How decentralized, really, is DeFi?
That’s a question sparked by Uniswap’s move to restrict investor access to certain tokens on its platform, seemingly in response to threats from regulators, and the topic of our column this week. We also explore the relationship between bitcoin difficulty and price and the meme fun that was had with Sen. Elizabeth Warren’s (D-Mass.) description of cryptocurrency developers as “shadowy super-coders.”
In our podcast this week, Sheila Warren and I were joined by my old friend and former CoinDesk colleague Noelle Acheson, who is now head of Markets Insights at Genesis, a CoinDesk sister company. The three of us picked apart a couple of prominent essays that were critical of Bitcoin and crypto assets. Have a listen after you read the newsletter.
The crypto founder’s dilemma – DeFi edition
It’s a question you hear a lot from crypto outsiders: Why did Satoshi Nakamoto choose anonymity? Why not write your name into the history books as a contributor to the march of progress?
I can’t answer the question definitively, of course. I don’t have Satoshi’s ear – not that I know of, at least. (He/she/they may well be among the many Bitcoin OGs (original gangsters) I’ve spoken to over the years.) But I do know this: If Bitcoin’s inventor was an identifiable human being or group of human beings, it would not have been able to grow as it has. In fact, it may well have died shortly after its birth, much like e-Gold before it or Liberty Reserve after it.
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One can imagine state or federal regulators knocking on the fully identified Satoshi Nakamoto’s door and hitting him/her/them with a cease-and-desist order for running an unlicensed money transmission business. The Bitcoin founder could have protested, “The network is decentralized”/“neither me nor my fellow node operators hold custody of customer assets”/“it’s code, protected by the First Amendment.” But the power of law enforcement at such times often means that nuances like that are lost.
There’s a lesson here for the folks who built automated money maker Uniswap as well as for other protocol developers in the decentralized finance (DeFi) industry.
Uniswap is a decentralized exchange. Unlike centralized crypto exchanges and wallets, it takes no custody of customer assets. In theory, it’s governed by a decentralized community, whose members use its native token, UNI, to coordinate voting on financial conditions and other elements of the system.
But last week Uniswap Labs, the company that launched the protocol, announced it would limit trading in certain financial assets on its site. Citing “a shifting regulatory landscape,” the company restricted access to tokens that are synthetically linked to the value of stocks and other traditional financial instruments. The move came after U.S. Securities and Exchange Commission Chairman Gary Gensler warned that stablecoin tokens pegged to traditional securities may themselves constitute securities that are subject to its oversight.
With this one outcome, DeFi is suddenly looking a bit less decentralized.
For some time, DeFi advocates speculated that regulators who’ve found ways to impose anti-money laundering, know-your-customer and securities rules on centralized, custodial crypto exchanges and wallets such as Coinbase would run into a dilemma with decentralized exchanges because, supposedly, there is no one in charge for them to go after. But Uniswap’s quick response to a regulator’s public comment is a reminder this was an overly optimistic view. The protocol might be distributed, but if there’s an identifiable, centralized entity running the interface with that protocol, and it can be pressured to block access to it, the distinction seems moot.
Regulatory test
It may still be that there’s a decentralization threshold beyond which regulators can’t or won’t intervene. Administration of a protocol’s governance could evolve to where it’s out of the hands of its founders and is guided by the decisions of its network, and so it escapes the scope of regulation. That’s kind of what SEC Director of Corporation Finance William Hinman said in a much-cited speech about Ethereum in 2019.
If so, a big test of that idea may come with MakerDAO, the decentralized lending platform that runs the dai stablecoin. In a blog post last week, founder Rune Christensen said the MakerDAO Foundation, which runs the lending system, will hand over control entirely to a decentralized autonomous organization (DAO), also called MakerDAO.
As Christensen explained on our podcast recently, the founders quickly learned it was impossible to launch an entirely decentralized platform from the start. The decision-making of the foundation was needed for the system to run effectively at first, but the founders worked to build out the participation, liquidity and a structure that would eventually allow the protocol to run by itself.
Whether the formal move in that direction now is enough to protect dai from the stablecoin regulation that is also expected to be forthcoming is another thing. Legislation to provide a “comprehensive legal framework” to regulate cryptocurrencies and stablecoins was introduced in the House of Representatives Wednesday.
It does look as if DeFi is now very much in the U.S. government’s crosshairs.
Hot on the heels of Gensler’s message and the Uniswap response, a new infrastructure bill that’s looking to raise tax revenue from crypto traders included decentralized exchanges and peer-to-peer marketplaces in its definition of the brokers from which information would be demanded.
As Anderson Kill lawyer and CoinDesk columnist Preston Byrne argued last week, the recent round of cease-and-desist actions by state-based securities regulators’ against centralized crypto lending platform BlockFi (see Relevant Reads below) may be a precursor to similar moves against DeFi. These agencies are viewing crypto interest-bearing products as investment contracts, and thus subject to securities laws, irrespective of whether they are offered by CeFi (centralized finance) or DeFi.
This is not to say DeFi doesn’t pose legal or even moral challenges for regulators. Many have argued that regulators are crossing some fat red lines by going after the developers of open-source code if those developers are making that software available to others in an open, token-regulated system and not taking custody of users’ funds or assets.
In other settings, software code has been recognized as a form of speech, protected by the First Amendment. And as Protocol Labs general counsel Marta Belcher has argued, some of these actions could constitute breaches of civil liberties based on invasions of privacy.
Still, law enforcement is coming. So, does that mean that the only solution is the Satoshi solution? Is the only way for a project to launch for the founder to use a pseudonym and stay in the shadows?
Sadly, that option may also now be unavailable.
As the Blue Kirby problem demonstrated, where a pseudonymous coder made off with investors’ funds, the market itself is now inclined to demand identity. It’s the best way for investors to protect themselves from a fraudulent founder.
Satoshi’s genius move to build something outside of the glare of public view may have been a once-in-a-lifetime opportunity, available precisely because so few people knew about it and because, to start with at least, there was not much at stake in the way of dollar value.
To me, DeFi founders capture the same inventive spirit that Satoshi embodied. It would be a pity if regulators quash their ability to turn it into something valuable and lasting.
Off the charts: diving difficulty
Bitcoin difficulty, a measure of how much hashing power is needed to mine a block of bitcoin transactions, underwent its biggest drop ever earlier this month. The cause: the massive reduction in hashing power brought about by China’s crackdown against bitcoin mining in what was once the world’s leading region for such activity.
The Bitcoin protocol automatically institutes an adjustment every 2,016 blocks, or roughly two weeks, to reflect changes in hashrate to maintain a more or less even spread of bitcoin issuance and reward distribution over time.
As the chart below shows, the recent massive drop in difficulty came slightly after the sharp decline in price from bitcoin’s mid-April all-time high of $64,829.
That’s a trend seen at other times of falling prices, as lower profitability can lead miners to shut down inefficient equipment, which lowers the hashrate, triggering difficulty adjustments. But if you look at the rising trend during the first part of the post-bubble price correction in 2018, you’ll notice that it’s not a lockstep function. It wasn’t until bitcoin took another leg lower in late 2018/early 2019, that miner profit margins were squeezed far enough to prompt hashrate and difficulty reductions.
In the latest case, despite the correlation, there’s also a strong case to be made that the price and difficulty adjustment relationship is at least partly coincidental. The China crackdown would have prompted a hashrate retrenchment regardless of price, though it’s also likely a decline in profitability accelerated the exodus by Chinese miners and dissuaded competitors from outside China from quickly jumping in to take their place.
The bigger question is: What now? Well, the lower difficulty rate makes existing mining less expensive, which means there’s a new profit incentive to offset the loss of a lower price. So with bitcoin back around $40,000 after dropping below $30,000 a week ago, and with Chinese miners starting to relocate to new locations, some could argue that the bottom has been reached.
