Year in Review
Wrapping up our Year in Review, part two will be a high-level exploration of the ‘whos’ (legacy financial institutions, new fintech firms, national sovereigns / regulators) and ‘hows’ (infrastructure, mode / method) of the digital asset space. In part one, we argued for a quickly maturing and converging digital asset space. In part two we focus on how actors have built and molded the infrastructure to carry out three functions in the both the centralised and decentralised digital asset economy: liquidity provision (exchanges, automated market makers), custody (institutional custodial solutions, self-custody wallets) and governance (blockchain DAOs).
1. Liquidity provision
Functionally, liquidity providers facilitate transactions between parties and enable marketplaces. Liquidity providers in the digital asset space are either centralised (exchanges) and decentralised (automated market makers).
This year, we saw the continued expansion of centralised exchanges moving beyond our traditional understanding of exchanges. Rather than just fulfilling the function of a marketplace, they are combining their offerings with retail-level services such as savings accounts or crypto-payment options (e.g Binance, Coinbase and Blockfi). These virtual asset exchanges go beyond their traditional counterpart to offer services such as custody, savings and payments integration etc. This is significant as digital asset exchanges can be thought of as portals or gatekeepers as they are typically the touch point for most retail entry into the digital realm from fiat. Moreover, while in traditional finance, requirements for listing are heavily regulated, there is no such equivalent standardisation for these digital asset exchanges. Many digital asset exchanges also have various incubation and funding programs for digital asset projects — such as Binance Launchpad, Huobi DeFi Labs, and Kraken’s grants to name a few. Considering the remarkable expansion of digital asset exchanges in such a compressed time frame and the multiple functions they offer, they are looking like they will exceed that of their traditional exchange equivalents.
Meanwhile, in the decentralized realm, automated market makers (AMMs) serve the function of liquidity provision (here is a good primer on AMMs). Instead of merely providing a venue for market makers to order match and provide liquidity, AMMs provide liquidity with no counterparty via automated pools with the price determined algorithmically. There are different algorithms that will determine the type of AMM, ranging from constant product (Uniswap), constant mean (Balancer), hybrid (Curve) to dynamic (Bancor).
AMMs are a ‘zero-to-one’ development from the centralised exchange model. First, they open previously siloed venues, opening global access and innovation. In traditional finance, exchanges are limited to the jurisdictions they are based in — listing of stocks is not jurisdictionally agnostic. This also applies to centralised digital exchanges. Second, as a ‘decentralised’ (note this is in degree among various aspects across different AMMs) venue it disperses power to allow greater participation. For example, anyone has the ability to bootstrap their own liquidity pools, compared to the centralised power of listing for traditional exchanges. Indeed, Uniswap has over 8000 trading pairs, nearly 100 times more than the largest centralised equivalent, Binance, as of Q3 2020. Given the accumulation of power of centralised exchanges (mentioned above), the importance of this to counteract potential gatekeeping is significant. Third, AMMs are part of the handful of financial primitives that make up DeFi space; crucial in allowing users to seamlessly swap between tokens to enable greater composability between protocols to use different currencies to use and build other more complex DeFi legos / protocols. As AMMs continue to iterate, it enables the usability of the DeFi ecosystem. For example, Curve, released in January 2020, uses an algorithm to optimise the trading of stablecoins — large volumes of stablecoins to be traded with little price impact and minimal slippage, which may have been a problem in smaller pools on Uniswap. (Here is the original whitepaper!).
While they are certainly a revolutionary ‘zero-to-one’ moment, AMMs still have various technological issues before they reach the same levels of efficiencies as their order book counterpart — decentralisation comes at a cost of cost, slippage, usability, scalability, capital inefficiency and interoperability, to name a few. However, looking ahead, the continued iterations of ‘second gen’ AMMs suggest that innovation is abundant and alive in this space.
2. Custody
2020 saw continued expansion of digital asset custodial solutions in centralised and decentralised finance.
For security tokens, beyond usual institutional grade custody providers, the end of 2020 saw more institutional involvement offer end-to-end primary-to-secondary market tokenisation solutions with custodial infrastructure. For example, DBS’ new digital asset exchange offers TaaS, exchange and enterprise digital asset custody for their clients. Interestingly, custodial solutions in the centralised realm may also offer brokerage and exchange services; for example, Archax (the first FCA licensed digital assets exchange) is a self-described ‘global, regulated, digital securities exchange, brokerage’. Indeed, many virtual currency exchanges do custodise client assets (on a relevant side note: here is a list of the biggest CEX hacks of 2020). The custodial solutions emerging in this space are more complex than their traditional counterparts.
In the retail space, banks have also been answering increased demand for virtual currencies. Key developments include Office of the Comptroller of the Currency (the regulatory body on the US Federal level) green lighting bank custody of virtual assets, while Standard Chartered in the UK has partnered to offer retail level virtual currency custody for their clients. In the same vein, South Korea’s largest national bank, Kookmin, announced it would build out digital asset custody services ready for early 2021. Similarly, Spain’s second largest bank, BBVA announced it would also be rolling out its BTC custody and trading services — with more virtual currencies to be added. Although these offerings are typically still limited to a few currencies (BTC, ETH, LTC) this development is still significant for virtual currency investment as legacy institutions offer familiarity and trust for retail investors.
In the decentralised realm, the maxim ‘not your keys, not your coins’ is often quoted. In DeFi — built on an ideology of financial autonomy without institutions or banks — if you do not custodise your own virtual currencies, you do not own them (essentially, digital bearer assets). While this rings back to the original cypherpunk notion of decentralizing power away from institution and financial autonomy, the responsibility of self-custody and ‘being your own bank’ has inherent downsides — particularly in cases of access problems. Should you forget your phrase, lose your wallet or send your coins to the wrong address, there is no backup. There is no ‘forgot password’ link to recover access or customer support. It is estimated that around 20% of existing BTC is ‘irretrievably lost’. Custody is not the most glamorous aspect of digital asset space or DeFi, but it is a centerpiece to the discussion of inclusion and adoption of a decentralised digital asset ecosystem.
The question of safe custody (i.e. one with as little avoidable self-induced ‘irretrievably lost’ assets as possible) is to ask the all too human question of how we do things with the technology we have, balancing between security (how safe, how much trust in other parties is required), usability (how easy it is to make transactions to and from the custodial solution) and cost (both in knowledge barrier and money). Here is an article that contextualises the problem social recovery solves, drawing together social, economic and technological dimensions, arguing for ‘social recovery’ wallets — a seemingly natural evolution from multisig wallets. With multisig, multiple private keys are needed to sign off a transaction, but it admittedly still does not address the problem of lost keys as if there are not enough cosigners, funds cannot be accessed. The idea of social recovery seeks to solve this: wallet holders have the option of appointing ‘guardians’ which can change private keys (should there be enough guardians) as a backup of last resort. While social recovery wallets are still rather nascent, we saw solutions like Argent come into fruition this year to specifically address this issue within decentralized finance.
Finally, sitting somewhere awkwardly in this discussion of custody in the digital asset space in 2020 is regulatory influence on custody. In 2020, chatter from regulators with AML and KYC requirements intensified, with various KYC and AML custody requirements on centralized exchanges. This twitter thread highlights the tension between self-sovereign custody and consumer protection and financial crime prevention on the other. The point is not whether regulation in the space does / does not amount to a zero sum game between self-sovereign financial autonomy and financial crime prevention, but rather how regulation will undoubtedly affect the constraints, degree of institutionalisation and adoption of the digital asset space. A good example of cause-effect relationship is in India’s crypto regulatory journey in 2020: after regulatory clarity there was a burst of virtual currency activity. As 2021 develops with a maturing and converging space between the various types of assets, we expect further national regulatory involvement — especially when one considers the addition of CBDCs (mentioned in part one of our review).
3. Governance
So far, much of the infrastructure has centered around the ‘what’ (i.e. digital assets) with the ‘who’ and ‘how’ revolving around an emerging digital asset economy and infrastructure, as an investigation of evolution / revolution of form. In investigating DAOs and governance, we turn to examining ‘how’ as an investigation of mode / method. Specially we examine how blockchain technology is changing governance in the digital asset space. For those interested, here is a great report from a VC on blockchain’s potential as a coordination technology to organise ‘open-source societies’.
Blockchain technology offers immutability and hence trustless community / social organisation along with the conveniences of digitisation and automation. 2020 saw the continued experimentation of blockchain technology for social organisation both in the centralised and decentralised digital asset world. In the centralised realm, institutions and managers continued experimenting with incorporating more efficient and automated voting mechanisms in security tokens. For example, our collaboration with an Asia-based VC fund illustrates greater democratisation of an illiquid asset class via the implementation of one token one vote. Security tokens representing real world assets can be embedded with autonomous smart contracts that follow the ‘if / then’ which can be triggered by the DAO upon voting. (For those interested in how this can change the ontological structure of the economy, see: ‘the blockchain economy’). The advantages of securitisation of real world assets via tokenisation with blockchain technology has already been proved, however the question of adoption pivots on a question of commercial need, something not fully developed in 2020.
In parallel, in the decentralised asset space we saw the release of governance tokens (essentially utility tokens) on DeFi protocols which entitle holders to vote on protocol parameters. The saga starts with COMP, followed by the release of the ‘valueless’ YFI token, closing with the SUSHI vampire attack / UNI airdrop fiasco. The saga this year raises several salient questions about protocol design and the DeFi equivalent of corporate governance. After all, DeFi protocols have nearly US$27 billion locked up (at time of writing).
The Sushi attack evidences the double-edged nature of decentralised protocols. Open-source societies enable decentralisation of data which has typically been controlled and siloed (e.g. Facebook, Google, Amazon etc.) in an open data layer, distributed and can be owned by users. Arguably, this means that the value of protocols and ‘open societies’ such as DeFi is no longer in proprietary software or infrastructure (anything can be forked) but rather in human capital / network value(dev, users, communities). Yet, because information is freely distributed and decentralised (DeFi users have full control over their digital assets), these assets can be moved by users if the incentives are right. It seems that users’ mercenary mindset might just be a tradeoff for ‘radical openness’ — in the vampire attack, overnight in September the total value locked in SushiSwap jumped from 200k to just over a billion dollars. Alongside demonstrating the importance of incentive design and governance, few commentators have highlighted how this will change in crypto M&A space in 2021 — how various DeFi protocols will interact with each other to protect their assets while also pushing innovation.
However not all is negative in tone, 2020 was also a year of progress in terms of DAO experimentation in the digital asset space: COMP holders successfully reduced community rewards — and overall, COMP can be seen as an imperfect but nonetheless successful proof of concept. Following Compound various DeFi protocols have developed their own DAO experimentations each with their own parameters and flexibilities which continue to iterate this mode of governance and social organisation.
Conclusion
2020 saw continued work in both centralised and decentralised digital asset spaces, though much of it was overshadowed by the ‘endless summer of DeFi’. Regardless, a common theme running through our functional analysis of the actors (who) and infrastructure / method (how) in the digital asset space is that it is both an evolution and revolution compared to their traditional counterparts.
Without a doubt, we can’t wait to navigate the familiar and unfamiliar, uncertain and exciting, uncharted digital asset landscape ahead.
