There’s a lot of hype around cryptocurrencies (or “crypto”) right now. It feels like 2017 all over again, but more intense because of the growing number of big businesses (i.e. Tesla) coming out in support of accepting Bitcoin and other cryptocurrencies as a form of payment. There’s also the Coinbase IPO mania, with industry and media pundits suggesting that the event is a watershed moment for the space as a whole.
This time around the discussions related to crypto are also wrapped around the bigger bow of decentralized finance (“DeFi” for short), which is described as a more egalitarian form of finance — a characteristic helping it to rapidly gain momentum in many corners of the crypto world and beyond.
Before proceeding further, I appreciate that many readers may not be keeping up with the latest developments in crypto and/or DeFi. Or still don’t know what those terms truly mean, for that matter. Let’s define them, courtesy of Wikipedia (because I’m not going to try to compete with Wikipedia):
Cryptocurrency represents digital assets designed to work as mediums of exchange for goods and services. Individual coin ownership records are stored in a ledger existing in a form of a computerized database (also known as the blockchain) using strong cryptography to secure transaction records. This ledger also controls the creation of additional coins and verifies the transfer of coin ownership. It typically does not exist in physical form (like paper money) and is typically not issued by a central authority. Cryptocurrencies typically use decentralized control as opposed to centralized digital currency and central banking systems. When a cryptocurrency is minted or created prior to issuance or issued by a single issuer, it is generally considered centralized. When implemented with decentralized control, each cryptocurrency works through distributed ledger technology, typically a blockchain, that serves as a public financial transaction database.
DeFi is a blockchain-based form of finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial instruments, and instead utilizes smart contracts on blockchains, the most common being Ethereum. DeFi platforms allow people to lend or borrow funds from others, speculate on price movements on a range of assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings-like accounts.
With the general definition of each term now established, let’s remind ourselves why we should be talking about what’s happening in crypto and DeFi. And let’s use actual figures.
The market value of all cryptocurrencies topped $2 trillion for the first time this month — let that sink in! Bitcoin, launched in 2009 as the first form of a decentralized cryptocurrency, now represents half of the total crypto market value with a market capitalization of just over $1 trillion.
The capital that has been pouring into DeFi has been equally impressive, considering this is a space that really gained momentum just last year. Between February 2020 to January 2021, the value of crypto deposited in DeFi protocols (for use cases such as borrowing and lending) increased 20-fold from $1 billion to $20.5 billion, representing a growth rate of nearly 2,000%.
Keeping these astronomical numbers and growth rates in mind, I went down a bit of a rabbit hole last week on crypto and DeFi after reading a tweet from the CEO of Shopify:
Hey #DeFi Twitter👋. What are the commerce related opportunities that you are most excited about? What role do you want Shopify to play?
— Tobi Lutke 🌳🌲🛒🕹 (@tobi) April 2, 2021
His question got me thinking about whether now is the right time for merchants to be seriously contemplating if they should work with cryptocurrencies and/or DeFi protocols. It’s a question worth pondering, considering the benefits of these emerging areas of finance that are often advertised to members of the retail community. I’m talking about benefits such as:
- Instant transactions: There’s a slow bank process behind sending money today. By being built on the blockchain, crypto and DeFi can reduce these inefficiencies to make the transfer of money more instant on a relative basis, which can benefit merchants who don’t want to have to wait for settlements.
- Enhanced security: The blockchain’s inherent security protocols are designed to prevent any kind of transaction interference, which ensures that customers make payments with money that they in fact have. This can protect against chargebacks and fraud issues that are common in present financial systems, and which represent a big headache for merchants.
- Lower transfer fees: Fees from third-party services are generally less for cryptocurrencies. With the conventional payment system, merchants often find themselves having to pay per transaction for credit cards or other payment methods.
- International payments: Accepting international payments today can be costly for merchants. Cryptocurrencies allow for the bypassing of international transaction fees and simultaneously present merchants with an opportunity to sell anywhere in the world.
The direct responses to Tobi Lütke’s tweet took the themes highlighted above further, with some people suggesting DeFi integrations with Shopify (i.e. Aave) that would allow merchants to passively earn interest on their crypto deposits. There were other suggestions centred around the application of blockchain technology specifically for the retail industry — examples such as having supply chain visibility to track where products come from and fight counterfeiting, or selling exclusive products in the form of non-fungible tokens (more on NFTs here). A whole post can be written about the potential use cases for blockchain technology for the retail sector (outside the context of payment and finance related functions) so I’ll save that commentary for another time.
Although there are plenty of benefits and interesting ideas being touted around the applications of crypto and DeFi within retail — particularly in the context of accepting/settling payments and managing crypto assets — we do have a bit of a problem. There’s currently a consumer demand issue for crypto, as validated by a study that examined the acceptance and adoption intention of crypto payments by a sample of online retailers. The study found that the current rate of crypto acceptance among online retailers is at a modest 2%, even though adoption intention is higher. Why? Because consumer demand, net transactional benefits, and accessibility influence adoption intention and acceptance — with the most serious barrier for crypto acceptance seeming to be a lack of consumer demand. These findings led the authors to conclude that it is unlikely that crypto adoption by online retailers will increase substantially in the near future.
The conclusion of the report is sound, and reinforces the popular assumption that crypto is currently a speculative investment as opposed to a legitimate currency. After all, much of the capital being deployed in cryptocurrencies such as Bitcoin is by investors speculating on the asset as a hedge for bad government or poor monetary policy (to name a few reasons). And much of the capital being deployed in DeFi protocols is by crypto investors collectively speculating on yield arbitrage opportunities for a quick buck.
This point about speculation matters when asking why exactly there’s a lack of consumer and commercial demand for crypto. The reality is that consumers and merchants cannot seriously think about adopting crypto in their everyday lives as a legitimate currency — with which to barter for goods and services — when speculative investors are driving huge price fluctuations on a daily basis. The existing behaviour of investors is not conducive to positioning many cryptocurrencies as legitimate forms of payment. The team at Terra Money — a new price-stable cryptocurrency platform — put it best in a white paper from 2019 when they stated:
Most cryptocurrencies, including Bitcoin, have a predetermined issuance schedule that, together with a strong speculative demand, contributes to wild fluctuations in price. Bitcoin’s extreme price volatility is a major roadblock towards its adoption as a medium of exchange or store of value. Intuitively, nobody wants to pay with a currency that has the potential to double in value in a few days, or wants to be paid in a currency if its value can significantly decline before the transaction is settled. The problems are aggravated when the transaction requires more time, e.g. for deferred payments such as mortgages or employment contracts, as volatility would severely disadvantage one side of the contract, making the usage of existing digital currencies in these settings prohibitively expensive.
Terra thinks it has the answer to the price volatility problem with a price-stable cryptocurrency — also known as a stablecoin. Let’s go back to Wikipedia for the definition of a stablecoin (because again, I can’t compete with Wikipedia):
Stablecoins are cryptocurrencies designed to minimize the volatility of the price of the stablecoin, relative to some “stable” asset or basket of assets. A stablecoin can be pegged to a cryptocurrency, fiat money, or to exchange-traded commodities (such as precious metals or industrial metals). Stablecoins redeemable in currency, commodities, or fiat money are said to be backed, whereas those tied to an algorithm are referred to as seigniorage-style (not backed).
The introduction of these stablecoins would suggest that there is a silver lining for broader consumer adoption of crypto in the near future, thus making it more timely for merchants to seriously consider using crypto payments and DeFi protocols in their own financial “tech stacks”. But not so fast! Prominent economists such as Gary Gorton are already sounding the alarm on the perceived stability of stablecoins, as stated in a recent article in Bloomberg by Peter Coy. Without running the risk of getting too detailed and complicated, the general assertion being made by Gorton is that it is hard to assure that stablecoins are appropriately backed when the blockchain can only guarantee who owns a particular coin, not that the coin is backed by anything real.
For example the popular stablecoin USD Coin — which is pegged against the USD — has in its disclaimer that it’s fully backed by U.S. Dollars or equivalent assets. It’s with these equivalent assets that things get murky. What are they? Do they include assets of questionable value, such as collateralized loans? As further highlighted by Gorton in the Bloomberg article, not knowing the real answer to this question means that stablecoins are vulnerable to panicky runs by holders who try to pull their funds out before others can. Runs on commercial banks ended in the U.S. after the creation of the Federal Deposit Insurance Corp. during the Depression, but stablecoins have no such backing. Maybe a similar arrangement or enforced banking charters will bring about the transparency needed to make stablecoins truly stable. Time will tell.
Beyond the ongoing issue of price volatility in crypto, there are other risks at play with new cryptocurrencies and DeFi in general that suggest that wide adoption among consumers and merchants is still a ways out. Some of these risks include:
- Lack of trust: With crypto and DeFi having been associated with a lot of illegalities, there’s a general sentiment in the public that this technology is mostly used by criminals to do bad things anonymously.
- Security vulnerabilities: Cryptography and blockchain technology are hailed as unhackable, but that is not true. As reported by ZDNet a few months ago, billions were stolen in blockchain hacks last year. The total value of the losses from 122 attacks in 2020 would be worth $3.8 billion today. Not the best look for a new technology that remains largely uninsured.
- Too many options and oversupply: With so many crypto currencies in the market now, and new ones coming out that use different protocols, it will be tricky to establish which ones the broader market should rally around for the purposes of engaging in everyday commerce.
It’s ironic that some of the factors (i.e. trust and security) that make crypto and DeFi compelling relative to the traditional financial system also represent a material source of risk. But given the nascence of the crypto and DeFi industry, on balance I think it’s fair to assume these issues will be sorted out to some degree in time as R&D continues to proactively cover for active blind spots, barring major systemic risk factors and shocks such as countries banning crypto and DeFi outright. Turkey banned bitcoin payments recently, and acclaimed investor Ray Dalio thinks the U.S. may eventually follow suit. In theory a total ban could happen, but I can’t imagine it will be an easy fight for governments with so much “big money” already behind crypto now.
Regardless of the underlying risks, the amount of capital flowing into crypto and DeFi suggests that the momentum and general interest among investors, the media, and general public is here to stay — even if crypto and DeFi aren’t quite ready for prime time when it comes to enabling real-world commerce at a massive scale.
If you’re a merchant with an appetite for an adventure and some risk, there’s plenty to experiment with right now. For example Shopify already allows merchants to accept digital currencies. It might be worth playing with that feature if you care to be among the first set of brands and retailers to be attached to the hype cycle. And Tobi Lütke’s tweet suggests there is more to come — whatever the major commerce platforms launch or evangelize could serve as a huge boost for the crypto ecosystem and consumer adoption overall. Finally, there are also opportunities around exploring applications of blockchain technology for other non-cryptocurrency and payment related use cases (one again, this is a whole other topic which I left outside of the scope of this particular post).
If you’re a merchant that doesn’t have a penchant for risk-taking, don’t worry. A lot of what the major commerce platforms are working on is still a big TBD. The regulations around the space are still evolving. And the speculative mania among investors continues unabated, contributing to huge volatility in crypto prices. So you just might be better off taking a wait and see approach for now before making any big decisions with respect to how you operate your business. You don’t have much to lose… except maybe 50% price swings daily on your crypto assets 😀
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