The PayPal effect on Cryptocurrencies

Pay pal crypto effect

As someone who studies cryptocurrencies, it is again a measure of maturity when a major peer to peer or business integrated financial application integrates cryptocurrencies. Paypal is the first of those businesses which are public that has decided to integrate cryptocurrencies. Such a move serves them multiple benefits. Firstly, currency markets have been slower to integrate i.e., transaction fees between EU banks and US banks continue to remain significantly high. Secondly, seamless inter-geographic trade is still not possible in most of the world ,since many currencies are not convertible to other currencies directly or indirectly even by Paypal.
As the internet and ecommerce grows – it is now possible through paypal to start paying for goods and services in cyrptocurrencies especially when these goods and services are offered in cryptofriendly regions such as south korea, japan or most of europe. Missing out on this market would have been a huge loss for any peer to peer financial business.

Nevertheless paypal has bought in more than 350 million global users who can potentially buy, sell and transfer cryptocurrencies through paypal’s network. This sudden addition of 350 million users onto the cryptocurrency network, has created additional demand for scarce assets such as bitcoin. It is only a matter of time before major global banks and banking networks and applications such as point of sale systems integrate with cryptowallets. Thats when the true mainstream adoption will happen.

Reputation: The most important sensemaking feature for alt-coin investors

cube image with cryptocurrency images

As the blockchain community matures slowly, there is a mechanism of  sensemaking happening for the 1000’s of alt-cryptocurrencies available for trade. This sensemaking process is what drives customers to buy and/or list tokens on exchanges or on balancers, which support liquidity pools.While most of the tokens we see are utility tokens that have launched with a primary sensemaking mechanism to it, with proven marketplaces –  several  new blockchains create tokens  which have to create a primary sensemaking mechanism by proving their own security, seamless integration and adoption in a crowded globally competitive marketplace rife with regulatory uncertainties.

REPUTATION  OF THE INITIAL COIN OFFER and COIN GOVERNANCE POLICIES ACES ALL OTHER SENSEMAKING FACTORS

Off all factors that matter to a coin or a token’s success, despite the technology powerhouse and the high end technical capability of the development team, cryptocurrency markets value reputation of the token issuance and governance mechanism the most. Retail investors and possibly institutional investors value the trust retail investors place in a blockchain’s token mechanism much more than the reputation of the team or the technology behind the blockchain. The technology puzzle, since it is open source will slowly – if not surely catch up – to the same if not better level. For example, Algorand was the only blockchain that has solved the blockchain trillemma and is live when it launched.  However, now we have ethereum’s becaon chain being launched and AVAlanche protocol being launched with similar properties if not better. Others will also join the “Trilemma solving party” soon.

As two examples, we look at uniswap and algorand. The first built on top of Ethereum, and the second an entirely new blockchain.

The uniswap community proved itself as a working protocol supporting a decenetralized exchange, and today there are a few hundred functional uniswap exchanges, that replicate the functionality, but also build useful applications on top of it e.g., zapper fi, etc. The protocol itself was built by Mathew Hayden and had significant traction before the team garnered investment from venture capitalists for further development. This stands out as an example where the primary protocol and market mechanism was first validated by markets and the reputation of the system to do what it was supposed to do, neatly and without any issues exceedingly improved upon their credibility. To top it all, uniswap rewarded all its initial investors  with an airdrop of 400 UNI tokens which bought significant bounties to individuals who held multiple accounts on uniswap. However, Uniswap is not without governance issues. A token vote mechanism failed to garner enough support to continue yield farming. So today, all those liquidity pool investors are left hanging without yeild interests and expensive rollback transaction fees, with very little incentive to continue on uniswap. As a result mass migration to sushiswap and other yield returning protocols will take place. Markets have memory and are non forgiving.

Another example, is that of Algorand, which in a year where most crypto-tokens doubled and in some cases tripled in their value, saw their token fall 92%. The team has great technology and the greatest of the technical minds there ever existed in economics, and computer science. In addition their platform, technology and the types of applications built on-top are second to none. Their programming language i.e., TEAL is in my opinion too one of the most, elegant programming language interfaces that resembles the most essential instruction set on top of which programmers could build wrappers for any programming language. So why did their token fall 92% from the IEO value, and why does it continue to falter? This is a puzzle and searching the archives of reditt.com or other forums the answer becomes apparent.  The initial touch base – tokenomics – for the ICO was possibly not handled well  wherein initial investors dumped a lot of tokens onto unsuspecting retail investors who purchased it at the ICO price, raking in more than 2000% profits. The sensemaking process of the markets, possibly never forgave this  gaffe in the markets, because once trust is lost in markets, it possibly takes a lot of effort to regain it.

Is there really a migration from Eth1 to Eth2?

ETH1.0 TO ETH2.0

Eth2 is A separate Chain

While everyone waits for a quick roll out onto Eth2, it is important to note that Eth2 is a separate chain by itself. Eth1 will continue to run, with its millions of dapps (and smart contracts) off a separate chain even after Eth2 is fully functional in the next few years. As of now the testnet is labeled Madella. The whole idea here is to have Eth1 and Eth2 run parallelly and application writers migrate their dapps over to Eth2. However, new dapp writers can start working with Eth2 as and when the entire main-net is live. As of now, i.e., phase 0 the development team is treading cautiously into migrating and getting the test infrastructure live, to check for any kinds of vulnerabilities or issues with this network.

Users who want to move from Eth1 to Eth2

Users who hold atleast 32 ETH’s can migrate ONE-WAY onto the ETH2 experimental beacon chain with validators, which will become live when a certain number of validators get on live.

https://ethereum.org/en/eth2/the-beacon-chain/

It is important to note that this is a one way migration i.e., those who chose to convert ETH1 to ETH2 will not be able to come back to ETH1. Additionally ETH2 is not yet offered for sale on exchanges. Over the next few weeks (possibly by Dec 1st) as the 16384 validators become live (or funded with approximately 16384 * 32 = 524288 ETH (or approximately in today’s valuation 250 Million USD), then the beacon chain becomes live,. with different shards (or subgroups of nodes) handling processing of transactions for smart contracts. Once rolled out the beacon chain and ETH2 will significantly increase the speed of processing and will enable a whole set of applications in the real world decentralized finance world and otherwise to operate seamlessly.

VALIDATORS

As of this week the seeding of ETH2 has started and as of the time of this writing approximately 9300 validators are live.
Here’s a list : https://beaconscan.com/validators

Additionally, if anyone wants to become a validator on the beacon testnet there are clear instructions on how to do it here: https://www.coincashew.com/coins/overview-eth/guide-how-to-stake-on-eth2-with-lighthouse

The Mirage of Liquidity Pools

Computer with market chart

The most common assumptions of uniswap.org or balance.io is that asset swaps and liquidity pools are risk-neutral, due to the balancing nature of markets.

The constant product equation does not hold under thee conditions a) selloffs b) reduction in value of asset n and c) when transaction fees for liquidity utilization increases beyond a percentage of the network’s value.

The constant product nature of automated liquidity makers make these products amenable to a V  = mxn formulation wherein V is the total value held in a pool in USD and m is the value of asset 1 and n is the value of asset 2. However, when shorts of m happen or massive selloffs of n happen. i.e., when the ration of m/n change and/or the ratio of m to the dollar or n to the dollar changes, this constant product need not necessarily be valid, amidst massive selloffs. the value of m and n would continuously decrease as will the product mXn as liquidity reduction happens in the market. Similarly, despite increasing liquidity in markets if the exchange rate of m or of n decreases then V decreases significantly. 

Farming Liquidity 

Liquidity farming, another trend in today’s marketplace wherein in addition to pool fees, users can stake their liquidity tokens into centralized pools to earn interest on the liquidity token. Such staking activity can earn the investor interests in the liquidity token through either proof of stake or through a guaranteed value mechanism. That however, could again be subjected to both entry (staking) and exit( unstaking) fees that are large. 

When ethereum is still maturing the crypto ecosystem is fraught with inconsistencies that are market dependent. To name a few, recent increases in transaction fees from about 1$ to about 30$ for smart contract transactions have made liquidity pool investing siginficantly difficult for small investors. 

Aave another protocol, similar to uniswap but different in terms of risk monitoring provides an interesting set of guidelines for analyzing risks with respect to liquidity pools and tokens available. With uniswap the philosophy has consistently been – that as a protocol, it is upto the users or services that are built atop uniswap to disclose or discover risks through disclosure of their mechanisms. Aave built atop uniswap and other decentralzied exchanges provide some amount of visibility into various risks faced by staked tokens. Aave has created this risk matrix that summarizes the overall risks a market faces.
https://docs.aave.com/risk/asset-risk/risks-per-asset

Decentralized Liquidity Pools and Automated Market Making with Uniswap

How Uniswap Work

uniswap.org is a decentralized constant product liquidity protocol, which is secure and creates liquidlity pools of ERC-20 token. given the recencey of uniswap, the protocol almost has 2 billion dollars worth of ERC-20 tokens locked up and faciliates close to 400 million dollars of decentralized trade every day (sometimes even more).

How does it work? – The basics.

Automated market making is defined as a smart contract mechanism by which liquidity pools such as the one we will describe below, automatically execute trades on the ethereum blockchain. What this means is that both the ETH and DAI would have an equal $ worth of tokens in the system. As a example, consider 1 ETH = 346$. Consider an ERC token DAI which trades at 1 DAI = 1$.  In a liquidlity pool, one would ideally invest both tokens in the ratio of 1:1 to keep the product constant. This means that for every 500$ of ETH invested, the total DAI value should be 500$ worth. Now consider a system where a user would invest 1 ETH and 346 DAI since 1 ETH = 346 DAI.

A constant product curve would look like the following where we would have 1000 ETH and 34600000 DAI.

Curve x * y = K

Whom does UNISWAP.org facilitate help to:

  1. Arbitraguers: Due to the decentralized nature of these exchanges, a liquidity pool facilitates mass arbitrage opportunities. For example, on coinbase or on hitbtc if 1 ETH is trading for 380 DAI. An arbitrageur can quickly come to uniswap and purchase say 10 ETH paying 3460 DAI from his wallet.  This would incur a 0.3% fee to uniswap, which is distributed to all liquidity providers of the pool, and is accumulated over a period of time. Then, the arbitrageur can simultaneously trade these 10 ETH for 380 DAI on hitBTC.org for a total of $3800 making a cool 340$ profit – 0.3% commission of about 0.3X3460 = 10.38$.  This kind of simultaneous no risk swapping of ETH to DAI on public markets is an extremely robust mechanism.
  2. ERC-20 token purchases and ERC-20 listings: One the largest challenges with centralized exchanges is their lack of visibility into new token listings, ICOs or IEOs. It becomes almost impossible to purchase  these types of tokens especially when legal controls are in place.  uniswap pretty much allows anyone in the world to list their tokens and to set their own private pools using their User Interface.
  3. HODLErs : This community is responsible for adding and creating the Liquidity pools on the uniswap network. What is interesting here is that HODLers do not really need to identify themselves on the network or to create an account or to register with a bank or anyone here. They can directly login to the uniswap by authenticating or connecting to one of their wallets e.g., metamask or coinbase, and can participate in the uniswap.org economy.
  4. Pool creators: Individuals can also create pools for all kinds of tokens on uniswap. for example, WBTC is the wrapped version of BITCOIN. One can actually purchase or list any cryptocurrencies that they create onto these pools themselves.
  5. Ordinary traders: Globally the trader pool of users cannot access the cryptocurrency token if it were not for centralized exchanges or other secondary peer to peer markets. Uniswap facilitates ordinary traders access to cryptotokens.

In a future article I shall write about minting, and yeild farming in the context of uniswap.  I shall also write about some of the risks of investing in Liquidity providers.

references:

  1. uniswap whitepaper – https://uniswap.org/whitepaper.pdf

The Coinbase Effect on Cryptocurrencies

Coinbase effect on cryptocurrency

The listing of cryptocurrencies on private currency exchanges has traditionally been a were-withal arrangement, wherein the exchanges determine unilaterally (almost) as to which ones get listed in a decentralized world, that is a rather one-sided agreement.  However, with or without centralized exchanges we have seen a significant growth of cryptocurrency adoption for many traditional cryptocurrencies.

That being said – there is a significant correlation between Coinbase listing cryptocurrencies on its site (as available) for trade, and the increase in prices of the cryptocurrencies. This is because the listing on Coinbase spurs demand, and gives legitimacy to a cryptocurrency token that is otherwise only traded on peer to peer markets or on bridges such as uniswap.com. As an event study we can observe that the event of listing Algorand increases the price.  As an example, one can see the price  increase  significantly  on  July 21st 2020.

These changes can lead one to analyze how the returns pare up in a typical event study – as can be analyzed. One can determine the cumulative abnormal returns for algorand upon listing by comparing how much the price changes compared to a standard cryptocurrency index or compared to the price of Bitcoin which has been fluctuating typically. One can also calculate the cumulative abnormal returns by totaling the abnormal returns for the next few days.

Blockchain based Decentralized Machine learning protocols and marketplaces that reward users

Blockchain based Decentralized image

Numerai is a platform, that rewards data scientists and assembles all models into a meta-model which is then applied to a centralized hedge fund. Based on the applicability of the submitted ML algorithm, users are rewarded. Also, users who submit their ML algorithms have to stake their corresponding cryptocurrencies in NMR onto the platform. More recently, the team behind Numerai released a protocol called Erasure, which creates a decentralized marketplace for submission and solicitation of machine learning or other forms of data. These data and algorithms marketplaces are completely decentralized having their own governance structure and rewards structure enabling peer-to-peer trade.

These decentralized machine learning (ML) marketplaces combine private machine learning and open blockchain algorithms, and enable crowdsourcing of models, without need for disclosing data  (by using homo-morphic encryption). Such an arrangement is a powerful harbinger to the Artificial intelligence revolution being enabled by web 3.0 – similar to the open-source revolution that drove most of the infrastructure used in the internet industry – e.g., Linux, Apache, WordPress, etc…

The value deriving mechanism in such a decentralized machine learning marketplace moves from data to the algorithms and the efficacy of the models,  which can now be crowd-sourced without having to reveal data. An added bonus is the ability to reward algorithm creators based on the resulting efficiency of the model in the real world operation. For example, on the Numerai platform, many individuals would have submitted algorithms with corresponding stakes, however, only those algorithms which perform (or return the highest) the best are rewarded with a percentage of the profits proportional to their model’s contribution. The bad algorithms are not rewarded, and very often the submitter loses their stakes through a process of burning on the blockchain. In the web 2.0 era, firms (large and small) possessed extremely sensitive and often private non-replicable data that was used to increase their competitive advantage. As a result, these firms focused on hiring the best of the talent from the markets to work for them.

With the evolving technology trends of Numerai, homo-morphic encryption, and the erasure protocol now – in addition to data – algorithms, models, and all kinds of services can be monetized directly in a peer-to-peer fashion. One of the early marketplaces using the NMR token from Numerai and rewarding both data scientists and algorithm creators, in addition to all kinds of data and algorithmic work is this website called erasurebay.org.

Decentralized Insurance for Decentralized Finance

In the previous post, I discussed why decentralized insurance options for smart contracts could be a feasible mechanism to guard against unforeseen vulnerabilities. however, the decentralized finance world – highly lucrative in terms of decentralized products; most of which operate on top of the ethereum blockchain has no such protections against loss. Due to the decentralized nature of investments products such as FDIC does not play a role in securing customer interests against fraud, hacks or even a plain economic collapse.

Insurance products for Decentralized finance have started seeing a huge resurgence with firms offering everything from wallet insurance to an options based insruance to hedge for or against market determined prices. Wallet insurance providers such as etherisc enable users to insure their wallets against theft, hacks or other forms of violations. However, wallet based insurance in itself might not be sufficient to assure users of protection when investing in decentralized insurance products. One would need protection of user investments. . That being said, there are products such as opyn which provide liquid insurance that hedges against extreme volatility

What this enables end users do is to set up a put option for ethereum at a certain price, on a certain day, which will guarantee the user a payout equal to the said price. the user also gets the option to either exercise the trade or not. These markets, though relatively new provide cryptocurrency and decentralized finance traders mechanisms to lock-in interest rates for cryptocurrency assets that would otherwise not have been possilbe.

Decentralized Insurance for Smart contracts

Computer keyboard with post title

One of the largest events that has impacted the smart contracts ecosystem is the lack of security and an ever increasing number of vulnerabilities in the decentralized space. A very detailed account of vulnerabilities in this smart contract ecosystem has given analysts, security firms such as trail of bits a lead in detecting and to some extent recommending best practices. That being said, there are too many of these issues to be tracked by teams building Dapps across the world. Very often these teams are understaffed and automation with tools such as Slither – which does static code analysis, and Echidna – a fuzzer for smart contract code accomplishes only so much. According to this detailed report by Trail of Bits, there are more than 246 different types of vulnerabilities that they discovered.

This is virtually impossible to detect and test using any type of automation, across all the millions of smart contracts that exist out there. As a result, Firms such as Nexus mutual have introduced a pooled insurance policy for smart contracts.

Their workflow is documented here : https://nexusmutual.gitbook.io/docs/use-cases

Whenever, a smart contract deals with finances of individuals or contracting parties, nexus mutual’s funds provide a significant fallback to users. Nexus Mutual allows individual users to provide guarantees for use cases that are not tested and that tend to loose funds or operate unexpectedly. Insuring smart contracts is also a community activity in which all those users who have participated in a particular smart contract system, can pool in resources to an insurance pool and be compensated in times of a crisis.

On the overall, what we see is an insurance plan that can protect people against the downside. however adoption questions remain

a. Will decentralized finance users who have no insurance subscribe to nexus mutual?

b. Will non decentralized finance users take up insurance using nexus mutual?

c. What about insurance products that are not dependent on code per-se and can protect investments or locked up funds in contracts against market fluctuations?

Decentralized Finance Service categories.

The decentralized finance industry is a revolution happening in the banking industry slowly but surely.

There are three main categories of Defi providers in the crypto-sector, most of whom operate via the Ethereum blockchain and its supported protocols. I label them as a) Centralized Defi service providers b) Decentralized Defi service providers and c) Auxilliary Defi Service providers.

Centralized Defi Service Providers

On one end of the decentralized finance, product spectrum are centralized entities such as celsius.network and nexo.io that have found innovative ways to return positive returns on cryptocurrency investments, by lending with collateral. Let’s call these centralized Defi Providers. They operate similarly to banks, often acceding to large customer service support, providing and maintaining KYC records for all customers, negotiating with legal teams across the world to ensure that local laws are not violated by investments with them.

Decentralized Defi Service Providers

On the other end of the decentralized finance spectrum are stable coins that provide no interest, and just provide the utility of moving money from one location to another quickly. In the middle of this spectrum is open source software managed is a decentralized fashion by teams as Ethereum contracts. These contracts provide both the lenders and borrowers access to loans directly from each other through smart contracts. This arrangement dis-intermediates financial institutions that use leverage to lend more from depositors. Often the lenders while subscribing to the lenders do not provide appropriate support and allow Defi-contract rules to execute as per design. Organizations such as compound.finance, dy.dx, maker etc. operate as decentralized Defi service providers. I have written extensively about the maker protocol and the DAI/MCDAI tokens supported by the blockchain.

Auxilliary Defi Service Provider

There are many auxilliary defi service providers. These service providers range from decentralized anonymous exchanges such as balancer, uniswap, etc. to the creators of stablecoins such as Tether, or USDC. While on one hand balancer, uniswap, etc. operate more as a token exchange system at the protocol layer using Ethereum smart contracts, they are not necessarily interest earning. Often the exchanges that facilitate this function of coin-swap use external oracles to convert the USD equivalent values among the coins to enable an exchange. Stablecoins off late has become a very large investment system in itself – with tether crossing 10Billion dollars in investment and USDC with a market capitalization of 1 Billion Dollars. These stable coins are etherum contracts that ties the issuance of new coins backed by assets whose value are equated to 1 USD. With USDC it is 1 US Dollar in the bank. While stable coins in themselves do not provide interest, a passive investment of stable coin in centralized Defi services provides interest income. The decentralized Defi providers also accept stable coins to facilitate certain functionality.

On the overall, the Defi space is an exceedingly interesting and positive development in the field of finance. However, the excessive interest rates in a market that has shrunk by 30% since its peak is always concerning to users. For example, many centralized Defi services return up to 9% APR which – given the times of COVID-19 seems too high. Another issue here is that of the local lending on the platform. The platforms lend at between 1% APR and 4% APR, but they return 9% APR to their users on stable coins. How is this possible? are they doing something else with our money to get such huge returns? Or are they just turning around new investor money to existing investors? – Only time will tell how this operates. As of now, things seem hunky-dory and people are seeing unheard off returns in this space giving it the necessary thrust needed to survive and excel against all other odds.