Hayden
Higginbotham

The promise of blockchain is profound: a shared database that is secure by design and doesn’t rely on a central authority.

Imagine you go to buy a used car. With your phone, you scan a QR code from the seller and you send the money, which will be held in escrow. Then, at the push of a button, the seller securely transfers ownership of the car to you and simultaneously receives the payment. Both the DMV and your insurance provider will be notified almost instantly so they can update their off-chain records. The transaction cannot be refuted by anyone.

Blockchain makes such an experience possible. Yet there are so few applications using blockchain in the real world, and nearly all of them are niche or worse than traditional alternatives. Why?

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DeFi is the wrong focus

Decentralized finance (DeFi) is where most Web3 and blockchain-based applications have concentrated. But cryptocurrencies, and any financial system built on top of them, are not financially sound. Money must fulfill a few core functions:

1. medium of exchange
2. store of value
3. unit of account

The primary reason that cryptocurrencies cannot work as money is that they are too volatile to be a store of value. At best, they’re an investment, and they’re an unusually risky and speculative one at that.

Unstablecoins

Fiat-backed “stablecoins” like USDC or USDT were created to address this problem by pegging the value to a real-world asset, like the U.S. dollar. These cryptocurrencies must be fully collateralized by reserves of the pegged asset in order to guarantee each token’s 1:1 redeemability.

Unfortunately, this guarantee leads to a reliance on traditional banking infrastructure, sacrificing the decentralization that defines blockchain. When the Silicon Valley Bank failed in 2023, a significant portion of the collateral for USDC was lost and the currency temporarily depegged, dropping to $0.61 - $0.88 (depending on the exchange).¹

One alternative is to collateralize with digital assets. For instance, MakerDAO’s DAI is backed by a diversified portfolio of other cryptocurrencies.² To absorb the price fluctuations of these volatile reserves without the risk of depegging, more collateral is kept than would be needed to redeem the tokens. While this appears to work so far, it’s fragile. It still relies on centralized collateral like USDC; some emergency parameter changes had to be made to prevent collapse when USDC depegged. Plus, the degree of over-collateralization required (150% - 175%) is incredibly capital inefficient, which will be a long-term constraint and a barrier to adoption.

Another creative alternative pursued to little success is a two-coin system, wherein the value of a stablecoin is algorithmically balanced by the minting and burning of a sister coin. The most recent example of this is the Terra project’s UST (the stablecoin) and LUNA (the sister coin). Since both currencies were in the same ecosystem, though, they were subject to the same pricing pressures. A few large sales in 2022, precipitated by changes to the chain’s lending protocol, were all it took to lose the peg for good, driving the value of both UST and LUNA to zero.³ Around $50B was lost in this collapse.⁴

Beyond collateralization

Historically, the U.S. dollar was fully collateralized by gold. When the Bretton Woods system was ended in 1971, the exchange rate between the U.S. dollar and gold was allowed to float,⁵ and U.S. dollars were henceforth backed solely by the “full faith and credit” of the U.S. government. In other words, the value of the U.S. dollar now comes from the fact that millions of people’s taxes are paid in the currency, fines are imposed in the currency, and so on.⁶ After the short-term pain of this transition (the so-called “Nixon shock”), the U.S. dollar saw decades of unprecedented dominance.

That same mechanism is impossible to replicate with a standard cryptocurrency. There is not — and should not be — a centralized sovereign entity who can prop up a currency by forcing people to use it.

It may still be possible to create a demand floor. If a cryptocurrency becomes deeply embedded in real economic activity, its demand becomes self-sustaining. We must go further, though. This demand must be not only self-sustaining, but inescapable. Once there is a truly non-optional use case for cryptocurrency, it will have the potential to become a functional alternative to real-world assets.

For one possible example, consider machine-to-machine payments. As AI agents proliferate, there will likely need to be a simple way to send payments, across borders, and without legal identity. Cryptocurrency would be the perfect basis for such a system. It’s possible that cryptocurrency would work so well as a medium of exchange in this context that to not use it would put firms at a competitive disadvantage. (Although this line of reasoning was rejected in 2013 by celebrated economist Paul Krugman, who claimed bluntly that “Bitcoin Is Evil.”⁷)

A cultural footgun

There is one area where cryptocurrency has proven indispensable: crime. A study in 2019⁸ found that…

“Approximately one-quarter of bitcoin users are involved in illegal activity. We estimate that around $76 billion of illegal activity per year involve bitcoin (46% of bitcoin transactions).”

This has not gone unnoticed. Cryptocurrency’s reputation has been repeatedly marred by such findings, and by extension, so has that of DeFi. While demand for cryptocurrency continues to be bolstered by illegal transactions, how many people actually want to be profiting off the demand for blood money?

Besides the direct usage of cryptocurrency for illicit financing, the world of cryptocurrency has been plagued by high-profile scams. Many of these take the form of a “pump and dump” scheme, where the creators of a new coin retain most of the tokens for themselves, artificially pump up demand using social media and hype, and then dump their stakes. This earns the creators thousands or millions of dollars, at the expense of destroying the coin and wiping out all other investors’ stakes. This is so common that a website which lets anyone easily create new coins calls itself pump.fun.

And more mundane still are the frequent large-scale volatility events. Despite cryptocurrency’s abnormal returns — which, again, have no fundamental basis — the risk alone is enough to put off most investors. Indeed, an interest in cryptocurrency has been shown to be inversely correlated with a long-term investment horizon.⁹ It therefore seems unlikely that any financial engineering (like cryptocurrency ETFs, for instance) will be enough to catalyze widespread institutional adoption.

The practical failures of cryptocurrency have evoked a widespread distaste with the technology that is bleeding into the associated concepts of blockchain and Web3. DeFi is not only theoretically shaky, but it is distracting from truly valuable blockchain innovations.

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Footnotes

1. FEDS Notes. Chuan Du, Ria Sonawane, and Cy Watsky. ↩

2. MakerDAO. ↩

3. Finance Research Letters 51. Antonio Briola, David Vidal-Tomás, Yuanrong Wang, and Tomaso Aste. ↩

4. Finance and Economics Discussion Series 2023-044. Anton Badev and Cy Watsky. ↩

5. Office of the Historian. ↩

6. This is somewhat oversimplified. The Federal Reserve also plays a role in stabilizing the U.S. dollar, including a promise to buy back and destroy U.S. dollars if deflation becomes a problem. ↩

7. The New York Times. Paul Krugman. ↩

8. The Review of Financial Studies 32(5). Sean Foley, Jonathan Karlsen, and Tālis J Putniņš. ↩

9. Journal of International Financial Markets, Institutions and Money 83. Akanksha Jalan, Roman Matkovskyy, Andrew Urquhart, and Larisa Yarovaya. ↩