If there’s one big thing that the mainstream coverage has missed about the various collapses in the crypto space over the past year, it’s this:
The downfall of crypto had very little to do with crypto.
David Z. Morris is CoinDesk's chief insights columnist. This article is part of Crypto 2023.
Cryptocurrency is the application of blockchain technology to build uncensorable, open-access and immutable global shared ledgers – usually monetary ledgers. But the headline crimes and failures of 2023 were almost uniformly attempts to use financial engineering to turn the future value of those systems into present-day U.S. dollars.
Too often, the finance bros bet big, using the same kind of fragile, nested and interlocking leverage that led to the 2008 financial crisis. Other times they used outright fraud – and they did it off-chain, playing by no rules, with no transparency. They were mistaken for part of the cryptocurrency industry, but it would have been more accurate to think of them as hangers-on and freeloaders, redirecting genuine public interest in crypto to their various unsustainable games.
The epic failures of these finance vampires, plus broader economic conditions, mean that 2023 in the crypto world will be a much different year than 2021 or 2022. Hedge fund gamblers and token-shilling hype men will be relegated to supporting roles, where they belong, as the shadowy super-coders who actually make crypto exist move back into the spotlight.
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But 2023 will also be different from previous “BUIDL eras,” during which huge squads of nerds were often set free to pursue whatever seemed cool to them. There will certainly still be some of that, but smart leaders will be pushing their teams much more firmly towards clearer goals: Building accessible and reliable front ends, for use cases with real-world demand, then (hopefully) generating revenue from users. The broad public now has a vague idea of what crypto is (for better or worse). The task now is finding out how to sell it as a tool rather than a speculative investment.
This will mean, among other things, less speculation on new tokens, particularly the tokens for new “layer 1” blockchains. In its place will be a relative increase in attention to services that leverage existing, trusted chains and ecosystems to build services with real demand that genuinely require the benefits of blockchains – cross-border fluidity, digital permanence, uncensorability and decentralized governance.
Betting on the future (but not building it)
This future, of course, assumes that the finance bros have been sufficiently embarrassed to feel some vague sense of humility, and that their marks have wised up a bit. Personally, I don’t think that task is quite accomplished. Like unruly dogs beholden to their animal spirits, institutional traders and speculators may still need their noses rubbed into the mess they’ve made. So, let’s do that.
Across many sectors of the economy, the 21st century role of finance has become catastrophically perverted. Rather than risking capital to generate long-term profit by building productive industries, the capital game has become about timing bubbles and picking narratives that will trick naïve investors (retail or otherwise) into becoming bag carriers. Meanwhile you, the pumper, head off to the White Lotus with the cash.
This isn’t a problem specific to crypto – especially not over the past three years. The litany of overbought, undercooked and sometimes just plain rotten companies rolls off the tongue: Clover Health (a 2020 Chamath SPAC joint on the verge of delisting), Meta Platforms (rebranded around an app with no users), Nikola (an electric vehicle fraud that raised $3.2 billion), Tesla (once pumped, now dumped), Theranos ($700 million in venture capital, another fraud).
The villains of the 2022 crypto collapse were, with one exception, born and bred in this darkness. They saw little more in crypto than the prospect of good hunting. Su Zhu and Kyle Davies started Three Arrows Capital to trade foreign currencies before transitioning to crypto. Sam Bankman-Fried infamously came to crypto from technical trading at Jane Street. Steve Ehrlich of Voyager Digital formerly helped run E-Trade. Alex Mashinsky was steeped in Silicon Valley tech VC and its accompanying blather. The one exception is Terra creator Do Kwon, who did build a crypto network – but did it on the shifting sands of venture capital, leverage and concealed risk.
The carpetbaggers saw crypto as the next hot thing, but they clearly never understood it. Above all, they didn’t understand that good cryptos are public networks and generate returns through vastly different mechanisms than corporations. This was most clear with lending platforms including Celsius Network, Voyager and Terra’s Anchor protocol, which offered high and fairly fixed rates of return on assets that didn’t generate revenue, leading inexorably to illiquidity and collapse.
A large element driving this mega-screwup was a decade of low interest rates set by the U.S. Federal Reserve to drive investment. With historically safe and predictable financial options like Treasury bonds returning next to nothing, capital was pushed to the far ends of the risk curve – much of it ending up in crypto. Then, against this macroeconomic backdrop, fiscal policy was loosened to keep the economy afloat at beginning of the COVID-19 pandemic. Excess cash found its way into bitcoin and other cryptos, which in turn found its way into emerging sub-sectors like decentralized finance (DeFi) and non-fungible tokens (NFT). Thus “DeFi Summer” was primed.
Some of blockchain’s johnny-come-latelies saw the early bubble in DeFi tokens, driven by the introduction of “yield farming,” and thought that was an enduring part of “crypto” writ large. The numbers and the jargon must have been intoxicating to them at first blush. In reality, of course, DeFi Summer was a one-time event that minted millionaires among knowledgeable insiders who navigated a minefield of smaller frauds and hacks. Durable DeFi platforms were in the end uniquely bad for the leverage gamblers, since on-chain returns are restrained by actual demand for loans – a restraint enforced by public code.
This is why, while Terra and its Anchor protocol looked like DeFi, they were in fact a sham – the sky-high returns promised through deposits in Anchor were coming not from system use, but from venture capitalists and other very finite outside sources. Dragonfly’s Haseeb Qureshi goes as far as calling yield farming an expensive “customer acquisition strategy,” where rates were paid out by marketing budgets. This month provided a poetic bookend to contrast that with stable DeFi systems: While Terra blew up while offering yield as high as 20%, MakerDAO recently reactivated 1% yield as demand for its products grew. One of those systems still exists as a going concern, and the other does not.
The use of VC funding to replace a functional business model is straight out of the Silicon Valley Venture Bubble playbook. Championed above all by PayPal co-founder Peter Thiel, the game is to subsidize user adoption then apply those “growth” figures to predict future *unsubsidized* use, attracting further investment, which is spent to subsidize more adoption.
See also: FTX Showed the Problems of Centralized Finance. Note DeFi | Opinion
Essentially, capital becomes a cudgel to eliminate enemies – including those with better-run businesses or superior technology – and build monopolies. While Thiel framed his game plan as a way to starve out the competition, the approach could also be considered a form of finance-driven deception.
But reality is reasserting itself: Uber, founded 15 years ago, is still above all an elaborate mechanism for setting money on fire. Facebook (now Meta), the investment that made Thiel’s name, was the worst-performing stock in the S&P 500 this year. But early investors in Facebook or Uber certainly don’t care: They’ve already cashed in. This love ‘em and leave ‘em financial philandering becomes even more insidious when tokens are involved, because VCs can dump their bags on the public pretty much whenever they want.
So from Silicon Valley to Wall Street, a long-term grift is being exposed. The continued rise in U.S. interest rates will peel away more strips of overcapitalized fat until, in many cases, there’s nothing left.
To be clear, I’m not calling for a purge of either venture capital or hedge fund-style speculation. There are good-faith funders in the space who are genuinely interested in building big new businesses over the course of years, not just grabbing the money and running. The crypto industry has for years relied on small-time traders to provide liquidity and rigor, and they will always have a seat at the table.
Unfortunately, the good funders and hard-nosed traders have been overshadowed by con artists we mistook for business people. Even more to the point, the 2020-2021 bull market distorted the natural order of things by making the finance bros the stars of the show instead of the supporting players they are meant to be. They built castles in the sky, funneling the life savings of naïve retail speculators into tokens from fundamentally flawed projects and collecting fat fees for the effort.
This exemplifies the tragic curse of the financier as a species: If you only understand numbers but not where they come from, you don’t understand anything at all.
And so, thoroughly spooked by crypto, institutions and hedge funds will take their ball and go home for much of 2023. Amateur day traders hoping to make life-changing money off the efforts of others will, hopefully, decide to do something more productive with their energies (and they’ll be better off for it). There will be less money to go around for developers: teams will have to go lean, and many projects (including more than a few good ones) will evaporate.
See also: Andrew Keys – 10 Predictions for the Future of Crypto in 2023 | Opinion
But again, in the big picture, this is largely for the best. Crypto still has limited capacity to responsibly absorb capital: contra Peter Thiel, you can’t simply spend your way to adoption of something so novel and complex. Actual developers working on crypto projects are still in the low thousands.
But for the next two years at least, smaller funders, more firmly rooted in the ideals and technology of crypto, will be in pole position on good deals and ideas. They’ll do what financiers are actually meant to do – not farm hype and magazine covers for themselves, but help the actual builders do their jobs.