background image

Coffee Series: A Discussion with Cryptoasset Analyst Nate George

    What was your journey into Crypto?

    I became interested in Crypto in early 2017. While in college, a friend offered to sell me $100 in Bitcoin for a discount. At the time, I didn’t know what it was all about but it seemed like a good deal, however, after seeing it increase in value, I figured I should learn more about it. I spent the next 6 months learning everything I could about the industry and managed to land a job working at a family office VC fund that was very active in the space. I spent about a year and a half working there helping manage venture investments and a liquid token portfolio. I began formally working in the crypto industry again in December 2020 when I joined Cumberland.

    There are several trends that I think will emerge in 2022, particularly advancements in DeFi, Web3 business models, and scaling solutions.

    DeFi

    Within the world of DeFi one area of interest is the introduction of permissioned DeFi protocols and the potential for undercollateralized and unsecured lending. Development in this space that can tie in recourse to decentralized protocols are necessary next steps for furthering the competitiveness of DeFi vs. traditional market product offerings. We have already seen successful products using this model with institutions. For example, Maple Finance has facilitated over $500 million in undercollateralized and unsecured loans to large trading firms in crypto. Expanding this to individuals seems like another important step, though it will likely rely on partnerships with on-chain identity providers to bring some form of social or financial recourse.

    Another important trend in DeFi is the introduction of new building blocks that facilitate the development of protocols that were not previously possible. One area I am excited about is interest rate swap protocols and the design space that unlocks. With the introduction of interest rate swap protocols, DeFi applications can start to construct yield curves and introduce various related products like expiry future protocols, more sophisticated structured products, and hedging mechanisms for fintech platforms that source yields from DeFi but take on fixed rate interest liabilities by offering users fixed rate yields. Other new use cases may be driven by the development and adoption of layer-2 scaling solutions, bringing a variety of more complex and latency-sensitive applications to the market. We are already seeing this trend emerge on layer-1’s like Solana that support fast, inexpensive, and low latency transactions as well as on layer-2 solutions like Starkware, zkSync, Arbitrum, and Optimism.

    Finally, I think we will see continued growth in the “real world asset” sector which includes companies like Centrifuge and Credix. The real-world asset sector of DeFi is focused on bringing traditional (non-crypto) assets on-chain to democratize access to financing opportunities and allow for non-crypto assets to be used as collateral on platforms like MakerDAO and Aave. The introduction of on-chain assets that are uncorrelated to the broader crypto market is an important development to the quality of collateral assets that can be used within the DeFi ecosystem. Other areas that have been explored for years, though never quite took off, such as security tokens and on-chain securities, may finally find product-market fit in 2022 as a result of growing institutional participation and potential regulatory clarity coming out of the SEC.

    Web3

    Another fascinating area of the digital asset market is the development of disruptive Web3 business models that seek to disrupt centralized incumbents through disintermediated structures that significantly reduce CAPEX and OPEX. One example of this is Helium, which has built out a low bandwidth network for IoT devices and which currently has over 400,000 hotspots and significant coverage in nearly all major US cities. Helium also announced plans to roll out a 5g network as well. Due to the design of the network, OPEX and CAPEX is worn almost entirely by the end users who purchase, maintain, and operate the hotspots. Hotspot owners are compensated with tokens from inflation as well as spending by users of the network.

    One of the other Web3 platforms with existing real-world use cases is Render Network, which has built a decentralized cloud for GPU compute power primarily focused on rendering jobs. Due to the economics of GPU cloud solutions, the Render network can offer more computational power than leading centralized providers at a far lower cost. The GPU network they have built is also operated, maintained, and funded by individual users with idle GPUs, driving the Render Networks CAPEX and OPEX requirements to near zero.

    Overall, I envision several incumbent business models to be disrupted by decentralized counterparts that offer significant cost savings as a result of protocol-based automation, outsourcing of hardware and operational costs through token incentives, and network effects.

    Scaling Solutions

    Scaling solutions are a very hot topic right now and arguably the most important aspect of the market currently. Wide-scale adoption of protocols on Ethereum have driven gas prices for basic DeFi transactions into the $100+ range in times of high demand. The pricing of gas (transaction fees) is quite simple and ultimately comes down to demand for block space versus supply of block space.

    Newer layer-1 protocols such as Solana, Avalanche, etc. offer significantly lower transaction fees than ETH by offering a larger supply of block space, though they generally have less users and thus less demand for block space. The more scalable blockchains are not immune from high fees, and could feasibly see gas prices in the $100+ range as well if the demand for block space exceeds the supply; it just will take much more demand due to the increased supply of block space.

    Ethereum is currently the focus for nearly all research and development for layer-2 scaling solutions with various scaling methods being built. These solutions broadly fall under two categories, validity proof solutions (typically zk-rollups) and fraud proof solutions (typically optimistic rollups). In the near term, the roll out of these scaling solutions could introduce off-chain execution environments secured by Ethereum’s layer-1 security, while having significant reductions in gas fees, transaction latency, and overall throughput.

    For me the most exciting aspect of the current scaling solution race is the long tail of possibilities that emerge from the development of “modular blockchains”. Right now, all blockchains are monolithic blockchains - meaning execution (E), security (S), and data availability (DA) are all controlled on the same chain. Layer-2 solutions start to separate execution layers while relying on the underlying blockchain for security and data availability. Where things get really mind-blowing is the concept of multi-layer blockchains with separation of all three elements (E, S, and DA). While roll-ups use on-chain data, solutions like Validiums (off-chain data) and Volitions (hybrid on-chain/off-chain data) could lead to the emergence of multiple data availability layers being made available to users. As I am by no means an expert on this topic, I would recommend reading the Medium Blogs and Twitter pages of @epolynya , the Starkware team, Matter Labs team, Arbitrum team, Optimism team, and the many others leading the charge on this tech.

    Do you foresee the Infrastructure Bill impacting the crypto space in the new year?

    The infrastructure bill itself doesn’t seem to bring any immediate changes to the crypto space. The crypto-related changes in the bill are primarily focused on tax provisions which go into effect in January 2024. The most impactful change is the loose language in the bill over reporting requirements for “brokers”, with the provision’s definition of a broker being very broad. Concerns seem to be focused on how this loose language is applied and whether the IRS goes after entities that fit the broker definition but are unable to collect KYC information such as non-custodial wallet software providers, validators, etc. While the infrastructure bill certainly opens up a further grey-area of potential risks, it is still unclear how it will be applied.

    How will DeFi regulation effect the markets?

    DeFi regulation is a complicated topic. Chairman of the U.S. Securities and Exchange Commission Gary Gensler frequently describes himself as a “cop on the beat” for the crypto industry and is not shy about his goal to push further regulation to the sector which he feels lacks sufficient investor protection and regulatory oversight. Gensler’s focus on the crypto industry has been reiterated on numerous occasions throughout the past few months, stating that teams building DeFi protocols should “come in” to work with the SEC and “get registered”. Members of congress as well as industry experts have asked Gensler on several occasions what he means by “register” as the applicability of registration and reporting requirements to DeFi applications is unclear. Gensler thus far has failed to clarify his comments in that regard.

    Going back to the September hearing between Chairman Gensler and the Senate Banking Committee, we saw multiple members of the Senate including Senator Toomey express concerns over Gensler’s approach to regulating the market. Gensler has also seen significant push back from SEC Commissioner Hester Pierce, who put out an official statement in December criticizing Gensler’s regulatory ambitions. This is the latest of many public criticisms from Pierce regarding Gensler’s overall regulatory agenda and particularly his approach to regulating crypto. It is certainly interesting to see pushback spanning from retail users and industry experts to congress and even within the Commission.

    Members of the Senate and House have also repeatedly asked Gensler for further clarification over his regulatory actions, which are much more invasive than most of the other G20 nations. Lack of clarity over what is and is not a security is another concern. Gensler frequently refers to the Howie Test but without giving any real guidance or clarity over how the multi-pronged balancing test should be applied or interpreted in the crypto context.

    Overall, despite Gensler’s frequent comments on how he plans to regulate crypto and threats of using enforcement actions whenever necessary, there is still a great degree of uncertainty over how Gensler ultimately will attempt to regulate the space. One thing that has become clear is that there is a strong interest from the general public, industry participants, and members of numerous US government and regulatory bodies to support the cryptocurrency market and push back on regulatory attempts that would potentially “stifle innovation”.

    Lastly, it is important to note that DeFi and the cryptocurrency industry as a whole, is global and permissionless. While the US may take a more heavy-handed approach to regulation moving forward, there are numerous countries, including many G20 nations, that have taken a far more accommodative approach. Additionally, the focus on DeFi regulation is already starting to prompt founders to build permissioned DeFi protocols that seek to build more compliant “walled garden” ecosystems that cater to institutions who must be more sensitive to regulatory and compliance risks.

    The US may be the most impactful regulator for the space, but as a truly global asset class, the pace of crypto innovation, whether permissioned or permissionless, certainly does not stop with Gensler or US regulators.

    What role will NFTs play in the future?

    NFTs are one of the more interesting things to take off in 2021, spanning everything from generative art to brand and user engagement mechanisms to products that require differentiated asset issuance such as on-chain identity, on-chain insurance coverage, and real-world asset ownership receipts.

    NFTs are most commonly associated with art, profile pic NFTs, and engagement methods. Projects like Bored Ape Yacht Club and FlyFish Club are trying to build exclusive social clubs with a Soho House-like spin. Quantum Art is pioneering photography NFTs, and projects like Art Blocks are building platforms that allow for the source-code of generative art algorithms to be embedded in the metadata of each NFT, essentially putting the instructions to generate a piece of art via code directly on the blockchain.

    Additionally, we are starting to see brands like Nike, Adidas, Pepsi, Budweiser, and many others venture into the NFT space in search of new and exciting ways to engage with their customers. While these are really interesting use cases that I am particularly interested in (maybe slightly obsessed with), there is an entire world of opportunity for innovation with the use of non-fungible assets on the blockchain that stretches far beyond just art and membership related use-cases.

    NFTs, or Non-Fungible Tokens, are just that – non-Fungible. In the future I imagine the uses here could encapsulate any case where unique and differentiated information needs to be attached to a token. Think legal agreements, physical objects, ownership interest receipts, identity, jurisdiction and accredited investor status, etc.

    What role will the metaverse play in the future?

    The “metaverse” has become one of the biggest buzzwords of 2021, with Facebook changing its name to Meta (referencing metaverse), Microsoft rolling out metaverse related products, and the explosion of interest in NFTs from both traditional brands and crypto natives. What I think is most interesting about the “metaverse” is how widely discussed it is, but how rarely it is defined. I think that is mostly because it’s such a fluid concept, and so it could be interpreted as something as simple as talking to friends on twitter or as complex as going to a virtual office and having meetings in VR. Historically, interacting with the internet was relatively one dimensional, to me the term metaverse applies to any online activity that adds further dimensionality to online interactions. While this could vary in terms of complexity, I think the term metaverse technically can apply to the wide breadth of multi-dimensional online interactions such as video games with voice chat and zoom calls as well as more complicated interactions such as play to earn games with ecosystem specific micro economies, virtual reality, augmented reality, etc.

    One thing that I am willing to bet on is that the current pace of innovation in technology, software, cryptocurrency, and computing sectors will bring in scores of disruptive metaverse-related companies and continue changing the landscape of communication, collaboration, and value exchange. Distance between people can be measured not just in miles but also in clicks, and as a result we are likely to see friendships, companies, and culture becoming even more globally distributed.

    Want to hear more real-time updates from Nate? Follow Cumberland on Twitter at @CumberlandSays.

    Disclaimer

    The information (“Information”) provided by Cumberland DRW LLC and its affiliated or related companies (collectively, “Cumberland”), either in this publication or document, or on or through https://cumberland.io/, is for informational purposes only and is provided without charge. Cumberland is not and does not act as a fiduciary or adviser, or in any similar capacity, in providing the Information, and the Information may not be relied upon as investment, financial, legal, tax, regulatory, or any other type of advice. The Information is being distributed as part of Cumberland’s sales and marketing efforts. Cumberland makes no representations or warranties (express or implied) regarding, nor shall it have any responsibility or liability for the accuracy, adequacy, timeliness or completeness of, the Information, and no representation is made or is to be implied that the Information will remain unchanged. Cumberland undertakes no duty to amend, correct, update, or otherwise supplement the Information. In addition, any person wishing to enter into transactions with Cumberland must satisfy Cumberland’s eligibility requirements.

    The Information has not been prepared or tailored to address, and may not be suitable or appropriate for the particular financial needs, circumstances or requirements of any person, and it should not be the basis for making any investment or transaction decision. THE INFORMATION IS NOT A RECOMMENDATION TO ENGAGE IN ANY TRANSACTION. The virtual currency industry is subject to a range of risks, including but not limited to: price volatility, limited liquidity, limited and incomplete information regarding certain instruments, products, or cryptoassets, and a still emerging and evolving regulatory environment. The past performance of any instruments, products or cryptoassets addressed in the Information is not a guide to future performance, nor is it a reliable indicator of future results or performance. Investing in virtual currencies involves significant risks and is not appropriate for many investors, including those without significant investment experience and capacity to assume significant risks. Any person seeking to invest in or trade virtual currencies should do so only after engaging in their own research and obtaining their own advice as to whether virtual currencies may be appropriate in the context of their individual circumstances.

    Cumberland is a principal trading and market making firm, and Cumberland may be subject to certain conflicts of interest in connection with the provision of the Information. For example, Cumberland may engage in transactions in a manner inconsistent with the views expressed in the Information, and transactions entered into by Cumberland could affect the relevant markets in ways that are adverse to a counterparty of Cumberland. If any person elects to enter into transactions with Cumberland, whether as a result of the Information or otherwise, Cumberland will be acting solely in its own best interests, which may be adverse to the interests of such persons.