Is this the death of the DeFi Mullet?

Yet another case of CeFi parading around as DeFi, enabled by misaligned incentives and improper diligence.

Nov 12, 2022

Welcome to another edition of the DeFi Mullet newsletter! In this newsletter, I hope to cover the arguably boring world of the most anticipated collab of the decade: Fintech x DeFi (ft. policy, markets, tech, product, etc).

If you are one of the fine folks who get a thrill from these topics, press subscribe below!

Preface

A lot has happened in the past week and this post is by no means a complete autopsy of all that has occurred and what the future has planned. That being said, this marks the end of speculative crypto, the epoch that has been supercharged by government stimulus and an addiction to the glorified slot machine that has been omnipresent in our lives of late. There have been countless takes proliferating the Twitter-verse and, if we are being truly honest with ourselves, much of this is engagement farming, continuing to succumb to the curse that led us to where we are today: a fundamental inability to separate oneself from the incentive structure being thrust upon us. There is a lot that remains in flux and this will be a saga that plays out for many years to come. The behaviour that has allegedly occurred is abhorrent; it is not a true reflection of the many wonderful and empowering things being built across all of DeFi/web3. These are some initial observations in a period that is perhaps being suffocated by too much disorientating noise.

Before we get started…

DeFi is not broken. DeFi has continued to operate without an issue. If anything, this tumultuous period has demonstrated the resolve of decentralised finance in navigating periods of opacity, financial engineering, information asymmetry, and asset rehypothecation. FTX is not DeFi and never was.

Consumer Fintech x DeFi

As customers understandably become sceptical of CeFi institutions, consumer fintech’s B2B2C distribution model of crypto investment will come under greater stress and scrutiny - rightly so. Fintech companies that purportedly support their customers’ financial well-being should question the incentives driving their decision to bolt on a slot machine to an everyday user’s general checking/current account. What does this achieve for the customer vs what does this achieve for the business? First, for the customer, they have access to an alternative investment class which, at a high level, is fantastic for breaking down barriers for access to alternative investments. Consumer fintech companies must consider the following:

How are consumer assets held (custodial vs non-custodial)?
Does the customer truly understand the risk that they are taking, not just in the asset class but also in the supporting infrastructure that enables the purchase and storage of assets?
Does the customer fully understand the incentives consumer fintech companies are building, scaling, and designing for?
Are there sufficient off-ramps for moving assets across to non-custodial DeFi wallets?

For consumer fintechs, why are you building cryptocurrency products in the first place? If it is for any of the following then it would prudent to immediately audit the risks exposed to customers and the business itself:

Crypto investment products increase product usage (DAUs, MAUs, 60 days active, 90 days active);
Create a new revenue stream by generating yield upon custodial user assets i.e. similar to deposit interest generated on checking/current accounts in TradFi; and/or
No real plan, our investors told us to do it.

Consumer fintech is stuck in a hard place: it is becoming incrementally more difficult to continue increasing revenue whilst also growing user numbers - CAC only becomes more expensive, churn becomes more of a challenge, and maximising CLTV effectively determines the valuation of the next round. Using B2B2C solutions for crypto investments can (not always - there are many fantastic companies and individuals building in this space!) be used as a bandaid that, if not implemented correctly or with the best intentions, can lead to more pain than what it was worth.

On-ramps and off-ramps

The role of on-ramps and off-ramps will be of increased significance as the major portal between fiat and DeFi. Transparent interoperability between DeFi <> fiat should not be considered a sexy and speculative business: it is critical financial services infrastructure. Ramps that operate transparently and in accordance with existing regulation will be best placed to continue serving this vital market need. What we as an industry should not be doing is making the on/off ramp flow more opaque, increasing friction, and/or exposing individuals to an increased level of risk. On-ramps and off-ramps are a pivotal piece of infrastructure and we, as an industry, need to proactively work with governments and legacy financial institutions to assuage their concerns and help better inform their policy decisions. It is not unlikely that regulators will take the following actions:

Push for disclosures about sources of liquidity;
Push for disclosures about custody providers and their risks; and
Heightened scrutiny of AML/KYC procedures, specifically for financial crime and countering the financing of terrorism.

Custody, Exchanges, and Auditability

Following the wake of FTX’s collapse, it should not be a surprise that there will be an increased focus on improving transparency across custody providers and centralised exchanges. We should be prepared to see the following changes, implemented via industry or regulation - whichever comes first:

CEXs being compelled to publicly declare their wallet addresses;
Custodians and CEXs providing as close to real time Proof of Assets with, at least, annual audits of assets in cold storage;
Increased reporting of off-chain/OTC transactions;
Increased pressure to disclose counterparties and counterparty risk; and
Related party transactions will become a hard no go zone.

CEXs play an important role in managing liquidity throughout the broader ecosystem especially when it pertains to on-ramping/off-ramping. CEXs have every right to push back on regulators as a lack of regulatory clarity in the face of obvious demand has led to a truly avoidable situation of fragility. TradFi has multiple avenues for compelling banks to adhere to a particular set of standards which in turn justifies either implicit or explicit protection in the event of financial calamity. If CEXs want to operate with similar protections, there will need to be a breaking of bread between market participants and regulators. CEXs are not DeFi but they play an important systemic role in facilitating the continued growth and operation of a broader decentralised ecosystem: regulating these entities is not a bad thing and can be done in a manner that protects consumers from the calamity seen over the last week.

Insolvency and Liquidation

The FTX bankruptcy is going to be an absolute mess and it should not be a surprise if we are still talking about this in decades to come (the liquidation of Lehman Brothers’ brokerage unit only ended this year, 14 years and 13 days later). An area that is lacking development in DeFi is that of on-chain liquidation and protocol end of life events. This is not to suggest that DeFi is in anyway ill-equipped to handle liquidation events; on the contrary, DeFi is best placed to handle liquidation events as smart contracts can be developed to programatically determine preferences and payouts based on a pre-defined set of rules. Further, a trusted understanding of state is maintained by nodes of a blockchain making it significantly easier to understand who is entitled to receive what and when. It is likely that, inspired by the unfolding FTX bankruptcy, we see increased development in DeFi of protocol end of life primitives that are truly decentralised rather than relying on off-chain governance implemented by a multi-sig.

Regulation

Regulation is coming and we should not be surprised if the playing field just became a fair bit more difficult. There are currently two major pieces of DeFi regulation being drafted in the West:

European Union’s Markets in Crypto-Assets (MiCA) Regulation
United States of America’s Digital Commodities Consumer Protection Act (DCCPA)

There are two important things to remember with regulation:

Regulation is not inherently a bad thing as rules and standards can provide much needed clarity for the vast array of varied participants in a fiduciary-driven ecosystem; and
Politics, regulators, and regulation are inherently intertwined → there will now be an increased political agenda in the formation of regulatory policy going forward applying to DeFi.
There is no value in compromising prematurely, we need to put the effort in to properly educate regulators and articulate the value of decentralised systems.

We as builders, users, and investors need to have patience and empathy for the position of lawmakers despite the fact it may feel like they are actively pursuing outcomes against our own best interest. We need to address this head-on, finding the voice of action and perhaps even considering the notion of pursuing change from within rather than being focused on adversarial positioning. The decline in political participation throughout much of the West has led to a great misunderstanding of the mechanisms of politics and of change. Tremendous credit goes out to everyone who has already taken action with respect to working with lawmakers and elected representatives. It is important to note that there will no doubt be pressure from certain lawmakers to put an end to the entire decentralisation movement - this is the nuclear option that must be avoided. It is incumbent upon us to participate in politics and advocate for the outcomes that we know best serve humanity. There is a reticence for folks to engage with political parties but, what you perhaps underestimate, there is a dearth of voices in these parties and they are in desperate need for fresh energy and fresh perspectives.

False Prophets and Complexity

Financial markets are incredibly complex and have developed alongside humankind for millennia, facilitating commerce for as long as we have existed. This complexity can often be lost on us especially as we seek to understand the world we live in and the decisions underpinning the financial services ecosystem we inhabit. It can be tempting to look to false prophets who seek to abstract away this complexity with sweeping statements of simplicity; claiming to fundamentally re-architect our understanding of financial services. This is not simplicity, this is obfuscation. FTX is not the first and it will not be the last. The idea that a system is so complex that no one human being can truly understand its immense scale is a thought that is hard to grasp let alone grow comfortable with → this is our reality and this is the problem in which people seek clarity through oversimplification.

The power of the internet has allowed us to have greater access to information than ever before → this also requires us to have a greater level of scrutiny for the ideas and concepts presented to us by strangers. Too often we rely on gatekeepers (i.e. Big 4 accounting firms, MBB consulting firms, major politicians, tier 1 VCs, journalists) to conduct the due diligence required to adequately scrutinise market participants. In more recent times, we have also seen the emergence of paid-for deep dives that can often result in a messiah-like characterisation of founders and their businesses. There can often be a significant misalignment between individuals and paid-for advocates. It is important to remember that if there is something you do not understand, we are in the greatest age in human history where the internet provides many of the tools and resources needed to learn and assess topics from first principles → embrace curiosity and auto-didacticism

Remember, what is the technology doing?

The primitive we have before us is a universal, decentralised, and credibly neutral set of rails for the generic transmission of value, without intermediation. The very idea that this exists is in itself incredibly powerful. We, for too long, have been fixated on utilising this technology to create casinos, slot machines, and lottery tickets rather than focussing our energy on solving the significant systemic problems scattered throughout our existing financial services ecosystem. Tourists and grifters have been sucked into this world looking for a lottery ticket to escape the broader macro set of circumstances they find themselves in; this is a topic many in the technology industry fundamentally struggle to empathise with and, in the absolute worst case, prey upon. For those that have always been focussed on building resilient systems with foundations of transparency and integrity, your time is now → continue the quest forward. DeFi is not about the financialisation of everything, it is about providing an alternative set of rails for the transmission of value, whatever that value may be.

DeFi is an industry with an opportunity to genuinely improve the lives of billions of people across the planet. With that opportunity comes great responsibility. It is naive to think that there is nothing to be learnt from centuries of human progress with respect to facilitating commerce between individuals. The notion that “speedrunning” finance is an inherently good thing is naive at best and negligent at worst. Ultimately, we have two responsibilities: to act with the utmost integrity and to build scalable resilient systems. The use cases are abundant → if you have not recently spoken to someone who is internet native and under the age of 25 then I highly recommend you do so: web3 enabled gaming, social, community, and commerce are coming to dinner table conversations sooner than you expect. Finally, the utilisation of techniques of memetic warfare to spread information evangelising DeFi is not a community service, it is propaganda and these actors require the greatest scrutiny.

If you are looking to build or are investing in what’s next, would love to chat - please reach out via DM on Twitter or reply via email 🙏