free pass on rent-seeking whenever it wanted? The answer to pretty much everyone is the former. Whether or not it, i.e., the regulation and its enforcement, works is a separate question.

Let's trace back to the Promethean cycle. Some will see the banks and such behavior, and believe it to be somehow special to these particular infrastructures, rather than a human trait. They will want to take the fire of finance -- how to make and distribute financial instruments across global markets -- and give it back to the people. The banks are Parliament, and V implements his Vendetta with a bang.

The Temptation of Anarchy

DeFi is the BitTorrent of finance. And it is having its moment in the anarchic, decentralized world of the financial Internet. It doesn't hurt to show the metrics again, with $12 billion now powering many of the asset classes we normally only see behind closed doors at the investment banks. Anyone, anywhere can have a taste of levered up derivatives. You can launch tokens and assets on Uniswap, straight to the Twitter-native crypto generation. You can slice and dice exposure, and bundle and re-bundle synthetic capital. Nothing is sacred.

But with this, comes the temptation.

We've written before about how some financial protocols are turning into Dadaist art. When the power to issue moneys is in the hands of everyone, can it mean anything anymore? And if money is an illusion, certainly everything related it to it merely a status game.

A fine line between the artist and the troll. Just ask Marcel Duchamp.

But if nothing matters and the status game is performance art, then why have ethics govern how we play it? If our creative spirit is so supreme that we see through the falseness of the system, are we not entitled to take what is ours? While burning down Parliament, should we not avail ourselves perhaps to some of its treasure?

A recent controversy has spread through the DeFi ecosystem, with insiders flirting with a self-dealing token -- some in jest, and some in earnest. While the conversation unfolded, allegedly a hacker launched an asset to capitalize on the moment. The experience has been a lesson in humility for the most ardent of the industry's defenders.

Why does this matter? As tokens are launched, early investors and miners benefit asymmetrically. Because token distributions resemble public offerings, where the cap table is fully diluted, rather than seed-stage venture investments, where the cap table will be diluted based on project performance, protocol founders are able to quickly monetize large founder rewards. It is true that without founders, there would be no technology or value in the first place. It is also true, that founders have inside information and are able to cash out prior to the functional deployment of valuable software.

We worry that longer term, the Alan Moore version of disruption is a distraction -- the way that MegaUpload being chased around with subpoenas is less useful than building Spotify or Netflix.

The Paths to the Wrong and Right Equilibria

It is easy and natural to fall into the gaping maw of the Internet. To push around edgy memes, hallucinating that this gives you more power than the US Federal Reserve.

If we really want to understand the natural destination of meme economies, we should understand the histories of our most polarizing image boards -- 4chan and 8chan. Nothing is more memetic than the radicalization that occurs at the edges, and the misinformation that it births for the rest of us. The QAnon conspiracy, arguably the most successful and destructive meme of the last decade, has been embraced by American politicians as long as it strengthens their power.

Do we collectively want to be governed by someone like Jim Watkins inside of a financial system that revels in the burning of the fire? One whose goal is to generate glee from the destruction? If Ethereum and DeFi devolve, or degenerate for those of you paying attention, into an unproductive financial virus, why should anyone with aspirations for permanent fruitful change invest their careers in this ecosystem?

They shouldn't. Watch how your leaders lead. Listen to their song not just for volume, but for truth, equity, and beauty.

So what are we actually excited about then? This:

There are the two fresh proposals by the European Commission on the regulation of crypto-asset markets, and a pilot regime building market infrastructures on distributed ledgers. Or as we like to say, open-source, programmable blockchains. These regulatory constructs would span across all of Europe, superseding member state rules and applying to token offerings across venues.

Two things stuck out. The first is the Commission's particular interest in stablecoins. To some extent, stablecoins are closest to sovereign fiat, and therefore raise meaningful alarm when a private entity prints them. And as a client, if you hold a dollar-equivalent, you shouldn't expect to lose all of that value if some smart contracts chokes on leverage and gets deconstructed in the Dark Forest of blockchain programming. Although this did happen to Auction Rate Securities in 2008!

The second is a potential exemption for blockchain-based market infrastructures from some Central Securities Depository requirements. Remember, CSDs are where securities actually sit in the traditional capital markets. They are, by design, centralized actors that perform a public function for the entire financial industry. In the case of blockchain-based markets, something like the decentralized Ethereum network itself is the asset repository. For the purposes of this regulation, we are still talking about a network run by a licensed CSD.

It appears that we may have already blown past the EUR 2.5 billion size limitation that the proposed pilot regulation envisions, depending on your definition of securities. There are also implications about transitioning to a non-blockchain based infrastructure that may be unachievable. But regardless, the benefits of having a clear path forward likely outweighs the short-term disconnect. For example, settling trades in tokenized money is a big step forward for traditional capital markets.

Final Takeaway

Some readers will take our position apart as compromising the values of the decentralized web. Others will see the need for regulation as obvious, and seek even more oversight. Both are somewhat beside the point. The crux of the story is that a middle road for DeFi will allow it to blossom into the next generation of the financial industry.

If it veers to far down into the flames, governments will find a way to stifle DeFi the way they have Chinese P2P lending scams and fraudulent ICO launches. If it slows down innovation to the point of looking for concrete guidance from prior regimes, nothing meaningful will be created and explored. Only by delivering on good, fair outcomes for a very large number of people, can a new paradigm truly light the way.