Coinbase and a few others aside, most of the big names in crypto finance will likely be the big banks and exchanges and custodians that are the biggest names in traditional finance, especially as crypto M&A picks up and crypto startups exit through the M&A route. In the post-crash ICO market, an increasing allocation of the pre-sale rounds are now going to established VCs, as a number of the trigger-happy crypto investors that adopted spray-and-pray strategies in 2017 and Q1 2018 are now forced to sit on the sidelines and ‘manage and support’ existing investments.
This is at the heart of the problem that a lot of maximalists have with the current marriage of crypto and finance. Crypto does finance significantly better in many ways, especially once the pesky issues around regulation have been addressed. What is not to like about security tokens, about blockchains in trade finance, or about ICOs. However, it does seem a bit like old wine in new bottle. There is no foundational, from-the-bottom-up, re-architecting of the financial ecosystem. This is not necessarily a bad thing, and this is what Wall Street and main street would probably like, a managed transition with some elements of clear continuity. However, this is not really the way of the Valley (or its spiritual cousins around the world), the ethos and the derring-do that drives disruption. And this is at the heart of the debate between the folks that swear by security tokens and those who swear at them.
Either ways, there are some exciting companies that are pushing ahead with re-architecting traditional finance. Compound (that raised a round led by Bain Capital, among others), is recreating the traditional money markets, allowing crypto holders to receive interest for their crypto holdings while enabling investors and traders such as hedge funds to borrow exposure without necessarily buying coins. DyDX is a protocol that enables margin trading in a decentralized, p2p, trustless fashion. Genesis and SALT are focused on the crypto lending space. Figure (ex-SoFi founder) is a startup that wants to use the blockchain to disrupt the home-financing and securitization market.
Which leads us to a thought experiment; When will we see the type of sophisticated structuring that changed the face of modern finance, the first Crypto credit default swaps or even Crypto CDOs? After all if crypto-synthetic repo markets are here, can synthetic crypto CDOs be far behind. How would one construct a crypto CDO? One potential way this could work is as follows
- Have a reference portfolio, that literally references price movements around an event, say the prospect of ETH going below $100 or say some protocol just collapsing and its value imploding
- Get investors to put money into a pot. Investors are now one side of the trade, let us say they are writing crypto-swaps on the event above, say ETH going below $100 (they could do this on DyDX btw, with some associated borrowing to offset positions on the aforementioned Compound)
- For assuming credit risk, the investors will demand a premium. This will have to come from the insurance buyer (the CDS buyer). Let us say this is a large fund that has a huge position in ETH
- As ETH stays above $100, investors continue to collect premiums from the buyer investors get gains. When ETH falls below $100, the pot will make whole the CDS buyer for the amount of protection they have purchased
- In a centralized paradigm, the ‘sponsor’ of the structure, presumably new-age crypto bank, or equally likely Goldman/JPM/Credit Suisse, make a small ‘house fee’ either ways. In a decentralized paradigm, the whole thing would be automated and traded on DyDX or some similar derivatives platform, in which case the fees would accrue to protocol sponsor
The above structure could be made more interesting by constructing a basket of tokens on which one side buys protection and the other side sells
(If any of our dear readers have Blythe Masters email id, please do forward this edition to her, would love her feedback! For the uninitiated, Blythe is a blockchain pioneer who is credited with creating the first CDS while at JPMorgan)
As an aside (shameless plug alert), check out our 108 update further down. The 108 Crypto index would be somewhat similar to a collateralized cash CDO, in its current avatar.