The past year was calamitous for people speculating on cryptocurrency, as the largest firms that emerged from “DeFi summer” co-immolated after an orgy of accounting fraud and prodigious magical thinking. But the grand casino of 2020–2022 was damaging more because of what didn’t happen than because of what did. Speculation was so profitable, and centralized financial businesses so well-equipped to capitalize on it, that the latter vacuumed up talent and funding. Businesses focused on building real, long-term value didn’t receive the resources required to make long-term bets.

I for one am excited that it all came crashing down. Perhaps pump-and-dumps and rug-pulls are finally out and the hard work of building real, boring financial tools is in.

The purpose of finance is to allocate resources to productive activities. If done efficiently, its success is not that managers of financial mechanisms get rich, but that all of us do. This is the promise of transparent, trustless, public ledger technology: instantly accessible markets with minimal regulatory friction and reduced dependence on intermediaries. Transparency should ensure that all market participants have access to detailed, real-time market information. Trustlessness should eliminate the need for many escrow, banking, and brokerage functions. Public ledgers should ensure that investors no longer need intermediaries to access markets. These factors should combine to automate reporting and limit the opportunity for market manipulation, reducing the need for regulation. Regulators, with much higher visibility into financial transactions, could dramatically streamline reporting requirements. Money should get to the right places more efficiently.

At a fundamental level, this does appear to work. Lost in the apocalyptic coverage of the crash is the fact that true DeFi “institutions” kept chugging along as expected, programmatically liquidating collateral and balancing their markets as designed. Three Arrows Capital, Nuri, Celsius, BlockFi, and FTX were all centralized firms and all imploded. MakerDAO, Aave, Balancer, and Uniswap — all decentralized — remained very much functional, transparently, without any indication of fraud.

If decentralized finance is both safer and more efficient, why isn’t everyone already using it?

Because decentralized markets are largely disconnected from the economic activities that really matter. This is the result of three related challenges:

Blockchains can only enforce agreements concerning purely digital assets. If a borrower offers bitcoin as collateral for a loan, a smart contract can easily liquidate that bitcoin when the borrower defaults. Loans against real estate, commodities, commercial revenue and other economically fundamental assets, by contrast, require physical contract enforcement. A building used as collateral cannot be programmatically liquidated; liquidation is a bureaucratic process, ultimately ensured by use of physical force. This is by design, given the potential harms of for example, foreclosing on someone’s home.
We therefore depend on traditional entities, grounded in traditional law, to bring real assets into digital space, in short: to tokenize. Banks turn homes into mortgages, real estate funds turn properties into investment offerings, corporations turn future profits into shares, artists turn imagination into intellectual property, and yet…
We haven’t focused on creating value for these asset originators. Broadly speaking, they want more access to capital, but usually the need is more nuanced. For example, the majority of tokenization projects emphasize high liquidity as part of their value proposition, but small to medium-sized real estate syndicators, which generate $50 billion in assets per year in the US alone, don’t usually want their offerings to be highly liquid. They want their investors staying put. Their investors, meanwhile, would love more liquidity. DeFi could square this circle, but it hasn’t paid enough attention to it (spoiler: Cooperativ Labs has). Fundamental to the success of DeFi is an intense focus on often subtle and highly varied needs of asset originators.

These aren’t challenges we can overcome with strictly technical engineering. Solving them doesn’t advance an exciting “network-state” agenda — at least not immediately — and won’t create opportunities to get rich off of clever art projects.

Making blockchain truly useful requires engaging in two mundane efforts: integration with nation-state law, and “Anchor”-centric product strategy (described below).

A Framework for real world integration

We need a framework for determining which Real World Asset (”RWA”) finance activities should be undertaken off-chain, and which should take place on-chain.

Off-Chain: If the activity involves creating tradable units out of physical or intellectual assets, or those which represent off-chain income flows, it should be executed by a traditional legal entity. At Cooperativ, we call these entities ”Anchors”. Their job is to use the simplest possible legal contracts to turn RWAs into tokens, then use their status as registered legal entities to defend the asset-token connection.

On-Chain: If the activity involves either transfer of ownership or control, or composition of new tradable units out of existing ones (indexes, derivatives, etc.), that activity should take place on a blockchain. We call these activities “Procedures.” Their role is to ensure that the composition and transfer of assets happen according to an agreed-upon set of rules (a.k.a. a smart contract) and that the history of such activities is transparent and immutable.

Let’s look at an example. Say that bank offers a loan to a car manufacturer to build a new factory. That company will generate off-chain income when it sells those machines in the future. The rights to the loan payments is our RWA. The only guarantee the bank has that the company will pay back the loan is the fact that the government with sovereignty over where the loan was made can compel the company to do so. If the company is unable to pay back the loan, law enforcement can confiscate the machinery the company used the loan to buy.

The bank is well-positioned to be an Anchor for two reasons. First, it can generate tokens (let’s call them “ATKN”) linked to a contract that promises a share of the loan payments. As it collects those payments, it can convert them to crypto (probably as a stablecoin), and send them to a smart contract for distribution to the ATKN holders. Second, the bank can engage the government to enforce it’s agreement with the borrower.

Let’s imagine further that a group of developers creates a smart contract that purchases such ATKN from three different anchors, then issues its own set of tokens (”PTKN”) that direct a proportional share of the revenue to PTKN holders. The smart contract is the Procedure. It is able to ensure, without any third-party involvement, that PTKN will always distribute the profits from ATKN. The digital and public nature of PTKN also mean that analysis tools can easily trace these derivatives back to their constituent assets (and their constituent assets), making it easier to identify risk.

Anchor-Centered Product Strategy

The industry has already spent time and money developing Procedures. Anchors, by contrast, have not received enough attention.

For Anchors to proliferate, companies need to build services that serve the needs of users. This may seem self-evident, but companies trying to apply blockchain to real-world use-cases are often too focused on presenting the technology as their differentiating attribute, ignoring important opportunities to serve customers and produce tokenized assets as a byproduct.

Blockchain is not a value proposition.

Simply offering to tokenize an existing process rarely works because the main benefit of tokenization — the ability to interact sans-trust with an ecosystem of interconnected financial tools — provides very little value while that ecosystem is still so small.

Imagine an effort to raise $100 million to build a hotel. It is common for developers to go to a combination of high net worth individuals and institutional investors to raise the necessary capital. These investors are already familiar with the traditional investment workflows: reviewing the offering memorandum, negotiating contract terms, and wiring funds. They often have offices with staff dedicated to this task. Even helpful modifications to the existing process create friction, simply by being different. Furthermore, these modifications usually aren’t very helpful in the first place. While tokens may be easier to trade than paper contracts, there is rarely enough of a market to take advantage of that tradability.

Investor: “Why can’t I just give you the money? why do I have to buy this token?”
Deal Sponsor: “This way you will get much higher liquidity.”
Investor: “Oh, really?”
Sponsor: “Well, no…”

This example is part of a broader theme. Blockchain products commonly ask for concessions from, rather than offer to serve the needs of, the customer. Buying a house via NFT doesn’t mean that the buyer can avoid title insurance, but it does mean that they need to have and maintain the security of a crypto wallet. Blockchain-based point-of-sale systems might reduce transaction fees, but not for the customer, who wasn’t ever paying those fees anyway. The very concept of direct asset custody, one of the main arguments for use of blockchain technology, ignores the priorities of most participants in the financial system. Consumers want to know that a party they trust (and they do trust banks) can restore their account access or cover losses through depository insurance if their money is stolen. Institutions often don’t even have the licenses to directly custody assets in the first place.

Anchors must have value propositions.

Blockchain is a technology. Companies choose a technology to serve their own needs, so they can in turn serve the needs of their customers. Recognizing this allows us to identify a set of anchor product strategy suggestions:

Suggestion 1: Products that serve customer needs usually won’t mention blockchain or tokens in their Unique Selling Proposition. A product should “provide a better user experience for investing in a private offering”, or “allow investors to participate in quality offerings at much lower minimums,” or “dramatically decrease paperwork associated with record-keeping and compliance.” It should not “let you buy fine art with crypto,” or “run your fund on the blockchain.” All of us should probably stop using the word “token.”

Suggestion 2: Products should use blockchain technology when doing so provides long-term strategic advantages to the business, even when it’s not the simplest or least expensive way to deliver value to the customer. For example, say that you are building cap-table management software. Your customers want an easy way to compliantly sell shares to investors, submit distributions, and facilitate the trading of those shares. You could easily build such a service using traditional database architecture, but if you build it on a blockchain, you position yourself to dramatically expand your value proposition as the blockchain ecosystem develops, while still maintaining the ability for your customers to operate conventionally. The investors on your platform could eventually trade your customers’ shares in global private markets. They could use their shares as collateral for loans. They could connect tax software to their account without you ever having to write an integration.

“Why does this product need blockchain?” is the wrong question.

To this end, “why does this product need blockchain?” is the wrong question. Investors and entrepreneurs should instead ask “does this product solve an important problem?” If the answer is “yes,” then ask “will building this on-chain contribute to and benefit from a future financial ecosystem?” If we believe in decentralized finance, we should be encouraging builders to use blockchain for financial transactions even when their initial product doesn’t require it.

Suggestion 3: Products using blockchain-enabled technology should target early adopters and new customer groups, not existing ones, then work their way up market as they improve and become more familiar. Consider the $100 million hotel development project discussed above. A key obstacle was the fact that the majority of investors were already familiar and comfortable with the existing investment process. Switching to a new investment process, even when superior to the old one, creates additional friction.

If instead, the product tokenized a much smaller offering, then offered shares at much lower minimums, it could attract a new category of investors who the existing mechanisms had priced out. Here, the value proposition is clear (access to exclusive investments), and the user base appreciates the process improvements. Serving the needs of increasingly larger investors happens iteratively, with the more adventurous ones trying the product first.

Here’s to a boring New Year

Blockchain technology has the ability to dramatically improve modern finance if we connect it to the real economy. Doing so requires an intense effort to create the connectors we call Anchors, but until now, most of the funding and innovation has focused on Procedures. Development of the latter without the former has facilitated aggressive speculation in non-real assets — those which exist entirely on-chain — culminating in the great crash of 2022.

We need Anchors to offer better value propositions if we want them to proliferate. For that to happen, we need to stop asking “does this product need blockchain?” and start asking “does this product address a problem, the solution to which could also produce real asset tokens?” The opportunities here abound. We could create artists’ collectives that legally own and defend the rights to its members’ intellectual property, then track those rights via tokens, which could artists can sell. We could help real estate syndicators offer part of otherwise traditional syndication at lower minimums via convenient digital interfaces. We could offer tools that allow creator platforms to disburse revenues to revenue-share smart contracts, which creators can configure automatic agreements with collaborators and save on costly, repetitive legal fees.

Each of these examples could be built using traditional software architecture, but by leveraging blockchain, each becomes an automatically integrated part of a shared financial ecosystem, making it easier to allocate resources to productive activities with fewer middlemen. At scale, Decentralized Finance can do for money what the Internet did for information: allow everyone immediate access to a global market.

The Future of Crypto is Boring

And that is a good thing.

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