D e P o n z i
First, a quick update on last week’s seed stage commentary. See this Crunchbase article, which is a bit more quantitative than my last post. The number of companies getting seed funding has gone up 8X in a decade while the Series A count only doubled.
____
And now, a few words about DeFi. I’ve been looking at an overwhelming flood of DeFi deals in the last 6 months. And I’ve come to the conclusion that the vast majority of these companies are playing a part (whether intentionally or not) in creating a decentralized Ponzi scheme. Blockchain has its legitimate uses, but the overwhelming majority of venture funding appears to be heading to companies built on the foundation of crypto-currency growth rates, short-term exploitation of high volatility, and marketing mania.
Read this to understand exactly what I mean when I say “Ponzi”. It’s the appearance of value creation over time that is actually solely driven by new investor cash inflows, rather than by revenues derived from an asset. That article also rebuts a variety of the common objections to this classification.
I’m not suggesting that the founders, investors and employees working on DeFi startup have ill intent or are trying to deceive the public (well, I’m sure some small number are, but no more than in any new and fast growing sector). I honestly believe that many of them are motivated in part by a positive desire to reduce what they see as corruption in centralized authorities, increase financial inclusion, protect against inflation, and ironically, to reduce transaction costs.
There is one crucial difference between DeFi and past Ponzi schemes, though, which makes it far more pernicious. DeFi’s evolution will play out over very long time periods, which will make it nearly impossible from most people to identify it as such today. For example, in the case of Bitcoin, there is not yet a “steady state” of operation for estimating long term transaction costs. The philosophical premise of cryptocurrency in general, and Bitcoin in particular, is that centralized banks are no longer necessary to validate currency transactions. The motivation for miners to engage in “proof of work” to create trusted transaction records on the blockchain comes from the reward of newly minted Bitcoin. You may have heard one of the big advantages of Bitcoin over fiat currency is that there can never be more than 21 million Bitcoin, and therefore there is a built in cap on inflation through money printing. Every four years, the mining reward will be cut in half, until it declines to zero…. in 2140!
If you ask Bitcoin experts what will happen afterwards, you’ll hear some hand waving about additional transaction costs, or switching from proof of work to some other trust mechanism, as if this is not a problem. But this will be a massive problem if you believe Bitcoin is the future of currency, regardless of whether it’s just a store of value (i.e. digital gold) or something more. Bitcoin mining is not free - it has hardware and electricity costs (and, as widely reported, environmental costs). And Proof of Stake is just a minor variation on the minimum balance sheet requirements of the current incumbent bank model. If technology were actually eliminating financial transaction costs forever and transmuting the cost savings into new revenue/value, that would of course worthy of investment. I’m not convinced that has happened yet.
Please note, this 22nd century issue I’m raising is completely separate from the fact that as Bitcoin transaction volumes per day grow, transaction costs based on priority/speed desires of the network users can also rise.
At some level of transaction cost, liquidity will dry up, which will reduce the demand to hold Bitcoin and lead to centralization of currency stores again. If you disagree, ask yourself how many gold investors hold physical gold themselves. The gold investment market works on a mass scale because there is a system of ownership and transaction that doesn’t require the movement of physical gold bars, which would impose tremendous transaction costs.
So where does this leave me on DeFi startup investments? As an investor, if it looks like there may be massive returns for decades from DeFi, regardless of the long term outcome, should I embrace the category? That is TBD.