Ethereum 2.0’s ‘Lock Up’ Will Drive DeFi Innovation

The “Summer of DeFi” might be over, but a looming event will give DeFi engineers a great incentive to crank up their “lego” innovation model and build more decentralized finance products: the Ethereum 2.0 upgrade. (See CoinDesk’s explainer here.)

With thousands of Ethereum 2.0 validators expected to stash more than 500,000 ether in a restrictive multi-year lockup, there will be significant demand for a creative solution that unlocks the value of those funds without undermining the upgrade mission. DeFi innovators will be happy to oblige. 

It’s a process of demand and supply that’s similar to how Wall Street’s “engineers” respond with new financial instruments when rules imposed on traditional markets put constraints on investors. It matters not that the behavior-constraining rules are imposed by a government regulator or, in the Ethereum 2.0 case, by a protocol. Constraints create an incentive for financial creativity.

Also, as with many Wall Street inventions, this one will create an interesting byproduct. As markets arise in the new instruments, their price signals will indicate how people think this massive Ethereum protocol change is performing. 

As discussed during CoinDesk’s invest: ethereum economy conference this past Wednesday, “phase 0” of Ethereum’s migration to a proof-of-stake blockchain involves having 16,384 validators each commit to place 32 ETH in a soon-to-be-announced deposit contract. Those tokens will then be “staked” to secure and govern a new parallel Ethereum blockchain known as Beacon, which will function as a live environment for testing the proof-of-stake system to which all of Ethereum will eventually migrate. 

The key point is that the locked ETH cannot be sent back to the original Ethereum blockchain and cannot be accessed until the two systems are merged and the duplicate ETH on the legacy chain destroyed.

The current timeline for the lockup is 18 months, but given how long it has taken for this first phase of Ethereum 2.0 to start, it could well take much longer. This transition is going to be difficult, not just technically but also economically, with its biggest challenge being how to manage incentives so everyone else moves their ether out of the legacy proof-of-work chain into the new one.

Those decisions can be affected by a host of unknown variables. It’s one reason why it’s hard to argue with Radix CEO Piers Ridyard, who talked during one panel discussion Wednesday, of “Ethereum 2.0’s epic complexity.”

So, there’s much at stake (quite literally) for the validators involved in Beacon. And while the total amount locked, worth $198 million based on current ether prices, is less than half of a percent of Ethereum’s total $42 billion market capitalization, these particular funds matter. 

By definition, these are high-energy funds. They are held by true believers in the Ethereum mission, who are actively interested in how it evolves, not by casual ETH investors. They are precisely the kinds of people who’ll be open to innovative solutions on how to unlock their value. 

Given what we know about how DeFi innovators use oracles and smart contracts to create new assets like “wrapped” (or tokenized) bitcoin, taking value created in one chain and use it as collateral in another, it’s a solid bet that new tokenizing contracts will be used to bring liquidity to all that otherwise locked ether. They’ll be bought and sold as tokens but also used as collateral in DeFi lending markets.

The locked ether presents a contract that promises a set of contingent future cash flows, with properties akin to certain types of bonds. In fact, that is what DeFi-ers will create: tokenized ETH 2.0 bonds. 

By transferring a token created by a fully collateralized smart contract to a creditor, validators can receive funds in unlocked original ether and, in return, promise that when the blockchain merger happens and the lockup ends, the creditor will automatically receive the original 32 ETH plus the accumulated staking rewards. 

Based on staking reward projections built into the system’s monetary supply, these “bonds” would earn a 20% yield on an annualized basis and then fall according to a sliding scale, as the total amount of staked grows. 

What’s not known is the precise date at which the funds will be unlocked or the value of the ether in dollar terms at that time. Both are somewhat dependent on how well and how efficiently Ethereum developers progress toward the goal of a full integrated Ethereum 2.0 transition. But they are also dependent on whether, all things considered, the broader Ethereum community thinks the migration to the new proof-of-stake system is worth it. 

What we could see, then, is the market prices for tokenized locked ETH bonds becoming, in effect, an assessment of how well these pieces are coming together. Whether this creates a positive feedback loop that gives developers a real-time sentiment signal to help them gauge whether the market thinks they are on target to achieve their goals, or whether it creates misaligned incentives to rush through upgrades that aren’t yet ready, remains to be seen. 

For the rest of us, this live market in “Ethereum 2.0 futures” will provide a great talking point and measuring stick. 

It’s not unlike products such as the CME Group’s “Federal Funds Futures,” which (before interest rates became anchored at near zero) functioned as a gauge of market expectations for the Federal Reserve’s monetary policy decisions. 

Another is the TIPS breakeven-even inflation rate, whose correlations with bitcoin we discussed two weeks ago.That metric takes the differential between yields on regular Treasury bonds and those on Treasury Inflation-Protected Securities (TIPS), whose payments are tied to the consumer price index, as a market-based measure of people’s expectations for inflation. 

In both cases, the financial engineering behind the product was initially meant to give investors protection against an event that’s contingent on a policy constraint, but the product evolved into a valuable economic indicator in its own right. 

This Ethereum 2.0 process is going to be fascinating.

We talk a lot about the case for bitcoin as an uncorrelated hedge against a future political meltdown in the global economic system. That story is enhanced by concerns that next month’s high-stakes U.S. presidential election could be fraught with tension. With long delays expected in a vote count skewed by mail-in ballots, and with President Trump continuing to suggest that he might contest the result, many are questioning whether democracy itself is on the ballot this year. 

And yet, for now at least, perhaps until there is an actual break in the prevailing system, it seems bitcoin won’t likely trade directly against election results, but rather track the election-driven performance of equities, with which it has been correlated over recent months.

If you want to look at how investors are betting on the prospect of turmoil, look instead to the options market, where derivatives can pay out in the event markets become more volatile to the upside, downside or both. And there, as The Wall Street Journal reported last Friday, we are seeing “bets go beyond the Wall Street hedging that typically precedes an election.” 

One classic indicator found in the chart provided in that article, shows how futures contracts on the CBOE Volatility Index, or VIX – whose payout to investors is based on the extent of future swings in the S&P 500 index – are priced in terms of the month in which those contracts expire. What’s notable is not just the predictable spike in the November VIX contract’s price, but also how it takes some time for later-dated contracts to ease in price. Bumpy times lie ahead.

NERVOUS GERMANS. Speaking of election expectations, YouGov’s recent survey of European opinion is worth reflecting on. The world’s confidence in the U.S. has ramifications for the dollar’s sustainability as the world’s reserve currency, among other issues. And it produced some striking – nay, alarming – results. 

In a survey covering Germany, France, Britain, Sweden, Denmark, Italy and Spain, the percentage of respondents who said they believed U.S. elections would be “completely free and fair” ranged from 2% to 11%, while those who believed they would be “mostly free and fair” were spread in a 27%-37% range. No country, it seems, had more than 50% of respondents expressing confidence the election would respect the norms of democracy. In Germany, whose history naturally creates a wariness of power abuse, a meager 25% believed U.S. elections would be either completely or mostly free and fair. 

It’s well known that Europeans tend to hold an especially negative view of President Trump, which could skew the data away from a more dispassionate understanding of the workings of American democracy and whether to trust it. Even so, these numbers are a wake-up call, especially for people like us who are interested in the future of money. 

American currency hegemony is founded on the international faith in its leadership of the global capitalist system, which is founded in principles of market democracy. Within that, there is a basic understanding the U.S. political system will continue to enable a peaceful, trusted transfer of power as it has generally achieved throughout the 76 years in which the dollar has been the world’s reserve currency. 

Anytime I warn of the end of the dollar’s reign, I inevitably attract naysayers who point out there is no likely successor and, by extension, argue the current system will keep muddling along, regardless of whether the rest of the world trusts America or not. That might be true, but it assumes the only way forward is for the current monolithic system to be replaced by another monolithic system, as happened when the dollar replaced the British pound as the world’s reserve currency. 

But that need not be the case. A multi-currency world is quite possible, especially when you take into account how blockchain and digital asset technology is fostering a proliferation of new alternatives, whether issued by central banks (China’s digital yuan), companies (libra) or decentralized communities (bitcoin.) The more those alternatives mature, the more significant a breakdown in international trust in the U.S. matters as a potential catalyst for change. 

CANADA IN A HURRY. Reports from a Canadian virtual event on Thursday suggest the Bank of Canada wants to speed up its adoption of a digital currency. BOC Deputy Governor Timothy Lane believes COVID-19 will accelerate the release of  a central bank digital currency. A “shift in spending habits” triggered the pandemic, “coupled with the speed of technological developments, has narrowed the window to deliver a digital currency issued by the central bank,” the CBC reported Lane as saying. 

It’s the latest in a palpable advance for central bank digital currencies (CBDCs), with many central bankers and government officials now weighing in on this topic. The European Central Bank has upped its rhetoric and last week the U.S. Treasury Department sounded more interested in the idea. It wasn’t exactly a huge statement when Deputy Treasury Secretary Justin Muzinic told an Atlantic Council event last week a CBDC was “something we’re studying.” But it was a significant signal from a department that has been reluctant to show its hand on this issue. 

Is COVID-19 really the catalyst? Might it be that China is marching ahead at a pace that no one expected? (See “Relevant Reads” below.”) There’s nothing like competition and geopolitical challenges to stir governments into action. Expect all this talk to get louder in Western countries. And then action. 

Nearly 2 Million Sign Up for China’s Digital Yuan ‘Lottery’. When China wants to run a live test of a new idea, it has the convenience of being able to sign up a massive number of people and still treat it as a small, low-risk portion of its 1.3 billion population. Even so, the huge “airdrop” of China’s new digital currency into Shenzhen, reported here by CoinDesk’s Sebastian Sinclair, is a major development. China’s Digital Currency Electronic Payments (DCEP) is live. Much will be learned from this – though it’s not clear how much of that information will be shared with the outside world. 

Trump’s Security Hawks Call Distributed Ledgers ‘Critical’ in US-China Tech Arms Race. Finally, it seems the U.S. government has noticed China is barrelling ahead with blockchain technology. In this report from CoinDesk’s Danny Nelson, we learn that President Trump’s National Security Council has included digital ledger technology in its “critical and emerging technologies” shortlist for the purposes of maintaining U.S. supremacy over China. Is a war using weaponized state-controlled private blockchains in the offing?

Filecoin Launch Finally Brings $200M ICO to Fruition. The initial coin offering (ICO) boom is often derided for bringing worthless projects to market and enabling quick exits for scammy founders. But some of the ideas spawned were truly revolutionary. One of those is Filecoin, which is really just one piece of a far bigger project, the Interplanetary File System. IPFS, if it succeeds, will radically change the entire structure of the World Wide Web, shifting its file storage, website hosting and indexing system to a decentralized model without hosting services becoming single points of failure (or censorship targets.) Filecoins are its mechanism for incentivizing and governing storage providers across the network. Now, after a $200 million token offering in 2017, it has finally gone live (albeit with some constraints on token liquidity) amid fervent speculation on its value. Read Brady Dale and Sebastian Sinclair’s breakdown of the launch and what it means.  

First Mover: Privacy Is Litecoin’s Ace in the Hole as JPMorgan Touts Bitcoin. For some time during bitcoin’s early days, litecoin attracted a lot of attention as an altcoin. But in recent years it has fallen from view and its price has sagged relative to bigger digital assets such as ether, even though the cryptocurrency remains sufficiently sought-after to sit within the CoinDesk 20. Now, as CoinDesk’s Dan Cawrey reported in one of our daily First Mover newsletters this week, Litecoin is adding key privacy features to its cryptocurrency to protect users from surveillance. That could offer the currency a lift, given surging interest in privacy coins generally.