Blockchain

Regulation and the FinHub-SEC

One of the most progressive endeavours in the financial sector affecting mass adoption has been that of whether governments are willing to actively regulate a class of assets against fraudulent rent seeking by unscrupulous market actors.

While most markets are governed by inherent reputation mechanisms, that operate as a forewarning to future investors, cryptocurrency markets – because of its international nature has taken more time to form these reputation mechanisms. As a result, regulation in the most advanced countries of the world are lagging and are a step behind the innovation. What is interesting though is that decentralization – like the cypherpunk movement – if left unregulated or if banned can continue to exist underground, without any oversight.

As many different types of assets such as security tokens and cryptocurrencies expand in their reach globally, SEC has stepped up in their functions by separating financial technology regulation from regular security regulation. The FinHub website recently separated from SEC’s main website offers several insights for all kinds of token issuers and for the general public. Similarly, the website also provides information about different decisions taken by SEC’s FINHUB team for example, the rejection of Winklevoss Bitcoin Trust ETF, the no-action letters issued to Paxos Trust and such..

These regulations, be they for ICO’s or for other forms of secondary token assets issued by the FinHub are worth a read at the FinHub website and provide guidance to those in the industry and those in academia about future directions the space of crypto. The separation of Finhub from SEC itself signals that existing regulations and frameworks for analysis may not be sufficient to regulate this sector fairly to prevent malfeasance and to protect the wealth of a county’s citizens.

Uniswap and the Life of a Protocol

Uniswap logo

In decentralized finance, and in the overall blockchain sector, what has always mattered is that the protocol survives beyond the scope of the current software it runs within. As a result, we have seen massive adaptations after adoption of the first instance of a successful protocol. For example, The bitcoin protocol has morphed into multiple different protocols and chains, and coins over the past 12+ years. Similarly, other token protocols have morphed.

However, within the scope of liquidity pools and decentralized exchanges, the feat accomplished by Hayden’s Uniswap protocol is a story unto itself. For example, when uniswap was released it received significant adoption since it offered ordinary retail users a chance to invest their coins and earn some interest from liquidity pools. This market making wherein retail individuals would park their coins in liquidity pools became a significant component of the decentralized economy and the protocol’s did not depend on a single team of individuals, or a single peice of software or even a common user interface. This software system runs autonomously, is governed by a decentralized team, and is managed and maintained by a globally distributed software team. While core protocol specifications and modifications to these specifications are the responsibility of a central organization, the development and user interface is completely decentralized.

When uniswap.org raised their first external investment from the professional VC community which required KYC, AML etc. adherence, the community that engaged with the code, decided to fork off and overnight several instances or clones of the uniswap started operating. True decentralization just needs an individual to login or connect with his/her own wallet, and does not need a login ID or password to access the services of the decentralized application.

In a short timeframe there are more than 100 uniswap protocol applications, some running on hosted services like zapper.fi. Some running within the context of the mobile phone apps such as moonswap. Some even running with their own separate unlinked liqudity pools like sushiswap. What matters is that the input to the liquidity pools in the form of token pairs are sourced from a variety of user interfaces such as zapper.fi or aave.  The more the Decentralized applications that run on the same protocol – irrespective of the user interface or the mode of operating (mobile app, web app, hosted application, windows application) the more the protocol’s life extends.

The network effects of such a protocol  – that survives beyond its source and provides access to users globally, – i.e., virtually anyone connected to the internet  – is  going to give this a life beyond what has been explained or thought of as possible in traditional software development lifecycle thoeries. There is virtually not going to be an End of Life or a single point of maintainence.

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.

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

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?