Crypto & Finance: Centralized Finance Limitations - Newsletter #205
Section 2 Begins: Crypto & Finance
We went back and re-worked our plan for topics this year, and it turns out, last week was the end of our section on Blockchain Fundamentals! đ Catch up on all our previous newsletters now. Or you can wait until we publish the book in early 2024.
Now, weâre moving on to Section 2: Crypto & Finance. This is the natural next step for discussing blockchain technology since the first use cases are solely focused on money and financial movement. Even now, most people think of blockchains as purely being related to money. When we get to Section 3: NFTs, Gaming, and The Metaverse, weâll expand this view to include a variety of compelling use cases.
Weâre taking 2023 to write our foundational content about blockchain technology so that we can build upon this in years to come. There is so much that will change over the next few years, and creating a solid starting place will give everyone a better way to stay up-to-date.
How Money Moves In A Centralized World
By Elliot Koss, Founder @ Future Mints
Technical Level: đ ď¸
Over the past couple months, weâve written about a variety of fundamental blockchain topics:
The Bitcoin Breakthrough (that started the blockchain revolution)
Itâs now time to take those foundational pieces and start to make sense of the new world that blockchain will create.
This next step naturally leads us to explore how cryptocurrencies will become a key technology in the financial world. The open ledger has obvious benefits related to transparency and fairness that are appealing to people who value transparency and fairness. There are also new capabilities never before available to the finance world that blockchain enables for anonymity in a semi-transparent way.
Before we can get into some of the juicer topics, though, itâs important that we first talk about centralized finance since itâs the status quo that blockchain will eventually build decentralized finance on top.
Centralized Finance In A Nutshell
In todayâs world, money and the money supply is controlled by a central government. Take the US Dollar. The currency itself is backed by the faith and credit of the US government (not gold) which has the legal power to tax US citizens. Since the United States became the world leader after World War II and currently has the largest economy in the world, the US Dollar is currently the worldâs primary currency. Some currencies may be stronger (for instance, 1 US Dollar is less than 1 British Pound or 1 Euro), but the US Dollar is more widely used.
To fight inflation, the economic term for when one unit of a currency has less purchasing power over time, central banks have a couple tools including interest rates for borrowers and managing the supply of money in circulation. In the US, the Federal Reserve is primarily responsible for maintaining the stability of the US Dollar along with the US Treasury.
Centralized Finance is the term that describes a financial system which is largely managed by a single, central entity. In the US, the financial system is centralized by the US Government which includes the Federal Reserve and US Treasury. They make the rules, and if you violate those rules, you could lose access to the US Dollar and/or be charged, prosecuted, and served with jail time.
In accordance with the Centralized Finance system, only authorized entities are allowed to perform certain duties such as provide loans, savings accounts, and financial advice. We tend to call these banks, credit unions, investment firms, and financial advisors. These take many forms with many names.
Sounds good, right?
For the most part it is. A central government with the power to create economic stability is vital for a country and its citizens to grow and prosper.
But there are a variety of limitations to this system.
Limitations Of Centralized Finance
Please note that while these limitations for Centralized Finance provide an opportunity for Decentralized Finance (DeFi) to do it better, these limitations will not be fully solved in DeFi.
Inflation
Imagine that your countryâs currency is NOT stable and 1 unit of your currency could buy a loaf of bread this week but it costs 10 units of your currency to buy a loaf of bread next week. You are paid in the local currency, and your income remains steady during this time. Instead of being able to buy 10 loaves of bread in that second week, you can only buy 1. Will you have enough money to buy food? Pay rent? Live life? đ¤ˇââď¸
This is the problem with inflation. Itâs one of the top focuses of the US Federal Reserve, and they generally do a good job. But what about Argentina? Or any number of governments that have consistently failed at this essential job?
Many people in countries where the currency is subject to massive inflation swings convert their money to US Dollars. If the local currency inflates (and therefore money in your local currency cannot buy as much stuff), the safety of the more stable US Dollar means that you can convert back into your local currency with basically the same purchasing power as when you put the money into the US Dollar.
If youâre in the US, you may think, well my government is stable and has the worldâs currency. Why does this matter to me? If youâve followed any financial news in the past year, youâll know that US inflation is at 40 year highs. And the favored world currency has changed throughout history, so itâs not like the US Dollar will continue being the preferred world currency forever. My prediction is that the next world currency will be a cryptocurrency.
Illegal Activities
The US Dollar is widely known as THE preferred currency for illegal activities. And if youâre in the US, youâre likely to have money in your possession that has trace amounts of cocaine on it. Government-backed currencies (aka fiat money) tend to have a physical version, and you canât trace physical currency easily. Sure, thereâs a serial number thatâs unique on each US Dollar, but there is no record for what happens to the $1 I spend at a grocery store. If I went to a private gambling space (generally illegal where I live), used US Dollars to gamble, took those winnings and bought groceries with cash, there would be zero record to tie those series of transactions to me. The same is true with a drug dealer who only accepts cash. That money is untraceable.
Donât believe me? Go watch Breaking Bad. Or, even better, go watch Ozark on Netflix. Jason Batemanâs character literally explains how you take drug dealer money, launder it through a cash-based business, and then turn that illegal money into legitimate money.
Fiat currency is the number 1 way for funding illegal activity today, and thereâs basically no way to trace these transactions.
Transparency
By default, all transactions in centralized currencies are private, and the only way that they become public is through some form of disclosure.
In many instances, this is a good thing. I donât really need people knowing how much I spend on dry cleaning each month.
Letâs say Iâm a dry cleaning kingpin, and I want to send a marketing campaign to potential target customers. The targeted customers would receive a discount which benefits them while I (as the dry cleaning magnate) would gain more customers. Itâs a win-win (except for all the potential junk mail that is generated by the promotional campaign).
Centralized finance doesnât allow for this, because there are only two options, either your information (finances and identity) are fully private or fully public. There is no third option, and centralized finance has opted for fully private. So even if my dry cleaning empire had access to know which bank accounts spent money on dry cleaning, there would be no way to send a marketing message to the owners of those accounts.
In addition to the positive use case of trying to offer targeted discounts to people who already use a specific product or service, the lack of transparency in centralized finance means that illegal activity is harder to detect. In the US, unless youâre doing a transaction above $10,000, banks donât have an obligation to report it (though there are other laws that trigger disclosures to federal regulators). However, there is no easy way, other than to initiate an investigation and make official requests via a central government agency to publicly follow the money trail of someone who is doing something illegal. It simply doesnât exist in the centralized finance world.
Direct Access To Money
In centralized finance, your money is both in physical and digital format. Physical is cold, hard cash. Having a $20 bill in a physical wallet is an example. But what if you have $5,000. Do you want that in your wallet? No, for two reasons. First, very few things require you to have $5,000 in physical cash on your possession and the ones that do are probably illegal. Second, physical currency puts you more at risk of getting robbed, because there is no way to trace the money if someone robs you which reduces the likelihood of getting the money returned. If you can identify who stole the money you may be able to recover it. But if thereâs no photo, video, or other way to identify the robber, youâre likely SOL.
So when you reach a certain level of income and savings (basically $1,000 per paycheck or savings), keeping your money somewhere securely becomes necessary. The solution to this problem is a bank. You open an account, put your money in, and then the bank is responsible for making sure that you have access to your money. The banks in centralized finance are regulated by the government and must follow specific laws. Banking laws are often some of the oldest and most detailed, but they are not perfect.
But what if you wanted to simply keep your money somewhere that could allow you to easily transfer it? SVB customers panicked a few weeks ago, and many would have loved to have had direct control of their money instead of being told by their bank (ie SVB) that their money was frozen over the weekend while federal regulators figured out what to do with the failed bank. The FDIC ensured that all SVB deposits were made whole, but there was a weekend of uncertainty that forced many business owners to figure out alternative solutions which created a lot of panic and stress.
If an every day consumer wants to control their money directly, there is no option in centralized finance.
Decentralized Finance⌠A Teaser
As you can imagine, blockchain advocates have a solution for each of the limitations noted above in a new type of monetary system known as Decentralized Finance. Like centralized finance, decentralized finance (or DeFi), is a monetary system that has a currency and enables economic activity.
However, there are a few key distinctions, which we will expand upon further next week. But the cliff notes version is that DeFi, in its current form, has no physical version, which means that the ALL of the economic activity is done digitally. Every transaction is recorded in a public ledger, and identity is kept separate from the account (in DeFi this is a wallet but weâll explain that next week) meaning that instead of my name showing up next to a transaction, a number shows up (unless Iâve chosen to be public). Control of the currency supply is more structured which, in theory helps with inflation. Bitcoin has a fixed number of tokens that will be mined over its lifetime meaning that once all the Bitcoin are created, there will never be more Bitcoin. Its advocates claim that this makes it immune to inflation since itâs there will be no equivalent to the Federal Reserve telling the US Treasury to print more US Dollars.
As weâll explore next week, there are solutions for each of the centralized finance limitation, and in my opinion, theyâre damn good solutions. But theyâre also not complete or perfect, because thereâs a reason that economics is considered a social science instead of a hard science. Human behavior is a key component to economics. Centralized finance uses a series of centralized controls to manage this, and DeFi uses technology to manage this. Since human behavior is unpredictable, trying to solely manage this with technology has its own limitations. But thatâs a topic for next week.
News of the Week
Cobie, one of the largest crypto Twitter personalities, accidentally caused a brief panic after an encrypted message was leaked. The sha256 hash message read âInterpol Red Notice for CZ," and was intended to only be revealed if rumors came to fruition. While these rumors were ultimately determined to be false, they undeniably caused a wave of fear regarding the Binance CEO and BNB.
Gem V2, the hit NFT aggregator acquired by Opensea, has been rebranded to OpenSea Pro. The pro marketplace is largely a competitor to BLUR, offering many of the same features BLUR has. Early Gem users may also be eligible to mint a commemorative NFT to celebrate the launch - Gemesis.
It was rediscovered that a PDF with the original Bitcoin white paper was hidden inside Mac operating systems. Even without connection to the internet, the Bitcoin whitepaper can be opened on any Mac since 2017 with a simple terminal command.