Crypto’s Strength and Achilles Heel

CeFi vs DeFi. Why crypto will ditch decentralization medium term but will change the world later, when it returns.

The Crypto universe exists in the virtual one in terms of regulation, law enforcement or protection. In the real world sovereignty is defended by the threat of force (from laws, police, courts and jails, internally and armies & weapons, externally).

Without physical enforcement, DAOs, NFTs, ICOs and tokens are ironically based on ‘fiat’ (saying it’s so) in terms of regulation and so usually have to connect to the real world to be able to do anything useful.

A DAO has to be embedded in a real corporation so that individuals don’t end up being liable for it. The recent Constitution DAO is connected to a real corporation otherwise individuals would be liable for its taxes. NFTs need to be governed by traditional ownership deeds in order to collect royalty streams, an ICO needs to be part of a regulated marketplace to trade securities and tokens need to be legal tender to have the same ease of use as cash.

There are exceptions — where crypto systems are embraced by sovereign states, where Bitcoin is declared legal tender or ICOs a legitimate way of trading securities, or where the connection to the real world is impossible to track. This is why Bitcoin, in its pure decentralized use case, has a difficult to use user experience. If you want to transact with Bitcoin and avoid the real world of taxes and the law, then you have to either use a system with no interface, or in extreme cases, download a one-off user interface from github. Alternatively you can use a service like Coinbase which is a centralized platform (CeFi) that has regulated custody of crypto assets. Coinbase is a portal between the world of crypto and the real world of US tax payers and because it isn’t trying to be untrackable it can offer a decent user interface. More elaborate systems such as Tether have had to emerge as intermediaries between non US crypto exchanges and regulated financial entities. Further, since most crypto assets are traded as speculative investments rather than currencies, easy to use interfaces have made crypto mainstream and Coinbase is worth the same as Switzerland’s UBS bank.

There is one way, however, that a truly decentralized entity could maintain regulatory independence through threat of enforcement and that is by being able to defend itself in the virtual world. Just as cyber warfare, state sponsored hacking and online propaganda have taken sovereign conflict from the physical to the virtual world, it’s possible to imagine a distributed entity programmed to defend itself, virtually. Imagine a DAO that contained smart contracts that monitored challenges to its existence and wrote alerts to the chain and escrowed funds to encourage third parties to carry out, say, DDOS attacks on entities that tried to harm it or shut it down.

The compromise between centralized finance, CeFi (part of the real world of centralized entities from sovereign states to corporations) and decentralized finance, DeFi, extends beyond ease of use to infrastructure efficiency. Much of the world’s existing financial infrastructure (or rails) runs on antiquated systems of Cobol code running on mainframes, linked by dedicated networks. It should all run on modern cloud infrastructure and widely used software, over the Internet.

This is what the impure world of CeFi (semi distributed or centrally regulated blockchain tech, without the pure decentralization) offers — a path, largely driven by consensus on standards as much as anything else, for the world’s financial infrastructure to be the Internet. This is why many of the world’s Central Banks are actively developing Central Bank Digital Currencies (CBDCs). In doing so they decouple regulation from technology, just like Coinbase does. A wallet for Chinese, digital Yuan can be implemented by a developer in Nigeria, if the Central Bank of China allows, but there are no permissions needed for the software implementation. Conversely, such systems would not touch proprietary payment channels like SWIFT and so it would be difficult for, say, the US to impose sanctions on a foreign CBDC.

Crypto offers three things: Efficiency (lower technology infrastructure costs), Security (harder to hack and more traceable, even if anonymously traceable) and Self governance (decentralization of consensus). As explained above, the governance portion either requires enforcement, concealment, or connection to the real world to operate, whereas the first two are immediate cost gains. DeFi’s achilles heel is where the virtual world meets the real one in terms of regulation, which is why in the short to medium term CeFi wins.

The Internet of Finance will be an amazing step forward in terms of global infrastructure regardless of its impurity with respect to decentralization. In many ways this will mirror what happened with the last wave of decentralization twenty years ago (peer-to-peer), when it merged with the blogger scene to create modern, many-to-many Internet platforms and social media. Where the founder of the biggest decentralizes file sharing system (Napster) became the President of the world’s most centralized platform, Facebook.

Over the longer term, perhaps after a crypto crash which wipes out the carpetbaggers and speculators, much like the dotcom bust did, the decentralized aspects of crypto may see a resurgence. There are needs for completely new types of organization because the social pact between workers and employers is based on an industrial era one of a single employer (how do gig economy workers get benefits like healthcare if they have multiple jobs at the same time). Similarly, how do ordinary workers in warehouses or delivery bikes, that operate the business controlled by platforms, get the equivalent of the stock options that people who build the platforms do? Membership of multiple DAO like entities over a lifetime could efficiently align incentives, reduce the standoff between unions and management, deliver fractionalized benefits and allow annuitized income streams into retirement.

In many ways this would be a return to entities that are more like mediaeval guilds than modern day corporations. This would be no coincidence, guilds and trade fairs were replaced by joint stock corporations and capital markets after changes to information and capital flows from the discovery of the New World and development of the printing press. This is provable, the distance to Mainz (where the printing press was established) and an Atlantic port determined whether joint stock companies and capital markets replaced guilds and trade fairs quickly. In Hamburg they did whereas Lubeck, thirty miles away, they didn’t as it was on the Baltic nor did they in Seville as it was too far from Mainz.

The resurgence of China and Asia and the development of the Internet have changed trade and information flows again, and it’s quite possible that new types of organization (maybe even DAO like) and marketplace (maybe even ICO like) will emerge, but because this is a structural change rather than an efficiency gain it will take longer than switching financial rails to be Internet based.



Architect: I used to design buildings, now I design companies.

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