The case for an open, digital financial system
Whether it’s the narrative of a decentralized currency, the promise of life-changing returns or experimenting with a new technology, everyone has a reason for getting into crypto.
However, there is still a fair amount of misunderstanding (even among those who have invested a fair amount of their own capital!) about what cryptocurrencies really are, and the potential they represent.
We started Shyft Capital because we have very high conviction that cryptocurrencies will provide the single greatest opportunity for return on capital over the next few decades, based first and foremost on a revolutionary new financial system.
While the past few years have spawned a multitude of blockchain use cases — from NFTs to Metaverse applications to Play-to-Earn — it is in ‘Decentralized Finance’ (DeFi) where we hold the most conviction.
We believe that the new financial system built on top of blockchain technology will revolutionize the way value is stored, transacted and transferred. Allowing for digitally native money, it will finally usher financial systems into the internet era, where money can move with the same ease and interoperability as text, video and audio.
Our basic thesis is built on the following:
- The fundamental innovation underlying blockchain technology
- The weaknesses of the current financial system, from the technical infrastructure to the fundamental model to the monetary and geopolitical issues of any nation-controlled form of currency
- The recent exponential growth of DeFi protocols — in users, in invested capital, in talent, in funding and in use cases
- A decline in trust in institutions, from governments to large corporations
In this essay we will briefly detail each of these points.
The blockchain
Without going into the detail of Proof-of-Work, SHA-256 encryption and distributed nodes, the simplest way to think of the innovation of blockchains starts with Satoshi Nakamoto’s white paper:
A purely peer-to-peer version of electronic cash would allow online
payments to be sent directly from one party to another without going
through a financial institution.
Put simply: money, sent online, directly from the sender to the recipient, without the need for an intermediary.
Prior to the invention of the idea of a blockchain, this was actually not possible to do. There needed to be a trusted third party keeping track of account balances. The blockchain was the first instance of ‘trustless,’ digital money — a digital store of value that allows two parties to transact directly.
This innovation allows an entirely new financial system to be built, one that is native to the internet; completely trustless, unencumbered by geopolitical boundaries, and controlled by no one.
While Bitcoin was the first to be built on this model and represents a compelling value proposition as ‘digital gold,’ we believe the opportunity is not in a digital store of value, but in a wider financial system built on this innovation.
Of course, finance is not the only field where this innovation will create meaningful change (wider Web3, NFTs, Metaverse, new creator economics), but we are focused on finance as the first and most natural use case, and one where we have a strong fundamental thesis.
The current model of money
Pre-blockchain, the only feasible model of global value transfer was that of correspondent banking:
In short, every bank has a ledger (basically an excel spreadsheet) of accounts and balances representing their debt to the account holder.
Transfers between accounts at the same bank are simply a shifting of debt:
Transfers to different banks, both domestically and cross-border*, essentially require each bank to have an account with each other:
Note what is really happening in this transaction:
- Bank of America’s debt to Putin has decreased by $10 billion
- JP Morgan’s debt to Musk has increased by $10 billion
- To offset this increased debt, Bank of America’s account at JP Morgan has decreased by $10 billion
*This explanation has been simplified. In reality, cross-border transactions run into the additional complexity where a bank only holds its own currency; i.e. US banks only hold US dollars in their own accounts. Transferring foreign currency means transferring from their account at a foreign bank.
In addition, banks can use the central banking method for domestic transfers, but this is not possible internationally as there is no ‘global’ bank.
This indirect method is fine, until we get to a point where we have a global society with nearly eight billion people and an estimated 25,000 banks. For each bank to have an account with every other bank — as would be necessary in case one of their customers wants to transfer money to that bank — there would have to be ~300 million individual relationships.
Obviously, this is not fine, nor feasible, nor cheap.
In practice, what happens is that each bank has a number of relationships with banks in different countries, and accounts with those banks.
When a customer wants to transfer money to a bank where there is no direct relationship, the money passes through an intermediary bank — a ‘correspondent bank’ — before reaching its final destination.
The indirect nature of this model has a number of costs:
- Increased fees. Initiating and maintaining a bank relationship incurs time and cost, which are passed on to customers
- Speed. Moving through intermediaries will never be as fast as going directly from A to B.
- Complexity. Different banks may have different transfer policies, settlement dates, hours etc. These increase the surface area for errors and delays.
- Accessibility. The costly nature of this model can lock out those in developing countries from the global financial system. The cost of an American bank exchanging documentation and maintaining a relationship with, for example, a Nigerian bank, may not be worth the margin.
It is also a system in decline, reducing its effectiveness:
If this model is so poorly designed, why is it the one the world still uses?
We will explain in depth in our piece on the nature of money, but fundamentally, the minimum cost base of using a trusted third party will generally always be higher than a direct transaction.
Old code
Cobol is the programming language that a vast number of financial infrastructure runs on. Here are a few facts about Cobol:
- It was first developed in 1959
- It underpins many powerful systems built in the 70s and 80s
- An estimated US $3 trillion in daily commerce flows through COBOL systems
- In the US alone, there is an estimated 240 billion lines of code processing billions of transactions per year
- Given its age and limited new use case, a lot of the experts in the language are retired… or dead
Stability and robustness are incredibly important features for a system processing large amounts of value, and the current systems fulfill these requirements — they have been battle-tested over decades.
However, this also means that they are very difficult to change as small mistakes can be incredibly costly. Combined with the fact that there are not many working experts in Cobol, and you get a system that works well but cannot be effectively upgraded or improved.
Old is not necessarily bad, but when the effect of the technical infrastructure being old is that it can’t be improved to keep up with technological innovations, this becomes a weakness and an opportunity.
Take for example the case of UK bank TSB, which in 2018 tried to upgrade its computers systems from a COBOL-based system. It was an unmitigated disaster:
- Internet and mobile banking suffered a meltdown for over three weeks
- An estimated 1.9 million customers were unable to access their accounts or make transfers, and there were reports of some customers seeing other people’s accounts
- The total cost of the migration exceeded £330 million: eventual customer compensation exceeded £125 million and financial fraud cost the bank £50 million
- TSB had to deal with more than 200,000 customer complaints
From a technical point of view, the time is ripe for a new financial system to be built.
Corruptible money
Recent global events have brought to the fore some of the inherent risks of the current financial system. Russia’s invasion of Ukraine and the subsequent sanctions on Russian-owned assets — including Russia’s $630 billion in ‘hard foreign currency reserves’ — made the world realize that in a central banking system, you don’t own your money, you just have the right to tell your bank who to send it to. If your bank decides not to, for whatever reason, that money is effectively gone.
We saw this with Western nations’ sanctions against Russia and Russian oligarchs, but we also saw this when Trudeau’s government froze the assets of those involved in protests in Ottawa.
When you also consider the case of Russian citizens, most of whom had nothing to do with the invasion, it becomes very clear that nation-controlled money is not an optimal solution. Why should the purchasing power of the ordinary Russian citizen drop 40% because his head of state decided to start a war?
While these may be relatively unusual events, inflation is not. Governments’ monetary policies affect all holders of a currency and can erode the value of holders’ savings, as has happened in any country that has gone through high inflation or hyperinflation (Argentina, Zimbabwe, Greece etc).
Given central banks’ responses to COVID around the world, people around the world are seeing a lot of the effects of inflationary policies today. Prices are going up with record-high inflation rates of 6% — 7% and the real value of savings — sitting in banks paying 0.5% interest — is falling.
Real Growth
A product is nothing without users, and DeFi is growing exponentially:
-> Total Value Locked (TVL) in DeFi protocols increased 1,200% last year, from $18 billion to $240 billion
-> MetaMask (a cryptocurrency wallet) users soared from 550,000 in Jul 2020 to 21 million in Nov 2021, a 4,100% increase
-> Venture capital funding is on the rise, with $30+ billion deployed into crypto startups in 2021
-> Real use cases are exploding, from on-chain (Anchor, Aave, Uniswap, Curve) to real-world (WireX, Crypto.com, CHAI network)
Declining Trust
Decentralization may not be the utopian ideal that some believe it to be, but it does offer some important advantages.
Humans are fallible, corruptible, and can change their minds. Institutions and governments are run by humans, and so they too share these characteristics.
The graph below shows how no institution is generally seen as both ethical and competent. Governments score the most poorly out of the four types of institutions.
There is a growing body of evidence that suggests that trust in public institutions in developed countries is falling, with trust in national government in the U.S. declining from 73 per cent in 1958 to just 24 per cent in 2021.
While modern societies have been built on trust, trustlessness is an inherent feature of blockchains. The code is open, for all to see, and it can only be changed by the consensus of the entire network. There is no need for any legal system to define and enforce laws, because on the blockchain, it is impossible to say one thing and do another.
What does this mean in practice? Well, consider Bitcoin’s hard limit of 21 million coins. ‘There will only ever be 21 million Bitcoin in circulation,’ it promises.
You don’t have to trust this claim: you can verify it yourself. You can read the code and observe the nodes that secure the network. There is no need for trust here — the code will do what it is programmed to do.
Politicians and institutions, especially some of those in recent times, do not have a particularly good track record on this front.
Whether you are dubious of governments’ and politicians’ ability to act properly in the public interest or wary of tech giants’ increasingly monopolistic power, you are not alone.
The thesis
Putting all this together, we get:
- An incumbent financial system based on a model nearly 100 years old, that has seen little fundamental change since then
- Old, extremely difficult to change technical infrastructure in COBOL
- Centralized, unilateral control by fallible and corruptible actors, and an increasing global awareness of the risks this poses
What would a financial system built on blockchain technology look like?
- Direct, ‘peer-to-peer’ exchange in a trustless manner native to the internet, improving on speed, cost, complexity and accessibility
- Fluid, open code, built for the internet age
- No centralized control of the system, so your holdings are your own — they cannot be easily ‘sanctioned’ or frozen
- Monetary policy that is not controlled by any one entity, but encoded in the programming of the blockchain and that can change only through network consensus, so money cannot be arbitrarily debased
- A globally accessible financial system distinct from any one economy or country
This is what we see rapidly turning into reality, and why we are all-in on crypto (not financial advice!) Just as the internet created enormous value by changing the boundaries of what is possible, we believe that so too will blockchains — starting with a truly global, digitally native, trustless financial system.
