Philip Gradwell is Chief Economist at Chainalysis. He provides data and insight on the uses of cryptocurrencies and the direction of the market at markets.chainalysis.com.
What does the phenomenon of retail traders coordinating on the internet to turn finance on its head have to do with cryptocurrency? Well, when I talk to financial institutions my message is that cryptocurrency adoption is a signal of unmet demand. Until last week, no one did meme-driven, nonsensical investment better than crypto. At a minimum it appears that crypto culture has spilled over into mainstream finance culture.
But I think that niche cultures spill over into mainstream culture when technology fundamentally changes the cost of doing things. The internet reduced the cost of distributing text to essentially zero, and so the newspaper editor has been replaced by whatever topic emerges victorious from the sum of human conversations. This is Aggregation Theory in action, where the zeroing of distribution and transaction costs by technology shifts the power in a market from suppliers to consumers.
Financial markets have experienced a fundamental change in costs. A Reddit army can trade against hedge funds because anyone, in the USA at least, can trade options commission-free from an app on their phone.
So the shift in power from suppliers to consumers that we have seen in the markets for text, video, taxis, hotels, etc. is starting to come to finance.
But it is the centralization that is currently lowering trade costs. Robinhood is commission-free because it aggregates trades. In contrast, cryptocurrency exchanges have high fees relative to traditional markets, and DeFi can be even more expensive.
However, over the next one to two years, fees on exchanges will likely fall due to greater industry maturity, scale, liquidity, and competition. Over the next few years, technological innovation will substantially lower the cost of decentralized operations. The optimist in me believes that technology will eventually push these costs so low that while centralized operations may be cheaper, both decentralized and centralized costs will be so close to zero that it will not matter. So distribution and transaction costs in finance will decline further, with either centralized or decentralized technologies doing the job.
The implication of this is that the finance industry will be disrupted as lower costs mean anyone can buy sophisticated financial products.
Currently, this means retail traders pumping Gamestop. But what if it meant an algorithm investing your money in a constantly evolving portfolio of products as the market and your needs change? Today, the algorithm for most people is an index tracker. While active strategies do not on average perform better than passive strategies, financial needs, beliefs about the future, and risk tolerances are not universal. So personalized strategies would be valuable but are currently expensive.
How do cryptocurrencies help deliver this? They are the first truly digital assets, and digitising assets is a requirement for lowering the cost of trading them, as digitisation has lowered costs across industries. But more importantly, cryptocurrencies are an open platform. Any asset, or financial derivative of that asset, can be represented as a token on a blockchain. ICOs were the first experiment in this, DeFi is the current experiment. Not all experiments go well, but at least they allow the next experiment to go better.
The open nature of cryptocurrencies means there will be an abundance of financial products available. While centralised technologies may be able to deliver the lowest costs for trading financial products, decentralised technologies can, eventually, provide both low costs and an abundance of choice. If the explosion of content on the internet, and consumers’ delight in it, is a guide, then this abundance will be important.
Imagine if the Reddit traders channelled their capital into more economically productive companies. That may be missing the point of why they are trading, but broader access to investment opportunities might mean less focus on the few hot, tradable stocks.
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