The Revolution Will Not Be Centralized

Ruminations on the future of fees in decentralized finance

Macroeconomic data releases did not move markets last week.  Markets did move, but not in response to data or any other discernable news event.  This has left pundits scrambling to make sense of the moves by reaching into dark corners of logic and probability.  Some assigned them to pronouncements by Fed officials about the terminal rate for the Fed Funds overnight policy rate. 

The difference in opinion between Fed officials amounted to little.  Atlanta Fed President Bostic released a statement, and a tweet favoring a terminal rate near 5.25%.  

Fed Governor Waller, who favors a terminal rate approaching 5.4%, brandished tougher rhetoric.  In citing strong employment data he said “One implication of the strong labor market is that the FOMC's maximum employment goal has been achieved and monetary policy can be utterly focused on fighting inflation.” 

Uh oh.  Sounds like he thinks there is nothing to worry about in the economy except inflation, and that continued rate hikes are the solution.  

Such comments would be expected to dampen investor enthusiasm.  Instead, markets ended the week with a sustained rally that began Thursday. 

Porn Bomber

The way the comments were presented might have affected sentiment.  Waller was scheduled to make his comments to the Mid-Size Bank Coalition of America via a Zoom presentation.  Unfortunately, the meeting was hacked by an anonymous participant who caused the presentation to display pornographic images instead of Waller.  Maybe the Porn Bomber lightened investors’ moods, sending prices higher.  In any case, most major indices ended the week with a strong rally.  Such fine differences in preferred policy rates could not be responsible for the 4% rise in the NASDAQ 100 and concurrent bond market rally. 

It Doesn’t Matter

Bostic somewhat acknowledged as much in his statement, which finished with an emphasis on expectations: “Psychology is critical in the inflation fight.” and “…the FOMC's fundamental mission is to free people from having to think about inflation…”.

Psychology is the “critical” Fed policy tool, not market mechanics?  It was the Fed’s failure at psychological manipulation that sent the CPI over 9% last summer?  Why raise interest rates at all then? 

While raising the Fed Funds policy rate from zero to 4.5% certainly has affected the short end of the Treasury curve, the psychological battle at the long end is lost.  The yield on 30-year Treasuries, at a mere 3.9% is only 2.5% off the lows of this cycle, and around the same level observed in the aftermath of the 2008 mortgage crisis.  It bears repeating that the historic yield curve inversion currently observed in the market is a bad sign for economic prospects.

6-month vs 30-year Treasury Yield Spread

Although the Fed has finally succeeded in moving the Eurodollar futures market to conform to their guidance on short term rates, investors in longer term issues are not chastened and do not share the Fed’s observation of high inflation and a strong economy.  This is graphically illustrated in the latest release of the Atlanta Fed’s GDPNow model of economic growth.  The model consistently indicates economic strength far higher than Blue Chip consensus forecasts. 

Source:  Federal Reserve Bank of Atlanta

Crypto markets appeared unaffected by macroeconomic developments and displayed dramatically uncorrelated price behavior.  Markets were range bound all week until around UTC 01:00 Friday when most major protocols plummeted about 5% in a matter of minutes.  In keeping with typically mature price action, once the new level was found, markets resumed trading in a tight range.


What caused the sudden drop?  Take your pick.  It is rarely difficult to find bad news in crypto markets lately. 

Panic over Silvergate Bank was a popular market narrative.  The crypto-focused bank delayed its 10-K filing with the SEC, mentioning its struggles to “continue as a going concern”.

SEC FUD over Binance was another justification for the move.  SEC lawyer William Uptegrove mentioned during a bankruptcy hearing for Voyager Digital that staff at the regulator believe Binance.US is operating an unregistered securities exchange.  Does that mean Coinbase and Kraken are as well? 

The problem is that none of the news was timestamped with the move.  My own theory is the same as always:  nobody knows.  More sellers than buyers, erm… number go down.

Shares in Silvergate Bank have taken a beating, and its legions of short sellers are running gleeful victory laps.  Fair enough.  Citing ongoing withdrawals, management has suspended its Silvergate Exchange Network (SEN) instant settlement platform.  The service was considered critical infrastructure for crypto markets which will now need to navigate far slower U.S. Dollar transfer services. 

I can understand if Silvergate management feels hard done by.  They had about $13 billion of crypto deposits at the end of September which they did not loan out but instead had backed by U.S. Treasury securities.  Pretty conservative, right?  Unfortunately, their bond portfolio was decimated by rising interest rates in 2022.  As the cascade of withdrawals continued, they had no choice but to liquidate and realize a loss in excess of $1 billion for their shareholders. 

Things have not improved.  But the Silver lining in the Silvergate saga is that there is a new opportunity for an adventurous bank with better risk management skills.

Law is Law

The aphorism “code is law” is popular among decentralized finance advocates.  It was put to the test this week with the “counter-exploit” of the Wormhole hackers.  

The saga dates to February 2nd, 2022.  A hacker exploited a vulnerability in the code of the Wormhole bridge between the Ethereum and Solana blockchains and drained ETH 120,000 from it, worth about $340 million at the time.  One major backer of the development team supporting the bridge was an affiliate of Jump Trading, the powerhouse high frequency trading shop in global markets.  Incredibly, after patching the vulnerability, Jump backfilled all the stolen ETH, making whole the users of the bridge.  When the offer of a $10 million bug bounty to the hackers was ignored, it appeared Jump would be taking the full ETH 120,000 hit. 

But the big-brains at Jump followed the hacked ETH until it wound up on the decentralized finance protocol, where it was earning yield.  After identifying a vulnerability in the protocol, Jump approached the Oasis development team to propose a “counter-exploit” to recover the stolen ETH.  The vulnerability was through the 4 of 12 multi-sig admin keys.  Oasis demurred, apparently unwilling to take the reputational hit from compromising user funds.  The workaround that was rumored to have been proposed by Oasis was for Jump to obtain a court order mandating Oasis’ cooperation.  Court order in hand, Jump joined the multi-sig quorum and executed the counter-exploit recovering ETH 120,000 (plus significant yield!).

While that is a happy ending for Jump, the result is mixed for the Oasis dev team.  While the security of the Oasis smart contracts has been incrementally improved, the confidence of large users should be incrementally degraded.  But with $2 billion in Total Value Locked (TVL) still on the platform, most users seem unfazed.


Hyperstructure by Orange-1

But the “code is law” ideal that presumably Oasis aspires to, has been violated by the “law is law” fact.  What could bring them closer?  A roadmap to the conceptual hyperstructure, proposed by Jacob Horne a year ago is a worthy model to re-visit.

Horne defines a hyperstructure, as “Crypto protocols that can run for free and forever, without maintenance, interruption or intermediaries.”  To achieve this, it must be:    

  • Unstoppable – as long as the underlying layer-1 blockchain is operating.

  • Free – insofar as fees are not value extractive and exist only for incentives.

  • Valuable – to users and owners.

  • Expansive – incentives are structured to build usage for the long term.

  • Permissionless – anyone can use it, nobody can change it.

  • Positive sum

  • Credibly neutral – it seems redundant to list this for anything that possesses the above.

The first characteristic listed above would preclude any layer-1 protocol from being a hyperstructure.  A widely decentralized layer-1 could be practically unstoppable by delegating all protocol changes to a DAO, for example.  And crypto advocates would agree that aspiring to the remaining ideals would only serve to improve a protocol.  But all blockchains require people to commission servers and choose core software to run on them. 

Hyperstructures are app-layer protocols.  Are there any? 

Crypto anonymizing protocol Tornado.Cash is a classic example.  Its suite of smart contracts use clever cryptography to disguise the connection between a sender and receiver of an asset transfer on the Ethereum blockchain.  It was built to address privacy issues that remain a major problem in crypto.  There were plenty of legitimate users of the service that simply did not want to share their balances with everyone they paid.  But they landed in the crosshairs of American authorities because of its alleged use by criminals and North Korea. 

Despite being confined by the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC) to the Specially Designated Nationals (SDN) list, Tornado.Cash still operates smoothly as designed.  With no admin key to access the code, it cannot be stopped for as long as the Ethereum blockchain is operating.  Authorities have made it difficult to access by forcing the web-hosted user interface to be taken down.  But decentralized storage protocols like IPFS (Filecoin) enable decentralized web hosting.  Maybe Tornado.Cash should now be called

Authorities have also coerced Ethereum validators to censor transactions.  According to MEV Watch about 49% of Ethereum blocks are currently OFAC compliant, presumably by validators located in the U.S. or extradition jurisdictions.   

For some reason, Tornado.Cash developer Alexey Pertsev, who was arrested in the Netherlands in August on charges of money laundering, remains in jail awaiting trial.  But no matter what becomes of him, Tornado.Cash will remain functioning.  I wonder if coming to that realization will affect the actions of Dutch prosecutors.    

Uniswap could also be a hyperstructure.  V1 deployed with no admin key or DAO governance and still has TVL of $8 million.  V2 and V3 are DAO governed and currently hold nearly $4 billion in TVL.  Interestingly Uniswap token holders have not voted to enable an extractive fee switch.  This is in contrast to Uniswap’s most famous fork, Sushiswap which skims a fee of 0.05% for its token holders.  Despite this, the market capitalization of Uniswap, at $4.8 billion, is approximately 20 times that of Sushiswap and continues to rise.


This speaks to another interesting idea Horne postulates:  something that is free to use can also be valuable to own.  In the context of real-world assets, this is easy to mentally model.  For example, a town that has good schools is valuable to its residents.  Imposing extractive fees to use them could drive residents to seek alternatives, with undesirable consequences for property owners. 

Likewise, Uniswap as the leading AMM protocol, provides value to its users.  Turning on a fee switch would be destructive of that value; ergo token holders do not do it. 

What does this mean for the future of fee extractive protocols?

Obviously new DeFi protocols can start with extractive fees in a bootstrapping phase.  A protocol needs to be built.  Somehow developers need to be paid, or at least they need to eat like everyone else.  Two and half years on from DeFi summer, plenty of exotic protocols are still around. 

But it is still too early in the experimental phase of this new wave of financial innovation to confidently forecast an end state, beyond observing the classic crypto trend toward disintermediation.  Maybe the end game for a protocol is to move in the direction of becoming a hyperstructure if valuable, or if not, oblivion.  If UNI token holder eventually decide to turn on the fee switch, it will be an interesting test case for protocol valuation. 

One surviving counterexample is Yearn.Finance, a yield optimization protocol built and launched in 2020 without any stake for the founders.  Instead, the Yearn development team led by Andre Cronje pioneered the concept of “fair launch”.  Anyone who participated in the protocol received YFI tokens proportional to their participation.  Yearn vaults continue to skim high performance fees for YFI token holders, sometimes as high as 20%.  With TVL currently over $400 million, users must still appreciate the value proposition.    

But what if a fork of Yearn had no fee?  If Yearn was working its magic on $400 billion instead of $400 million, the incentive for a user group to fork the code and deploy a new version without a fee would be far greater. 

As the march of asset tokenization continues, protocols will not be the new middlemen extracting fortunes from the world’s citizens.  The new financial primitives are going to work for the users, not the other way around.  To paraphrase Gil Scott-Heron: “The revolution will not be centralized.”  

Gil Scott-Heron

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