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© Frank


The Known Unknowns

by Regina Cai
January 15, 2020

Regina Cai leads financial engineering and financial product design at UMA, a start-up building infrastructure for decentralized financial contracts. Previously, she was an equity derivatives structurer at Goldman Sachs. 

frank | Let’s start at the top. In the WIRED article you sent as a brief intro, it begins, "the original blockchain is a decentralized ledger behind the digital currency, Bitcoin." – can you break that down for us. How do blockchain and Bitcoin fit together? 

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RC | Blockchain is the name of a general class of technologies that people are now building instances of. You can think of someone deploying a blockchain the same way that someone would deploy a spreadsheet. 

Spreadsheets are like the name of the general class of technology, but anytime someone sends you an Excel file or a link to a Google Sheet, you can also say they’ve made a spreadsheet. Similarly, there are many deployed blockchains and one particularly successful blockchain is the one that powers Bitcoin.

There are many people who are building different kinds of blockchains. Some blockchains have special features. Some process transactions more quickly than others. Some require people to mine blocks like you do in Bitcoin. But, the basic idea is that a blockchain is this technology in which there's usually an embedded native token. Does that kind of make sense?

Yes. A lot of people in the space also talk about blockchain facilitating a transition away from our current, centralized banking system. How could we transition away from state monitored or state controlled banking systems and currencies to something that's borderless? Can you explain what that transition looks like?

I would think of Bitcoin or any other kind of digital currency as being an alternative way to track how much money someone has. If you have an alternative accounting system or alternative currency, then you have a different way for people to assess how much money other people have. Right now, we track how much money people have based on what central banks and correspondingly, the big system of large banks from each country, have in their ledgers. We use them as the definitive authority on how much money people have. But, I think what this is trying to say is that if we're able to transition trust away from their accounting systems to an alternative accounting system that is secured by a different community, then it means that we don't have to trust that centralized authority.

Different blockchains use different mechanisms to come to consensus on how much money everyone has. Once people believe that the value of money that people have is determined by the blockchain versus the government or versus other centralized authorities, that's when,

I think, the power dynamic will shift, because it means that now people trust this alternative ledger more than, or at least as much as, they trust the centralized authority.

There could be other factors that increase adoption, like a richer ecosystem of tools and services, but eventually, I think adoption should reflect that people believe in the veracity of the blockchain. 

There is also a future where these coexist. For example, video games are a really great mental model for this. There's no denying that if you're playing Fortnite, and your Fortnite account says that you have X thousand V-Bucks, and another player has twice that number of V-Bucks, that they have more V-Bucks wealth, right?

They have more V-Bucks than you do. You trust the centralized authority of the Fortnite game operator, who tells you how many V-Bucks everyone has. But at the same time, you can't really cash out those V-Bucks for dollars or for euros. So we also trust governments to tell us the dollar or euro balance in everyone's bank accounts.

In this world, even if we have two different accounting systems, they mean different things. V-Bucks don't translate well to dollars or euros because you cannot cash out your V-Bucks, right? You can only pay fiat money for V-Bucks.

You can't cash out your V-Bucks back to fiat.

The big difference is that with a lot of these cryptocurrencies, exchanges are willing to actually step in and say, yes, you can really go from bitcoin to dollars, back to bitcoin, and so on. They're a venue where people are making a market for bitcoin’s dollar price. As a result, you can somewhat accurately say, "Well, if they have this many bitcoin, that means that their wealth also is increased by the bitcoin dollar price times number of bitcoins they have.” 

Now that we have a fiat price for those cryptocurrencies, I think that's the big thing that's driving the narrative of, "It's possible that because we have a linkage between fiat money and cryptocurrency, now, bitcoin or another cryptocurrency can take over as money for everyone across the globe."

What does regulation look like? Given that circulation rates of money are so closely tied to inflation nationally and internationally, how do you foresee regulatory bodies stepping in? What are the regulatory bodies that govern circulation with Bitcoin and other cryptocurrencies?

There have been a few attempts to determine the correct valuation for some cryptocurrencies using a classic monetary economics equation of exchange, where MV = PQ. This basically states that in any period of time, the amount of money that exchanges hands in an economy should equal the general amount spent on goods in the economy (commonly referred to as the GDP of an economy), with any of the factors (money supply, velocity of money, or spending) affecting the price of the cryptocurrency.

In the world of crypto, I'd say it's less that there is/will be a governing body over each of the variables in that equation. Rather, I see more of an effort to identify key factors and players who could influence the velocity of money or the GDP of a crypto-economy. For example, growth in the ecosystem of web applications or physical stores that take bitcoin can affect both. 

Some people say that if we have many more fiat to crypto on-ramps, those should affect the velocity of money. Because once people can go from fiat to crypto, circulate that crypto a lot, and then pop that back out into fiat, yes, potentially there could be some influence there without increased spending within the crypto-economy. 

It’s not yet clear how it would affect all the other factors in that equation, but exchange volume is something that a lot of people are watching to get a pulse on what the velocity of money is. “Accurate” trading volumes are an area of work for a lot of projects in the analytics, data, and trading space.

Is that the reason there have been such large swings in the Bitcoin market, because the V is not controlled? If, over time, there is more regulation and crypto becomes more mainstream, do you foresee it becoming less of a swing market?

There are so many factors that go into the volatility and the overall trend of the market that it's really hard to say. There are always rumors like, "Oh, well a big whale who happens to own a lot of bitcoin decided to sell half their stake. And that's why bitcoin's down."

There are others who will say, you know, "Oh, well, actually it's just because there's this technical trend that people have been following, and of course, if enough people believe the technical trend and then implement trading strategies to will that into existence, then maybe it's the technical." 

The big thing that I want to say about speculators is that I think they tend to manifest themselves more in derivative exchanges like BitMEX or Deribit than they do in spot exchanges like Coinbase. If they do trade in spot exchanges, I think they’re more likely to trade in cryptocurrencies with smaller market caps, or what are called “alt coins”. Because they have lower trading volumes, their prices tend to swing a lot as well. 

This is one area where I think decentralized finance projects are trying to find product-market fit. A lot of these projects are trying to create protocols or methods for speculators to get 10x exposure to a cryptocurrency, even if it only goes up by 1x, without relying on a centralized operator like BitMEX or Deribit. The success of these projects is going to depend on finding both retail speculators who want to trade and professional market makers to add liquidity. Right now, though, I think most retail traders are trading in spot markets.

How do you think the government is handling or going to handle the stability and growth of blockchain technology and blockchain finance? Do you think it's going to have a positive or a negative effect on the industry?

Yeah, I think this question is definitely top of mind for anyone who works in decentralized finance. I think I'll segment it again by user base. 

For the traditional retail, small, mom and pop buyer, I think they're going to rely a lot on centralized exchanges or centralized custodians to help them manage their crypto exposure. In that case, I think the relationship between the centralized service providers and the government is one that has plenty of lawyers, and some industry bodies that, I would imagine, talk with the government fairly frequently. So I think for many retail people, right now, just because of all the tax and regulatory headaches, are probably going the centralized custodial route. 

On the other hand, you have big institutions. For big market makers, trading desks, or asset managers, I'm sure they have teams of lawyers that help them with their regulatory or tax issues, but I’m not sure what their individual, unique, strategies are. 

One of the big themes in decentralized finance and decentralized technology in general is moving work that is traditionally done by a centralized service provider to the actual person who owns the cryptocurrency. For example, if you were to trade a U.S. stock, you would typically call or email a custodian who manages your equity position for you, right? On the other hand, with cryptocurrency, you might want to self custody.

That means that instead of asking Coinbase to hold or custody your bitcoin for you, you will hold your bitcoin yourself on a hardware wallet or some other storage method. There are people who say, "well, actually, the government might protect us by monitoring and regulating these centralized service providers", while there are others who say, "actually, I'd rather eschew all of that surveillance and yes, of course, protection, and handle it myself." This line of thinking for the latter represents a mindset shift and maybe part of the overall crypto zeitgeist. An extension of this might say, "if a lot of people think that way, it'll change the way that everyone has to think about regulating centralized custodians", but for right now, my sense is that most retail investors are fairly comfortable using centralized custodians.

I think governments will still have a fairly good handle on supervising custodial services where their purpose is protecting retail investors. On the other hand, regulators also monitor traditional markets for market manipulation.

In crypto markets, there are big, unknown actors who engage in trades that might count as spoofing under traditional financial markets regulation – but how should they be tracked and prevented, or should there be a different type of regulation for crypto markets?

Those are open questions. I think on that front, preventing market manipulation is probably one of the biggest things that worries regulators, especially since exchanges and markets are where big market makers and institutional finance meet the retail investor. For now, at least you can protect people by making sure that their custodians are actually holding enough bitcoin for them and doing their proper blocking and tackling there. After that, how do you ensure market manipulation isn't happening? I think that's one of the biggest concerns, especially due to the pseudonymous nature of the blockchain.

That was actually my next question. Intuitively this is a market for people who don't have access to current markets, people with bad credit, people without citizenship, et cetera, et cetera. And by that thesis, it's an equalizer. But there is also a concern about financial literacy and / or less understanding of financial institutions, does that leave room for a greater amount of manipulation and with less oversight?

That is definitely part of the narrative around crypto – that it acts as an equalizer. If anyone can access cryptocurrencies, they can participate in this global economy without being bound by their local currency. I think that narrative is really powerful. I think it's really motivating and rallying.

It paints a picture of the vision of the world where a lot of financial risk is unlocked for people. One of the biggest hurdles I think is going to be, again, getting people to transition their wealth and their accounting method from their local currency into a cryptocurrency. 

That's where there’s potential for sort-of-centralized cryptocurrencies, such as Central Bank Digital Currencies, or CBDC, to provide local people with access to an internet of blockchains. Having access to many different cryptocurrencies on many different blockchains around the world without forcing them to use something like bitcoin or something with features that a central bank might not find desirable. I think that's why that's such a focus for some central banks. For example, people might want immediate transactions on the blockchain, but if those transactions are publicly visible, you can add privacy layers to ensure that certain kinds of information aren’t made public. CBDCs can give you a lot of blockchain features without having some of the other undesirable features from a government regulatory specific perspective.

Right. That's interesting. What about the addition of corporate actors? Like Facebook and Libra?

I think a lot of people who are currently very busy building their own projects and products on Ethereum or another Layer 1 platform see Libra as a separate Layer 1 project that they don't need to worry too much about.

Because it's an up and coming project for Facebook, eventually they'll want to have projects built on top of their blockchain. But for now, I think Ethereum still has a fairly strong moat of developers who are building projects on top of Ethereum.

For the general public, I think Libra has become top of mind for a lot of people because it’s had so much attention from both regulators and the media. 

I think it's a good opportunity for people to realize that a lot of traditional financial services run on fairly old and complicated payment rails.

If the joke about the internet is that everything is held together by duct tape, then I think it's especially true that in financial services, for banking and retail finance, it's definitely held together by duct tape.

I think a lot of people have experienced trying to send money from one account to another and having to wait multiple business days, trying to figure out how to get payments stopped or started, and how to freeze a credit card.

A lot of that stuff indicates that traditional financial services are pretty old and haven't been updated for a while. And really that’s because I think these systems are very fragile; no one wants to shake the whole thing up and start from scratch.

Everyone's adding things on: duct tape here, duct tape there, patch here, adding a little feature on top...

It's like the grid.

Exactly. So it's something where I think, especially because it's money, you really don’t want to mess it up. It's shipping hardware, not software. You're shipping software that's going to impact people in very, very real ways. You don't want to move too fast.

That's one of the big criticisms you hear a lot about Libra, that you cannot take Facebook's “move fast and break things” motto and apply that to money. You can't operate that way. I think that's one of the big reasons that traditionally big tech companies haven't really gotten involved in the payment space or tried to become a bank. Both from a regulatory perspective and a company culture and brand perspective, there are a lot of hurdles. I think that cultural point is something that speaks to a lot of builders on bitcoin or ethereum or any other kind of blockchain.

When you use people's real money, you have to be really, really careful.

It's really hard to come up with a nice sandbox in which you can really test the success of financial products or financial markets without having real money on the line. How do you do user testing for financial products when you can’t put a lot of real money in them? 

Looking at something like Libra, I would say, keep an eye on it but expect it to take a really long time to develop and expect it to have a lot of influence from the government in terms of how development progresses and how they test their products.

I think it's promising that people are using and becoming more interested in blockchain technology, but I think a lot of people are split on whether the interest in that technology is drawn more to Bitcoin and Ethereum, to private or government controlled blockchains, or general cryptocurrency technologies.

On the other hand, it could turn out that this interest in blockchain technology just means that people want to build more things like Libra.

I think it'll be interesting to see whether the people who become interested in the space fall down the rabbit hole to understand more about the technologies underpinning Bitcoin and Ethereum, or they go down the other, more manufactured, rabbit hole of understanding Libra and private blockchains.

That was really, really helpful.

That's awesome. I'm glad I can be helpful.

Would you simply define Defi?

Defi stands for decentralized finance and I would characterize it as a group of projects, builders, market makers, traders, and users who are all interested in creating a decentralized financial system.

What I mean by “decentralized financial system” is a set of tools and banking products that don't rely on a centralized authority or entity to operate. That can take the form of, on one extreme, pure peer-to-peer risk matching, where individual counterparties find each other and offer financial services to each other. Or something that's a little bit less pure is a peer to contract type of product, where everyone interacts with a smart contract, which you can think of as a trust, but on a blockchain, if you're familiar with traditional trusts in finance.

You have a spectrum of decentralization, from the purest peer-to-peer (p2p) services to more blockchain native or peer-to-contract (p2c) services. I think p2c services are where a lot of the work in Defi is happening, where people are trying to figure out how people can interact with smart contracts to access financial services, and financial risk, without having to rely on a centralized entity. 

For example, rather than relying on a centralized bank that's run by a bunch of people, or even an algorithm, to figure out whether or not you can get a loan, what if you could get a loan from a smart contract on the blockchain?

What if there was a pool of capital that was publicly available on the blockchain that could run those algorithms itself to give you some types of financial risk?

I think right now people are focusing a lot on figuring out what fundamental infrastructure and building blocks need to exist in order to attract more users. If the goal is to get a really liquid set of products for users to access financial services on the blockchain, these products should, in theory, bring them away from traditional centralized financial products they rely on now, which have a whole other list of “duct tape” infrastructure problems we talked about. Lots of people in Defi are trying to decide, what are the different kinds of products that we should offer and what supporting infrastructure and scaffolding is needed to help support those products? 

Let's say we have a peer to contract product that’s powered by smart contracts on a blockchain. If we have that, what else do we need?

We probably need market makers. We need arbitrageurs, we need capital providers, all these things that traditionally have existed in fiat that we're trying to attract onto the block chain. Once we have those, can we have the right user experience for people to actually interact with that contract in a really comfortable and easy way? We probably also need front end products, like apps or websites, that people actually want to use day to day. I think Defi is really the set of projects and people that are focused on trying to build all the layers for these kinds of services on the blockchain.