In 2017/18 cryptocurrencies went through a speculative bubble that saw its flagship currency Bitcoin reach peaks of $20,089 and a market cap of $320 billion. At the height of euphoria, the total market cap of all cryptocurrencies reached $790 billion. While Bitcoin and other cryptocurrencies (known as altcoins) have been around since 2009, it was the consolidation of mindshare and public interest in 2017 and 2018 that has made it a mainstay for alternative investors. But the fact remains that we are yet to see the adoption event that will make it a mainstay for all investors.
Most recently Cryptocurrencies have once again found a place in the news cycle following two years of dormancy post the bubble. The central trend appears to be around the phenomenon of decentralised finance otherwise known as DeFi. The quantity of activity and community participation in DeFi and related activities have been pointed to as potential indicators of a return to the speculative mania that took place in 2017. By the end of July, the total value locked up in DeFi related projects was $4 billion. A somewhat marginal amount given that Bitcoin is now over $200 billion in valuation and the whole market for cryptocurrencies is approaching $350 billion.
Regardless, DeFi represents a strong use case for cryptocurrencies as a means to provide lending and borrowing capabilities and is also geared to attract significant speculative interest. One of the most basic and pervasively engaged features of DeFi at present is yield farming. Cryptocurrency assets can earn or ‘farm’ yields in three main forms:
- Participating in financial products as one would in traditional markets
- Locking up some cryptocurrency liquidity in return for an interest-like reward.
- Staking cryptocurrency (like collateral) to fortify the security of a Proof-of-Stake based blockchain platform, where ‘staking’ some tokens prevents malicious activity similar to how a collateralized loan prevents default risk.
However, the attention decentralised finance (DeFi) is getting right now, looks more like a bubble than a catalyst for adoption, where volatility (price, scams, hacks etc) of the industry hasn’t been solved.
The question then is, what is a catalyst for adoption? Given that financial products (form 1) on any platforms, blockchain or otherwise, can provide yields through participation, let us focus on yield farming native to the nature of blockchain (forms 2 & 3), Proof-of-Stake – where providing security/liquidity returns yields.
Proof-of-Stake is simply the mechanism whereby a decentralised platform is able to provide security against attacks on the immutability of the ledger on the blockchain. The name holds the key to understanding this mechanism where ‘staking’ (locking up) the currency on the platform, is the means by which you are able to validate transactions on the ledger (the state of the blockchain) and add to the ledger. The game theory of securing the chain via staking is tied to rewards for being a good actor and penalties for being a bad actor. These rewards represent the yields earned for securing the chain.
What is particularly interesting as the speculation starts to ramp up once more is that Proof-of-Stake based platforms are gaining more attention because of their ability to provide yields in return for a financial stake in the platform. Yields on a Proof-of-Stake network represents a passive income avenue for a spectrum of individual/retail investors all the way to institutional players. This differs from the Proof-of-Work mechanism, most popularly represented by Bitcoin, which consumes electricity (mining) to secure the ledger. Where mining BTC is more difficult and less accessible to the spectrum of investors (currently there are a few large mining farms that make this their primary occupation) most BTC investors will make capital gain returns based on price appreciation through adoption. In the absence of BTC becoming a true global currency it will depend on a series of consolidating speculative bubbles to edge toward adoption – a chicken and egg problem perhaps sped along by the more consistent rewards associated with Proof-of-Stake.
Yields: A Ponzi scheme or a catalyst for cryptocurrency adoption?
Thus far the speculation on the future potential of blockchain technology, and cryptocurrencies by extension, is what gives the industry the large valuation it holds, even as use cases seem scarce or utilised by few.
In such a case, providing yields for no inherent value due to lack of use case, appears more like a Ponzi scheme than investment in a nascent technology. The idea is that when more people take a financial stake in the platform and lock up those funds for yields, all the prior participants will continue to benefit, not only from the yields but also from the price appreciation of the currency and market capitalisation of the platform. Of course, the integrity of the platform will only be realised when the use cases are actualised at some point in the future. In the interim, the Ponzi characteristics are exacerbated by the lucrative yield returns (often ranging from 5-20% per annum) made available by Proof-of-Stake networks, in comparison to traditionally available yield/interest earning financial products. It’s important to note that platforms vary in risk and reliability, we can liken it to investing in financial products across different tranches – some more junk-like than others.
Bitcoin, on the other hand, provides an entirely different avenue of investment in blockchain but comes with its own set of challenges – namely the chicken and egg problem we discussed above. Bitcoin requires the expense of electricity through mining activities to secure the network and ‘earn’ Bitcoin. While the rewards for mining on a Proof-of-Work network can be equated to the yields earned for staking on a Proof-of-Stake network, the ‘work’ performed for Proof-of-Work (cost of time and initial investment) makes it impossible for it to operate like a Ponzi scheme. Essentially, this means that Bitcoin can’t propagate its adoption through the mechanism of mining, where mining does not lend itself to the low-effort traits of Proof-of-Stake currently attracting attention to the DeFi bubble.
The lower effort in work required to secure the Proof-of-Stake network allows more users to participate meaningfully and earn yields. This is the beginning of a solution to the chicken and egg problem, where increased participation can bolster the market capitalisation required for widespread traction. In summary, easier participation increases the likelihood of network effect for a platform, where earning yields becomes the initial use case for the platform – as risky or unreliable as it may seem. Increased traction over time is very capable of evolving the volatile and Ponzi-like DeFi space into a mature financial structure supporting the blockchain ecosystem.
During 2017/18 the prevailing narrative of Proof-of-Work and crypto’s use case as a currency was not substantiated and resulted in a bubble rather than an adoption event. While it gained attention on the global stage, the widely held perception was that there was no immediately apparent use case that could sustain and grow its valuation beyond pure speculation. In the last couple of years following the bust of the speculative bubble, Proof-of-Stake has become a more significant narrative for the industry. The most marked indicator being Ethereum (currently Proof-of-Work), the second largest cryptocurrency, indicating its intent to transition to a Proof-of-Stake network.
The narrative of Proof-of-Stake is ballooning out quite rapidly, popularly considered to be propagated by the perceived benefits for scaling transaction capacity. However, what we have identified is that the use case of earning yields has the potential to catalyse the next boom cycle similar to 2017/ 18, and perhaps even to a greater extent. Even in the absence of yields as a catalyst for the next boom cycle, it represents a solid use case as a financial ecosystem to sustain speculative value and drive cryptocurrencies closer to mainstream use.