Finance is the centuries old, perhaps older, art and science of organizing human resources over time using contractual arrangements involving what you might call financing. Referential definition, what’s financing then? Financing is planning for the future, and getting someone to agree to that plan and take a risk, that in some way accounts for resources that would otherwise not be made available to some project, and in so doing enables the economic producitivity of the project to, with some luck, repay the financier. Doing it this way got us tech, globalization and the population boom.
TradFi is the Traditional Finance world, wherein highly regulated and licensed legal entities with only moderately tarnished centennial reputations engage in debt contracts and very segregated derivatives contracts, in order to make developed economies go around. Central banks prop the whole thing up and in the modern era, economic complexity makes the relationship between quantity of money and some formula of broad price inflation not quite correlated. Professionals charge fees persuant to agreements under which they take fiduciary obligation, almost a hippocratic oath for finance. It is a place with great corruption, yes, but at the end of the day the SEC or FinCEN can collect billions of dollars in penalties and everyone gets paid.
In DeFi, nefarious young people wearing Guy Fawkes masks entrust the arbitration logic of debt or derivatives contracts to a virtual machine executing the contracts as code on a “smart contract” facilitated blockchain. They speculate in various volatile assets, just like in TradFi, using fixed rate or variable rate or secured or unsecured debt, or using swaps or futures, and the sophisticated ones also speculate on those rates and leverage the disparate time-value of two instruments to earn big that way. It’s a lot more fun than TradFi because it is permissionless, anyone outside the US and some other jurisdictions can legally start with little capital, on chains where the fees are not too high, they can thrive. Even Bitcoin, that conservative chestnut of a vanilla cryptocurrency Store of Value, is getting DeFi via Discrete Log Contracts, the Lightning Network, and TradeLayer, as well as several sidechain projects.
Pro’s of DeFi:
Open to anyone
Makes leveraged time-value arbitrage a viable strategy for sophisticated users
Assets have high up-side volatility for trend following
No arbitration, predictable outcome and settlements
Transparency of systemic risk
Con’s of DeFi:
Ambiguous operational risk as to auditing of smart contracts
Tax accounting grey areas add overheads
Concerns about Collateral Quality
Pro’s of TradFi:
Has already built much of existing civilization so that’s a vote of confidence
They just mail you 1099-Bs or analogous tax forms per jurisdiction
Insurance that is ultimately backed by the US government’s printing press (even for foreign financial entities viz the Swap Lines and other monetary benefits the Fed extends abroad)
Weekends off is very good for mental health over a career
Less eccentric seeming
Con’s of TradFi:
Cantillion Effect exacerbates inequality compounded over generations
Political Risk for Capital Holders
The opposite force to the above: Financial Lobbying runs roughshod over the institutional integrity of the Democratic Republic, for which it stands
Withholding and excise taxes
Office Christmas Parties
Regulatory capture limits knowledge and expertise in derivatives, which are interesting financial technology that should be broadly available with some guard rails and limits, to an elite few who trade for an Eligible Contract Participant or Registered Swap Dealer, or who use venues with a near-monopoly due to regulatory moats.
It’s very hard to find collateral in the TradFi system that has a good discount rate and is therefore preferred to hold.
And this is what it all comes down to folks, these assets like Bitcoin can be hedged in USD and earn a high carry that is generally above the rate of inflation in USD, whereas USD-denominated debentures with a similar risk profile yield half or even one tenth as much. The risk is effectively similar to secured lending but with rapid and automated settlement of collateral. You can buy $10,000 worth of BTC, hedge -10000 BTCUSD-PERP contracts on some venue, and accrue the swap rate paid on that instrument, which is variable based on overall premium in the instrument. Many of these contracts are inverse-quoted and that means there is no liquidation price for a 1x hedge, it is synthetic cash that acts like USD earning a variable money market rate. This does indeed imply, yes, that the rate could go negative and the “money market” position breaks the buck - what’s interesting there is it can be unwound with the swap trading at a discount and this can net some profit unwinding back to traditional USD deposits with 0% cost of carry.
In some economies the cost of carry for cash is not 0% but slightly negative and in the COVID panic of March 2020 we saw the world swoon with demand for eurodollars to just preserve value and give people a needed sense of calm.
In the TradFi system the Fed backstopped everything under an abundant reserves regime (no more 10% reserve requirement, now 0). The Fed already began monetizing the repo market to facilitate this flexible abundance, in Sept. 2019, they then underwrote a large expansion in the Fed’s balance sheet and an associated fiscal push. This is surely not new information to you.
In the DeFi and CeFi systems around these strange new forms of volatile property, there were some liquidation funds that lost a couple million dollars, paid back in by the shop from its profits, there were some venues that had serious throughput issues and backlogs that associated with downtime near the pivotal bottoming of a one day move that clocked a total ~58% drawdown in 24 hours. That’s extreme volatility, much more extreme than we saw in even the high-beta headliners of the S&P 500. But the volatility was priced in by a blown-out term structure that left huge arbitrage opportunities to anyone with BTC borrow available or just cash and a willingness to buy futures at a 10% discount to spot. It might seem unprofessionally extreme, but it kept working. At some level the fee cashflows and arbitrage flows in this system are fueled by the high volatility, which drives high swap rates and futures premiums, or the extreme opposite. When the term structure is positive and stable, this provides institutional capital the opportunity to earn nominally risk-free yield by buying spot BTC and selling associated derivatives. This can also be done, sometimes with higher yields, on more volatile, younger, less liquid assets such as ETH, SOL, LTC, and so on. This is Cryptodollarization.
Post-TradFi, finally, is what TradFi inevitably going to become.
Ok not inevitably, I’m a CEO trying to work a reality distortion field - but in a rhetorical sense.
Post-TradFi has worked out the mental and legal blocks that have prevented more trillions from coming after the Cryptodollarization trade. Because these assets are scarce or semi-scarce, like stocks, they tend to get squeezed by this kind of inflow, so the dollarization trade does become a more patient form of capital holding up the market and charging some rent. Eventually it can lead to price moves that generate large swap payments in short periods. What custody, regulatory, tax accounting, counter-party quality, liquidity and market structure issues need to be solved to get this party scaled up?
Everyone wants to earn carry holding synthetic bills that are guaranteed to do 25% on the LP money and then you use that collateral to do other arbitrage. The volumes in this space are going to continue to grow. The utility of this cash interest rate market for every retail user on the planet, many small businesses who aren’t getting nearly as good a deal in their local system, many savers who are collectively losing trillions a year to financial repression, so there’s going to be enough noise trading flow to make this Post-TradFi system lucrative as it integrates with cryptocurrency and cryptodollarization.
Finally, the pitch:
TradeLayer can be used in an anarchic way if people want to do it because we built on Bitcoin-like protocols and they are based on psuedonymous addresses, *but* we did build in KYC whitelists into the protocol to make issuing assets legally safe, to enable filtration of counterparties. With sufficient meta-data layered into the hashes that mark these KYC transactions, it’s possible to sort out a lot of compliance issues. When you add enough meta-data to a graph of addresses transacting with each other, it becomes people to get a very high fidelity look at any pattern behavior that may indicate wash trading, money laundering, or attempted market manipulation.
Custody in BTC is solved with multi-signature addresses, right now there are a growing list of institutions that provide single-signature, wholesale BTC custody but this environment can become more sophisticated as time goes on, including integrating with DeFi protocols. We will increasingly see the full suite, but expensive service providers getting licenses and firming up one-stop-shop platforms where they hold custody and also broker lending, trades and DeFi applications, this is the new generation of prime brokers and this kind of gambit is possible for start-ups now because we’re seeing an epochal shift to financial technology that tends to come only ever 20-30 years due to organizational moribundity in banking.
BTC services are easy to understand because of how many full-custody services there are, Ethereum seems scarier, more things can go wrong. The Travel Rule is not yet being enforced on the supply of USDC and other stablecoins, but on TradeLayer such assets can be issued with whitelists and comply with the Travel Rule on the back-end.
Probably something like DFinity will capture more market share for replacing things Sun sold Wall St. in 2002, but Lightning Network participation may be supported by these custodians. Some institutions will embrace multisig or MPC, which is an analog of multisig, and maintain some custodial controls while having security protocols in place with back-up keys, possibly including using licensed custodians. There will be very little yield in pooling BTC on the Lightning Network, and somewhat more yield in staking ETH and hedging it, and somewhat more yield still in being an active arbitraguer and holding some of your own keys.
The biggest challenge to get to the Post-TradFi world is precendent - it’s a lot easier for financial professionals to try something and adopt it if there is a clear case of it being used by other reputable parties in a regulated setting, creating a model for regulatory clarity by example. This is part of our business strategy at TradeLayer. First we build global liquidity operating in less regulated environemnts, then we try to do a regulatory pilot. We’ll also be testing systemic risk through a series of experiments, to stay ahead of regulators’ legitimate concerns with a data-driven approach.