SLP311 Bitcoin: Only The Strong Survive – with Big Al

Big Al, pseudonymous co-author of the “Only The Strong Survive” article joins me on the show to talk about various critiques of non-Bitcoin ‘Crypto’ projects. In this explosive discussion, we talk about the key things you need to know on Bitcoin as contrasted with ‘Crypto’ and DeFi.

We chat:

What truly sets Bitcoin apart
DeFi not being decentralised, and not finance
Everything fights for liquidity
The problem with utility tokens
Dishonest TVL metrics and massive leverage in ‘defi’

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Stephan Livera links:

Podcast Transcript:

Stephan Livera:

Big Al, welcome to the show.

Big Al:

Thank you for having me, Stephan. It’s a pleasure.

Stephan Livera:

Yeah. So I really enjoyed this piece that you and Allen [Farrington] wrote recently around what’s going on in the Bitcoin and the crypto space, and it’s called Only The Strong Survive. For listeners, Big Al or Al is under a pseudonym today so we’re not going to dive too deep into his background, but maybe if you could tell us a little bit about your process of writing this article with Allen?

Big Al:

Yeah. Allen and I have known each other for quite a number of years and over the past year we’ve become closer and we were always having back and forths and discussing what was going on in Bitcoin as well as just broader, especially with everything going on in DeFi. I think both of us like to take a pretty open-minded approach. I certainly do not consider myself a maximalist, I don’t think he does either. And so as we together dove deeper into what was going on in “decentralized finance” today, we decided that we wanted to put our opinions on paper. I believe we must have started this about five months ago. It’s been quite a journey writing all of this, but we wanted to be as thorough as possible. It actually at one point was 72 pages.

Stephan Livera:

You guys got it down to like 48 or something?

Big Al:

Exactly. This is actually the shortened version. What we were really trying to do is put out our opinions and the best feedback has been from people who helped edit it who don’t quite agree but still appreciated the level of diligence that we tried to put in into expressing our feelings.

Stephan Livera:

Yeah. Let’s start with defining some terms because there’s all these words people are throwing around, “crypto” and “DeFi” and things like that. How do we even define what crypto is? Because I mean really the hardcore answer I’ve heard is more like, No, crypto means cryptography—crypto is nothing. Do you have a definition of that? Or how would you encapsulate what we’re talking about here?

Big Al:

It isn’t a hardcore definition from what we use or how I use it. I am going to give the market the benefit of [the doubt], if they want to dub it crypto what is going on [at] all these different “blockchain-based” applications—that are maybe decentralized, maybe not—fine, we can dub them crypto. What were trying to do is just differentiate “crypto” and all these other things versus Bitcoin and other chains that are perhaps actually touting and doing what they’re touting. So we stayed with the market-version of what crypto was, because we thought that was what was best for the reader.

Stephan Livera:

Right. And definitions can move and change over time and that seems to be what the world is going to despite my protestations of “Bitcoin, not crypto.” But anyway, also there’s this term DeFi. How do you define DeFi? What does DeFi mean to you in the context of how you think about things and this paper?

Big Al:

Absolutely. So Allen and I—and I’m going to speak for him as much as he would have loved to be on and talk about this as well—but Allen and I definitely agree on this. We love the concept of decentralized finance. The idea that you’re building an ecosystem that is more fair, accessible, has less middlemen in the financial world which notoriously has had middlemen throughout the ages. There are things going on in the backend. There’s also issues with how the monetary policy is done in many countries, especially as [with] what we’re seeing today so it’s probably a good time to have written this paper. But from a concept, decentralized finance and building out the building blocks of capital markets and financial markets in a more free, accessible, and open way for everyone is how we define decentralized finance. And we make this hopefully very clear: we love decentralized finance. Our concerns are about a lot of what we’re seeing being called DeFi today, and is it actually living up to that beautiful definition?

Stephan Livera:

Yeah. And as we’ll get into, I think some of the problems are: it’s not decentralized enough, and it’s not finance. It’s unfortunate in that way. You were touching on this earlier in not being explicitly a Bitcoin maxi, but that also comes up in this conversation because there are attempts to do DeFi-like things or DeFi in the Bitcoin world and have lending and collateralized loans and so on as an example. Are things unequivocally good merely because they are built on Bitcoin?

Big Al:

Absolutely not. If I start to see a lot of the shenanigans that we have seen on other chains and rehypothecated tokens, tokens that do not have a clear tie to real-world value, tokens that earn yield—but yield requires a connection to a real monetary asset and a real productive asset—if I begin to see those come on Lightning or Layer 2 Bitcoin or Layer 2 Lightning, I’ll be the first one to write another one of these.

Stephan Livera:

Yeah. That’s an important point to make and others have framed it similarly. Alyse Killeen has framed it more like being a sound-technology maximalist as opposed to being doggedly or ideologically or like being an ideologue about only Bitcoin, I suppose is the way people are framing it, right?

Big Al:

Absolutely.

Stephan Livera:

It’s important to talk about what the real breakthrough with Bitcoin was—Guy Swann and I were talking about this in a recent episode about why you should focus on Bitcoin and not get distracted—but I think it is worthwhile to talk through that important breakthrough. From your point of view, what is the breakthrough here? What is making Bitcoin distinct?

Big Al:

Yeah. Without doxxing myself, I got into Bitcoin years back because I was doing a lot of game theory research. What got me into it was the beauty of creating a consensus mechanism and a permissionless settlement layer—but truly permissionless. Truly open. Of course especially when you first learn about it you think about the issues: well, it can’t have the transaction throughput, et cetera, et cetera. But as you learn more, I view Bitcoin as a settlement layer. I love using the analogy: it’s like a good judicial system. No one really wants to deal with the judicial system, deal with the Supreme Court, but how you create any sort of economy or strong monetary value out of that has always for history been based off having a strong judicial system. A judicial system is like a settlement layer. When there are issues, it is secure. And so using proof of work, using cryptography, using “blockchain” or “timechain” as we call it for the most part, those technologies by themselves are actually quite boring, quite old, and quite inefficient in a lot of ways. It’s the combination and creating a beautiful consensus mechanism—and I would probably attribute most of it to proof of work.

Stephan Livera:

Yeah, absolutely. It is an important point because this also comes up when someone is a newcoiner and they’re thinking, Oh, but is Bitcoin the MySpace? And obviously anyone who’s been in this space for any reasonable amount of time has heard that probably thousands of times by now. But essentially it’s saying that these pieces existed in certain forms, but it was about the combination of them and certain tweaks—proof of work, the difficulty adjustment—that addition of it, combined, made this something valuable, and this idea that we can have a ledger that you don’t have to trust and we can all come to agreement on what is the true state of that ledger: who owns this coin and who owns that coin. We are not in dispute about that.

Big Al:

Exactly. And that needs to be bulletproof if we’re going to accomplish the goals and the dreams of what decentralized finance—as well as a lot of other things that are being built on this—hope to accomplish.

Stephan Livera:

Yeah. Let’s bring it to some of the high-level problems as we were touching on earlier: some of the problems with so-called crypto is that it’s not decentralized enough and not really finance. So do you want to expand a little bit on those ideas? Why is it not decentralized enough?

Big Al:

There’s a lot there and I’m going to try to distill for the sake of a helpful interview. One, in a lot of these different chains and a lot of these different projects you simply do see key leaders, key figureheads, constant changes to their base chains. It goes to simple quotes like, “If the government were to come after you, could you turn it off?” And I think the answer for a lot of this is, Yes. If a couple of people showed up in your house with guns and they said, Hey, we’d like you to turn this off. It could be turned off. And that is, for one, the issue of decentralization on some of those assets. Then of course, with some of the extrapolations past the base layers that we see—I don’t want to harp and attack too many of the base layers—but a lot of this talks about what we’re seeing in DeFi which are these one-offs which essentially can be traced back to a handful of people who control what goes on in those “DeFi” projects.

Stephan Livera:

Yeah. For anyone who’s following this space, it seems that every week or every second week there’s a big hack and it could be $50 million or hundreds of millions of dollars worth of some token [stolen]. Maybe there’s been an exploit or it’s been stolen by somebody and then they’re trying to get it back. And then you’re seeing the shenanigans around the decentralized ecosystem saying, Oh, please, please send the money back to us! Right?

Big Al:

Yeah. Only the strong don’t have to call the IRS when they create an oopsie. But I don’t want to attack any specific project or anything like that. That was just a really funny—I had a laugh when I saw that.

Stephan Livera:

Yeah. Now I want to be fair here as well, because Bitcoin is not unblemished. In the early days of Bitcoin, there was the buffer overflow, I think it was late 2010 or maybe 2011. And it was like 84 billion Bitcoins got created. In 2013 there was a fork, and although arguably that was because of that BerkeleyDB thing that happened. And there was an inflation bug in 2018, but it was not exploited in Bitcoin. There have been times in Bitcoin’s past where people have, as an example, tried to say, Oh, look, this mining pool is getting too big! We need to try to not point hashrate to this mining pool. In fairness, that mining pool—GHash or something—in 2014, they voluntarily lowered their hashrate. So I want to be fair here. It’s not that Bitcoin has had this perfectly unblemished record, but I think it is fair to say it might’ve started out centralized, obviously with Satoshi and Hal in the early days, and it has continually and progressively decentralized. I think that is a fair statement. What do you think?

Big Al:

I completely agree. In this piece, what I hope comes across is that we’re not dismissing all of these things. I have many close friends, people who are significantly smarter than I am, who have dedicated their professional careers to helping build out these other chains. And perhaps they will succeed. Perhaps there will be something that changes and it becomes decentralized and it becomes what they say it is. This was really talking about: right now, what is going on, and what is being said [is] decentralized finance, is so far away from what’s actually happening in the background. It’s a classic thing in investing. You always have to get a little concerned when there’s one thing being publicly said, ideals being spouted, and then what’s actually going on behind the back of the door is slightly different. But you’re absolutely correct. You never want to just fully dismiss other things. You never want to say they can never get there. It’s just, we’re writing this piece as of the evidence that we have seen today.

Stephan Livera:

Right. And fair to say, this is based on your views as of September 2021 and the few months preceeding to that—that’s essentially the time period that you were assessing and writing this piece. I think it’s also fair to say that there are pressures and centralization pressures, and so for listeners check out the earlier episode with Alex Berge where we spoke about, for example with Ethereum, there is arguably pressure towards centralization in the Ethereum ecosystem because of the interaction between staking derivatives, exchange incentives, and so on that might lead towards someday a lot of the power being held and controlled by certain individuals and institutions who are essentially choosing who are the validators. Whereas in the Bitcoin world it’s saying, No, it’s proof of work, and that’s how you tie the real world to the blockchain or the timechain. And in that way, keep the system open in terms of who is able to be a validator. Do you have any thoughts or reflections to add there?

Big Al:

Yeah. I could not agree more with that. I believe from what I’ve seen is that there might actually be a push to more centralization on let’s say something like a Ethereum. I am frightened of proof of stake. Perhaps there are ways to solve it that doesn’t make it just an oligarchy. But when I think about proof of stake it goes against—especially as you said, it could centralize into certain institutions and they choose who the validators are. You’re creating sort of the opposite of what we were hoping to. Proof of work, anyone can go online. I actually help with a Bitcoin miner and we’re not new to the game, but we’re just some random people building large Bitcoin mines. Everyone is allowed to participate, but if it becomes proof of stake where all the assets are staked, that sound starts to sound a lot like an oligarchy, which I concern myself with. And maybe I’ll be proven wrong, but certainly I would need to be proven wrong for me to change my belief on that.

Stephan Livera:

Yeah, I see. It ultimately comes down to accessibility. So in Bitcoin, it’s very cheap. You can run a Bitcoin node just on your laptop and you will be validating the entire supply of Bitcoin. You will be validated. You can validate every transaction that’s ever occurred in Bitcoin, at least in terms of the main chain. And that’s just simply more accessible than a lot of the altcoins are. So that’s also a very important point to consider there for people.

Big Al:

Absolutely. I mean, being able to run nodes and being able to at least validate what is going on is incredibly important. That needs to be accessible. It’s simply a must. And if other chains ignore that, you’re ignoring one of the core principles here.

Stephan Livera:

Yeah. Because it’s such a complicated space and that there are different moving parts, it’s easy to confuse people by talking about, Oh, look how much transactions we can do. Or, Look at this metric that we can show. But they’ve made a trade-off in the background without telling you about that. So they’ve made some kind of trade-off that says, Okay, we’re trading off the decentralization of this ecosystem. Or, We’re trading off the ability for the everyman, the retail individual, the man walking on the street, to be able to run his own full node and fully participate and fully validate as well. So I think that’s an important point. People who are new to this world might not be as familiar with that. I wanted to ask you a little bit about this point where, over the last few years, the economics angle has also been quite important. I think it’s a mix of economics and technical, but the important point to understand here is that there’s always this tendency towards the most saleable, right? So if you’re talking in the realm of something trying to be money, then that’s an important consideration. But maybe this is one of the counterpoints we’re starting to hear again—and it’s not a new point—but this idea of, Oh, fine, we’re not even trying to be money. What’s your thought on that scenario: the proponents of that altoin marketing under that pretense?

Big Al:

There’s a lot of thoughts there and I’ll try to condense them. We’ve talked a lot about DeFi, right? And that is really what we’re talking about. Much of what “finance” is: one, you need a strong monetary asset. The base of any financial system. That is a fact of economics. But two is that much of this has to do with yields, and yields generated by these tokens. But if your token is one of two things—one, simply just a utility token—the liquidity and the value that will come to it simply isn’t there. No one holds casino chips because they want to hold casino chips. You use them and then you leave. You get an iTunes gift card, or at least back in my day when I’d get those for birthdays, you’d get an iTunes gift card and you’d gift it. No one was using those as solid currencies. So let’s say you’re not that. Well then you become [a token]. And I hate to use the word because I know there’s a lot of regulatory pressures and I don’t always agree with the SEC and regulation. Especially in the industry I work they’re always a pain—but no, I love the SEC don’t listen to that—If you are then giving a token, label it a governance token or whatnot, the only reason it would maintain value is that you have an expectation of future free cash flows and yields. And if you don’t have a monetary asset as a base there for those future free cash flows and those yields, it’s sort of a self-licking ice cream cone. You’re creating a token to yield more of that token, but without that ending connection, it’s not true yield. That is not what a yield is.

Stephan Livera:

Yeah. So let me paraphrase that and put that in another way. We could think of it like there’s the world of investments, right? So you buy a stock—that’s an ownership share in a company and you will generally be receiving a dividend, a stream of the profits from the productive enterprise of that company. Or you might own a property and you might be getting rental payments, because again, somebody is paying you to use the house or the apartment. Or you might have a bond and you’re receiving coupon payments—interest payments, right? So that’s in the world of investment. Then in the world of holding money, we hold money because it reduces our future uncertainty. Bitcoin doesn’t necessarily have to be an investment in that sense. It’s more like savings. So if you’re not in the trying to be money category like Bitcoin is then there needs to be a reason for people to hold it. As you were saying, there’s not really a reason to hold it other than to create more of that coin, or there’s governance coins or governance incentives and things around these. It just ends up being that there’s not necessarily a good reason to hold these coins.

Big Al:

That is unfortunate because honestly when I came in, I was like, Oh, wait, decentralized finance is actually being built. This is awesome! And as I’ve dug through the onion layers—and I’m sure there are people who are a lot sharper than me—but Allen and I have spent a lot of time digging through the layers here and yes unfortunately it has not become clear to me why these tokens should accrue longterm value outside of simply speculation. Which we emphasize, and it’s very important to emphasize: speculation in [and] of itself is not only not bad, it is actually good in a lot of regards. It funds some of the most innovative ideas. But speculation on speculation that it will continue to have value without a bridge back to a real-world monetary asset? You’re misconstruing some other speculative investments that have done very well—like venture capital and early tech and what not—to a space where it might not be deserved to be applied.

Stephan Livera:

Yeah, I see. The other point that you make in the paper is this idea about coordinating security costs. Because as we were saying earlier, proof of work gives that link between the physical world and the digital, and if you’re now taking that away, well what’s the security model? Could you elaborate on that?

Big Al:

Yeah I mean, I think it’s actually that simple, to be honest. I think it really is. If you’re taking away the link from the work, from true-world electricity costs which are real things—coordinating all the machinery, the energy, the electricity, to validate the network—and instead you’re just purchasing the asset and putting it in there, you’re disassociating one of the core links from the real world and the value that should be put in, to the coin [instead]. It takes once again another link [out], which leads us—and we write a lot of pages on this—on where are these yields coming from? Where is finally the connection in all of this? And I have to emphasize again: I still take an open mind. I would love to be proven just completely wrong on this by someone who is so much smarter than me, but I just haven’t heard it yet. I haven’t seen it.

Stephan Livera:

Yeah. So it seems that the yield comes from creating more coins? I’m a bit confused. Let’s try to steelman this for a second. Could it be that this platform enables some kind of thing that’s only possible in this way, and in order to use this platform, you need this utility token. Is that the reason why you would hold this coin? I’m trying to make this argument. I just really can’t even make it make sense in my own mind. But if you had to steelman, what would the argument be?

Big Al:

If I had to steelman our own argument, it would be exactly that: that there’s something so valuable about using this network—let’s say there’s some new “internet protocol”—suddenly we all stopped using Google Chrome or whatever browsers and the only way you could do it is if you bought their made-up token and to use that Internet you hold the token. When I even try that steelman—and I should probably have a better steelman to my argument because that’s intellectual honesty—but then I just say like, Okay, when I was younger and I wanted to buy a song on the iTunes store, I would get my iTunes gift card, but I would spend it. So you fight for liquidity, and we go into a section [in the paper] about the fight for liquidity. If you suddenly become a utility token and people and companies everywhere [use it], that makes it essentially inventory. Whether it’s personal, whether it’s professional, you don’t hold those inventories, you plan on using those inventories. So hopefully that was a decent answer, but it is difficult with the steelman. I struggle too sometimes.

Stephan Livera:

Yeah. Another way I’ve heard of it—[from] my friend John from Sydney, actually—he’s framed it this way: I’m not sure if he invented this or other people have, but it’s this idea that [you] imagine you had a coin to pay your bank-fees with. Bank-fee coin. Who in their right mind is going to prepay their bank fees? You would just buy the bank-fee coin at the exact moment you need it, pay for the service, and then boom—you’re done. You’re not sitting there holding a cash balance of bank-fee coin, right?

Big Al:

No, you are not.

Stephan Livera:

And that ties into that point you were making earlier that everything fights for liquidity. In the world of money, you want to hold the most saleable commodity. And that’s again the Mengerian, Austrian story around money. So bringing it to the utility tokens idea as well, even in this whole notion of, Okay, so in order to use this platform, you need this utility token—but again, you might still be at the risk then of somebody else running in and being like, Oh, you’ve made this platform with an unnecessary coin. Let me just remake this platform without the coin and strip it out. Right? So that’s also a factor. You’re just always going to be vulnerable to that.

Big Al:

Yeah. It’s a beautiful point. From what I do professionally as I disclosed, I’m not going to disclose all, but I do work at an investment firm, a hedge fund here. And as we’ve looked into the space, you see a stark difference with regards to the issuing of tokens, that the fact is, most of these tokens do not need to exist. There have been some brilliant economics done to try to create them and try to convince people to move them around. I believe probably the most famous examples are Uniswap and SushiSwap, right? How SushiSwap created the token to then incentivize LPs and try to get people off of Uniswaps. But what you notice in the Bitcoin ecosystem and what is being built out—be it a lot slower than the “move fast and break things” ecosystem which is very admirable in its own right except maybe a little dangerous—but when you speak to founders of these projects in Layer 2 on Bitcoin, I don’t think a single one of them has basically spoken about creating a token because they’re like, Well, we don’t need one. It’s unnecessary—we’re using the base monetary asset that people want.

Stephan Livera:

Yeah. Ultimately the reality is basically these coins don’t need to exist other than Bitcoin. I’ve been Bitcoin-only the whole way, but I guess people have to make their own assessment on whether you think a token needs to exist or whether it really should have just been engineered and designed in a different way, such that you didn’t need that token. Also, there’s been a lot of misleading use of different metrics and you touch on a very interesting point around rehypothecation, which is going on in the DeFi altcoin world. Can you tell us a little bit about that idea? The rehypothecation?

Big Al:

Yeah, absolutely. And I’m going to be honest: when Allen and I were writing this, we found this to be one of the most difficult sections of the paper because we were playing around trying to rehypothecate assets at all these platforms and it gets quite funny. I have to give a lot of credit: the Coin Metrics team put out a report on rehypothecation I believe a month and a half ago—we stole, but we gave them credit on that part in the report. But what you’re seeing essentially is that it’s being pitched as overcollateralized and in the first step, it is overcollateralized. Most of these things—let’s use the wrapped ETH example—you put wrapped Ether in an original loan and then you can take out a thousand of Dai. But you’re allowed to then put the Dai—and let’s say that you put another thousand of USDC on Uniswap—and then you’re in their pool. You’re in the USDC Dai pool as LPs. So you’ve got $2,000 put in right now. But then you also can redeposit those again into another loan of Dai, so suddenly when you—and we did a bit of a graph of this—you’ve essentially turned $2,000 into $5,500. So that’s on the total value locked and the rehypothecation of the assets that are going on. Which again, lending in and of itself is not bad. Lending is a very, very important part of any sort of financial ecosystem. It’s [that] it just gets more dangerous when you start taking assets where I’m already concerned if they have actually any real value outside of speculative value and then you start rehypothecating them on each other to market yourself as having all these volumes, when truly it’s a lot of leverage. And that’s always a little scary there.

Stephan Livera:

Yeah. And so just walking that through, because there’s a lot of terminology there. So for listeners, if you’re new, just walking that through: TVL means total value locked. And now one thing a lot of these altcoin proponents are doing is they’re coming out and saying, Oh, see, look how much TVL is in my altcoin DeFi protocol! And the reality is, as you were just saying there Al, is that a lot of that is actually rehypothecation. But the trick is—you have to understand—it’s rehypothecation in a pseudo way across multiple layers or even different coins such that the ecosystem is as a whole rehypothecating up on top of each other. The superficial understanding of it would be that, Oh, see this particular loan, it must be 200% collateralized or 150% collateralized and therefore we’re safe if something were to happen. But as you point out, the reality is that people can take a certain amount of ETH, say $1,500 of ETH or whatever, and pyramid on top of each other and keep going into different assets and into different platforms such that they get new tokens and receive more governance tokens and then use that to lend out on some other protocol and before you know it $1,000 has become $5,000.

Big Al:

It’s funny, human nature—we’ve seen this in traditional finance—it’s led to a lot of issues in traditional finance. The funny thing is, once you start going down this path, it’s very tempting. Because if you do it right or if you’re the—let’s call it the middlemen, you’re the people who are creating these—you can make a lot of money. But it’s very dangerous for the ecosystem overall. So when I say I love decentralized finance, I’m saying also let’s please not just repeat the same mistakes that we’ve done historically in traditional finance.

Stephan Livera:

Right. And people like Caitlin Long, also a past guest on the show, has been very vocal about the problems of rehypothecation both in terms of securities and in terms of money. She has been very vocal about that as many, many people are. It really does seem like some of these people are just recreating the fiat system but just in this “crypto world,” unfortunately.

Big Al:

The beauty of it for them is they get to be the new bankers and the new Federal Reserve, which is always a nice place to be because you can make a nice chunk of change there!

Stephan Livera:

Yeah. I just want to read this section as well, it’s related: you were saying, “A given asset can be used as “collateral” in one protocol contributing to a new asset being minted and then either itself re-used, it’s collateralized end-products were used, or its securitized governance rights reused all again and again, throughout multiple different protocols.” Right?

Big Al:

Exactly.

Stephan Livera:

The other question would be, What would it look like if there were to be a collapse in some of these DeFi coins or potentially the price of some of these DeFi altcoins?

Big Al:

It’s a tougher question. And just for background for the audience and for yourself, Allen and I had discussed actually just walking through an example or a historical one, but we felt like it was too hypothetical because, again—to give the ecosystem credit—during times of major distress there has been new capital flow in. But the way it would look is it is a very classic example of almost a bank run, to be honest. It would almost look like that. So if ETH started collapsing, a curve price [would start] collapsing, there would be collateral calls. The collateral calls will close out other collateral calls on different protocols, which would then require the users to re-stake. But if the users didn’t have new money to throw into this system, they couldn’t. So that’s a fall on that collateral as well. And that starts to cascade through the ecosystem until all this pseudo-leverage has sort of been washed out of it. And that doesn’t mean that these things collapse to zero, but it does mean a very nasty way down in collateral calls and things that become forced liquidations through all of these. Because again, this is all algorithmically done. So once the collateral isn’t there, it’s a forced liquidation. And a forced liquidation then means an open market sale of some of the assets. So what you do is a classic sort of debt collapse, or view it as a bank run as people try to get their money out. It would require essentially some sort of a difference, but it’s a very good question and something that we didn’t want to give some historical example, because frankly, during most of those flash crashes that are due to this there has been new capital to backstop it.

Stephan Livera:

Yeah. And it’s also important to note that it might look like it’s all okay in the first few years because you might be able to bail it out with progressively injecting more and more capital from investors who [have] taken the Kool-aid and they believe in this altcoin DeFi so they’re happy to just keep plowing money in because they’re getting cheap credit from the Fed anyway, and they’re just plowing it in. But they might reach a point where the size of that altcoin DeFi market has just become too large to actually get bailed out, effectively, by new capital injections. And so what might have been okay when it was smaller, as it grows, they won’t be able to save it next time. As to when that point comes, we don’t know. But it’s an important point to appreciate.

Big Al:

The larger the cookie gets the worse the crash will be. And I’m not just saying this about crypto or DeFi. You can say it about actually almost any market in the world right now. You see it in equities. In debt. And really it’s a dangerous situation to start to play around with. But you’re absolutely correct. No one knows when it’s actually gonna happen.

Stephan Livera:

Yeah. You never know how much money the central banks of the world are just going to keep printing up or [how much] the governments of the world are going to just keep printing up for their stimulus and for their various spending packages and all that money sloshing around and maybe people just keep going. But it has to stop at some point. I can understand as well for some people who are new and they’re looking at their friends who are gambling and hitting 3x and 4x and here they are sitting just making 10% or 20% or whatever it is—that can weigh on their mind. There’s a competitive pressure and desire there. And that may be also what forces or pushes people and pulls them in to this shitcoin casino, basically.

Big Al:

FOMO is a very real thing. And also when it comes to institutional asset managers and a lot of the people who, if you look at who actually owns these and the percentages, most of these DeFi products are bulk-owned by a handful of firms. The incentives are for AUM. It’s an AUM game. Even if they’re scared of the carousel going around, the incentives from not only retail FOMO but from institutional is to keep the games going for as long as possible.

Stephan Livera:

Yeah. And on that, I’m curious as probably you would have looked into this as part of your research, do you know the split in terms of the actual retail number of people using these DeFi coins versus the amount of professional money managers’ funds and those kinds of people who are involved?

Big Al:

I’ve looked into it, but I don’t have the best answer to be honest. I think the number that are actually using it, especially if you’re doing it on a volume-weighted basis is going to skew very heavily to the large institutions. And on an ownership basis I mean that’s obvious—it skews very heavily. But I don’t have a great answer for you.

Stephan Livera:

Yeah. I guess it does. And it seems to me like common knowledge and yet depending on who you’re listening to or who you’re seeing it’s almost like there’s this idea it’s being marketed as—coming back to what we were saying—this idea that anyone in the world can lend and borrow and send. But then the reality is it’s mostly big firms and high-net-worth investors and fund managers, professional-level money managers who are actually using this thing. As opposed to the everyman on the street who is getting a loan for whatever he needs in his real life.

Big Al:

Exactly. I mean, the professional money managers have the infrastructure and the time to be able to execute the arbitrage that keeps coming up because there’s new token launches, new yield liquidity pools, all of that stuff that come up all the time. They’re ones who [do it], and that’s what they’re using it for. They’re using tokens to trade other tokens to gain yield in other tokens. I’m going to be interested to see what their exit strategy is on how to monetize this into a real monetary asset, because at some point the cows will come home and I’m interested to see how those large institutions get out of it.

Stephan Livera:

We’ll see. Yeah. And so in terms of those large institutions, what would you say are their main advantages? Is it around having high-skilled individuals who know the nuances and the ins and outs of the ecosystem? Or is it maybe better access to cheap credit? Or is it better access in terms of information on what’s going on? Do you have any thoughts on that?

Big Al:

Yes, I do. And I’m going to be careful and subtle on this one. I believe it’s access to information. One point I joke about which I’m happy to say on here is that what I see in this ecosystem—knowing a lot of them, being friends with a lot of them—if I told what goes on on a daily basis in DeFi at my job, I would be in handcuffs by the end of the business day. Look, if it’s not regulated, that’s fine. You’re not breaking [laws], but I’ve really never seen anything like it. I’ve never seen it. I’ll stop there before I—.

Stephan Livera:

Yeah, totally. Only say as much as you’re comfortable to say, but it seems like there’s this whole cottage industry. Because you’ve got exchanges who have an incentive to promote this stuff because they want the trading fees. You’ve got all kinds of different people all with their own incentive to get involved in their own way, whether you’re involved in the influencing and the marketing of it and you’re getting paid out to do that, or write articles or interview the founder or things like that, or whether you have found some other role as a technical expert to help find these opportunities and arbitrage and things. So it’s a very weird ecosystem and it just seems to me like the everyman, the retail individual, just has no idea what they’re up against.

Big Al:

I couldn’t agree more. I think you actually articulated it better than I even could.

Stephan Livera:

One other point I really wanted to get your thoughts on: in the paper you talk about, okay, so it’s a quote like, Ether is allegedly the right to run decentralized computing. But you had a really interesting point about how that’s more like an operating expense than an equity or something that should be floating around as an actual price. Could you explain what you were getting at with that?

Big Al:

Yeah, that one was certainly a nuanced point and Allen and I had a back and forth on that one. Essentially it is an operating expense and it’s this idea of, Okay, you need the Ether to run the computing. That’s actually okay with me, but it creates this system of then all those other shenanigans that might be going on on top of Ether become based on the operating expense of Ether itself. And there’s this mismatch of incentives that takes place due to that, where if that gets more expensive than transaction fees go up, unlike with Bitcoin and proof of work, it actually makes the chain more secure. That’s a good thing, right? That’s making you bulletproof. That’s wonderful. Here it is: Well, that’s actually a bad thing! You’re passing it on into all the users of the decentralized finance and of course there are going to be scaling solutions and I’m excited to see and monitor what leads to scaling can accomplish. There’s probably some brilliant things people will do. But it I think that point—boiled down as simply as possible, because it was a very nuanced point and even Allen and I had a lot of discussions on that one—is that you’ve created this system where, Okay, it’s a way to pay for it so it’s an operating expense, but then there’s this mismatch in if it goes up in value, the operating expenses go up for everyone trying to build on you. Which is supposedly a bad thing so you want to lower it, but why should that be a bad thing when it comes to the security of a network? So I think that encompasses most of that point.

Stephan Livera:

Essentially, put in other words, it’s almost like the “success” of the system can almost put the system at cross-purposes from a security perspective and that it might then become less secure as the price runs up. It’s a really weird thing there. And also there’s a really weird sense in which it just seems like a weird incentive, right? So as an example, and I think you made this analogy, it’s this idea that let’s say you had a bank that has its office and its electricity bill, but it indexes that ratio to the price that it charges to the customers in terms of their electricity or their rent, when they should just be charging their fee, whether that’s a percentage fee or an upfront fee or whatever. It’s like trying to involve the customers to have a share in the electricity cost of the bank, is a loose analogy, right?

Big Al:

Yeah. That was the best analogy that—maybe someone will come up with a much better analogy than us—but that was the best one that we could come up with. So yes.

Stephan Livera:

It comes down to this point that, as you say, it’s like the altcoin token is trying to double as computational credit and a security incentive. And then potentially those are the ones really at peril, right?

Big Al:

Yes. Very much so. I don’t see how those two can exist in cohesion.

Stephan Livera:

Whereas comparing back to Bitcoin, it’s much more of an explicit, This token is trying to be money. You hold it, you save it, you spend it if you need to, and over time, the security of the network is coming from all the miners who are trying to mine new Bitcoin and they want to receive transaction fees. And that’s it. It’s a very honest and incentive-aligned or incentive-compatible system in that way. Whereas when you compare to altcoins, it’s not really the case.

Big Al:

Exactly. Getting past Ether—again, a lot of brilliant people work on it. You have to give credit where credit’s due. But with Bitcoin, in Ether, but [also] in a lot of the other coins, there’s no promise of a yield. It’s a floating-point value. It’s what the community and what is built off it chooses is the value. It’s incredibly fair. And I like that for my base layer. And we can talk about what I’d like for the Layer 2s, because I think there’s actually some of the “move fast” attitude that can be learned from in the ETH ecosystem on the Lightning ecosystem. That absolutely does not mean tokens, but it does mean I like my base layer secure and boring like a judicial system. But what you do on top of that, there should be an entrepreneurial attitude.

Stephan Livera:

Yeah. I love that point about having the base layer secure. And even in the example of the Lightning Network, it is arguably like a court in a sense. That the two channel partners are trying to close their channel and the blockchain is essentially the one that’s deciding who’s getting what, in terms of how many sats are going to each side of that channel. It’s not like a full-on “code is law” or whatever, but in a restricted way it’s deciding who gets what in that sense. And so it really is like that, especially in the examples of Lightning and other Layer 2 protocols like that. Let me put it this way then: what would have to change for your view on altcoins to improve, on this kind of idea of crypto and DeFi?

Big Al:

Okay. I think that one is—we talk about this in the section, Why We Might Be Wrong so you really do try to be intellectually honest here—if there is an ability for different projects, I’m not sure if DeFi can ever get there, but there’s certainly other chains, other projects that connect to real-world value, things that people value as humans whether it’s gaming stuff coming up now, some audio music stuff coming up now, if that can actually translate to value to an end customer, then okay. I still don’t quite see why you need a token. Why not just use your base layer asset, ETH? But that’s a different story. We’ve discussed that enough for the interview. Sometimes—I don’t believe this but it can always be true—things like what we saw with the Internet, it doesn’t always turn out as perfectly as you’d like it to be. And maybe the average user is willing to give up and give away the fact [that] this is truly decentralized and what not for these developers and their huge developer ecosystem on these other chains creating projects that, again, create value. With DeFi, the problem and the promise is is that—there is just such a disconnect for me—is that, especially with DeFi, you need real world yields. Let’s say if we can have lumber companies utilizing DeFi—you buy wood to build your new patio, right? And it’s somehow on these DeFi protocols? Then I will look at that. But we go through a couple points on why it might be wrong. But again, until we get that connection where it isn’t just tokens being created, rehypothecated, and then you gain more yield on other tokens you trade? I struggled to see where that will end up accruing long-term value. Short-term you can make a boatload of money. And good for them!

Stephan Livera:

Yeah. I think you put it well there. And maybe one way to summarize it is: there needs to be some kind of link back to production. Productive capital. And so maybe that’s one way to think of it. As an example, I recall—I’ve been in the Bitcoin world since around early 2013, basically—and I recall there was this site called BTCjam. And this is early days lending out Bitcoin to get interest on it. And people would say, Hey, this is why I want this loan, because I want to do Bitcoin mining, or whatever. And you were going to earn some money back in Bitcoin, right? Later that site got shutdown and so on, but you would need to see real productive use of that money. And as you were saying, whether it’s lumberjacks or whatever other business that you’re going to do, there just needs to be that productive link there. I wonder then, do you have any thoughts on the future of Bitcoin and DeFi, specifically? As an example now, one of my sponsors is HodlHodl. They’ve got this idea that you can collateralize and you can borrow against your Bitcoin and borrow stablecoins against your Bitcoin. So that’s one example. Maybe in the future, if we were to start to see more people using that as a way of funding their business ideas, maybe that would be something more aligned with what we would call Bitcoin DeFi.

Big Al:

Yes, I absolutely agree. I think one of the key distinctions is that Bitcoin is intentionally trying to be a monetary asset. It’s a floating-point asset. It doesn’t have a yardstick to the real world. It has a yardstick to the usages of it. I will have to look deeper. It’s actually on one of my to-do lists. As you know in this space, there’s always a million things to do, but I think that you can see a future where—lending in of itself is not a bad thing and borrowing is not a bad thing—matter of fact, there’s a lot of evidence to show that strong financial capital markets and the ability to lend and loan and raise debt is one of the best things that can show whether or not a society will be productive and affluent. I’ve looked a little at HodlHodl. I’m looking a little at Sovryn just to learn about them. I’m excited about what they can do and look, I’m going to take the same critical opinion to anything where I think that unnecessary tokens are rehypothecated and whatnot. But if you keep the base layer, you keep it strong, and you have a very clear—you can create a monetary asset off of a strong judicial system that goes through countries and everything. And that is why I continue to believe that most of the beautiful things or really cool things that might be a little scary on ETH or other chains will port over to Bitcoin because they will come to the realization that having a strong monetary base is critical for any economy to flourish. And at the end of the day, we want this to be an economy.

Stephan Livera:

And maybe one other point just to add to that might be that look, the world is undergoing Bitcoinization and eventually it will culminate in hyperbitcoinization, right? At least that’s my view on where we’re going. It could also be that until then the best, most productive use is for people to just buy Bitcoin and hold it. And then only once we’ve reached a point closer to full adoption, then it would make more sense for people to actually start investing that Bitcoin into other ventures like business ventures. Because at that point we would anticipate the purchasing power growth of Bitcoin to start to taper down. So if you look historically right now, it’s probably like 140% per year or some ridiculous number, right? Obviously that will have to taper down over time. It can’t just sustain that forever. And maybe once it—call it 5% per year, something in that range—then at that point, you might have more productive businesses and more of a reason to have a lending and debt market but denominated in Bitcoin, using Bitcoin DeFi, to fund productive capital. What do you think?

Big Al:

I think you’re absolutely right. I think everyone overestimates what they can do in two years and underestimates what they can do in 10 years. And I think that we will get there sooner than people think maybe in a 10-year basis, but you’re absolutely right. I couldn’t agree more. Bitcoin will not continue [at this pace]. As [we] get hyperbiitcoinized, I hope that we do create an economy that is perhaps more fair and perhaps fixes a lot of issues that we see in our current monetary system which exacerbate a lot of both political and social issues. But that’s a little outside the scope of this paper and we could probably nerd out about that for a whole another hour!

Stephan Livera:

Sure, sure. So Al do you have any closing thoughts or any final points that you wanted to make for the listeners?

Big Al:

No, I think for the listeners—and one, Stephan, I really appreciate you having me on and I really wish Allen was able to jump on as well—I just hope that for all the readers and the people, if you actually read through it: Look, both of us are always happy to be proven wrong. I’ve been wrong time and time again. And this piece was meant to just put out our opinions. We tried to be as thorough and thoughtful as possible. So if anyone listening to this or anyone who has read it wants to reach out—I don’t check Twitter very often, I have a fake profile I’ve used for basically nothing, but please do reach out to me. And again, I would love to see where Allen and I have missed things. So that’s really all I have to say in a closing comment.

Speaker 1:

Fantastic. Well, thanks very much for joining me. And I really enjoyed chatting with you.

Speaker 2:

Thank you, Stephan. Me too.

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