[Original Post Date on previous blog: October 7, 2017 at 5:40 PM]
I was recently having a conversation with Niraj about the upcoming Raiden release. We were having a bit of a debate about the upcoming Layer 2 protocols for off-chain transactions. The conversation centered around the risks of centralization within these networks, as the graphs are distributed, but rather decentralized. We also noticed that there seemed to be growing competition for crypto assets. Purchasing this token or that token, and with the influx of talent into the space, it seems to guarantee a future where many different things would be competing for your crypto dollars.
Competition for Crypto Dollars
Since crypto assets are extremely liquid and can be instantaneously changed into some other digital asset, it's tempting to do so. Unless you're a day trader in the top 1%, you'll probably lose money. With all the complexity in dealing with crypto assets, a person's best bet is usually to hold, or rather HODL. In this case, individuals are hoping that the base crypto asset that they purchase appreciates in the future. HODLing is basically stashing your coins under your mattress, which many of my friends have expressed as their dominant investment strategy.
However, if we compare this to a traditional asset like cash, that can earn interest by sitting in a bank, stashing your cryptos under a mattress doesn't seem too enticing. No one's really figured out a way to earn interest by HODLing for this, of course, we’re not the only ones to have this thought.
Lending Right Now
If your intention is to earn interest in crypto, right now you can lend token on Poloniex. When the markets are volatile, you can earn up to 0.1% per day for essentially tapping a button. However, there are two downsides to this. You don’t earn that much money because of the fragmentation of order books. Fragmented order books drive down the liquidity and potentially the demand for your lent crypto assets. Which drives down any interest you could earn. Second, lending (and investing) on centralized exchanges carries high counterparty risk. A centralized exchange could be hacked and your funds stolen, the exchange could shut down leaving your assets locked up on the platform, or the exchange could invest your crypto and lost it
Instead of a holding my token on a centralized exchange, I'd be interested in depositing my ETH or whatever token in a smart contract that would allow me to earn an interest rate, denominated in whatever token I'd deposited. All depositors can pool their funds together, which can then be lent to another party, with a loan that is administered through a separate contract. Of course, this is exactly what a traditional bank does. Lots of people deposit their money, banks lend it out at interest and split some of the money with depositors.
In crypto, there's already a movement to do this. Mining is effectively an operation that allows you to convert BTC into more BTC. Miners often finance the purchase of their equipment with other things. And by pooling your hardware assets together in a mining pool, you can turn this into less of a lottery and more of a fixed interest annuity on an emerging commodity. Decentralized mining pools potentially allow a decentralized, smart contract implementation of these things. Already we see in mining pools, those that have algorithms to optimize which alts they should be mining on at one specific time. This also carries the additional risk/annoyance of having to exchange your base token that you’d prefer HODLing into another, potentially more volatile currency to generate a return. However, we’re going to continue seeing a proliferation of protocols, and managing this will get unwieldy.
Even more related to our crypto bank concept is a decentralized mining pool for staked tokens. You don’t have to convert your crypto into dollars to purchase hardware to earn crypto, instead, you give up the time value of your crypto assets for more cryptos in the future, and that’s okay if we’re HODLing. Rocket Pool and 1Protocol are both staked mining pools. Rocket Pool and 1Protocol both implement a token ontop. In Rocket Pool, every ETH deposit generates a one-to-one redeemable token for Ethereum. This harkens back to private currency solutions and other bearer bonds of years past. However, cryptobanks could be used for more than just for staking protocols and letting individuals margin trade.
Furthermore, lending to purchase other tokens is only a slice of activities someone might undertake with a lent crypto asset. Crypto banks could drive liquidity by lending into all these different protocols.
History Applied to Crypto
Fractional reserve serves two purposes. One role is operational. Banks make transferring money easy. Instead of moving my gold bar to Timmy, I can ask the bank to change the ledger entry. The other role is economic, providing investments to individuals. If we look at the history of banking in general reserve we went from warehousing money and not lending it to lending it for a fee and only retaining paper slips that allowed you to transfer money from another.
While the operational role of banks are greatly lessened in a crypto economy, as individuals can directly transfer tokens with other individuals using the built-in asymmetric key cryptography. However, individuals may still want to earn interest as they hold, and this is where a cryptobank might come in.
In the far, far future, when on-chain transactions are too expensive (hopefully this never happens), crypto bank contracts/DAOs may enable scaling of transactions. They could operate as layer 2 hubs, with connections to other cryptobanks and then finally to individuals through payment channels. Although we should continue to work on scaling the base protocols, banks could potentially keep the operational role of transferring money (the traditional role of banks). We’ll leave the discussion of whether or not this is a good thing, due to centralization for a separate topic.
A common bitcoin debate is if it needs to be used as a medium of exchange as well as a store of value. The argument in one sentence for bitcoin needing to be a medium of exchange is that if everyone holds bitcoin and never spends it, there will be no transactions, miners won't be incentivized to secure the network and it'll fall apart. However with cryptobanking, bitcoin HODLers who are in it for the long haul are able to lend their bitcoin to others, driving transactions, paying fees to miners, and keeping the bitcoin as a medium of exchange dream alive.
And that’s about it! Thanks for reading.
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