Tuesday, May 10, 2022

A "Blockchain Certificate of Deposit"

Thanks to cryptocurrencies being decentralized they can eliminate the middleman, which leads to the fabulous offer from middleman Hex.com to revolutionize my finances that arrived unsolicited in my US mailbox last Wednesday.

How could I refuse to not just "earn up to 38% APY" but also receive "significant price appreciation" from the "fastest-appreciating digital asset in history"? It is a "blockchain Certificate of Deposit" and I know that Certificates of Deposit are issued by banks and are:
a safer and more conservative investment than stocks and bonds, offering lower opportunity for growth, but with a non-volatile, guaranteed rate of return.
Middleman Hex.com says:
This common investment tool is used by hundreds of millions of people worldwide with a market value in the trillions.

HEX uses blockchain technology to offer the same concept without the middleman.
The top national guaranteed rate for a 5-year bank CD is currently 3.15%, so clearly eliminating the bank middleman who seems to be taking a 35% cut means a blockchain CD guaranteed by middleman Hex.com is a winner with no additional risk!

Below the fold I look this gift horse in the mouth.

Does Hex.com have competitors? For example, there is BlockFi, backed by Coinbase, offering 3% APY on amounts up to 0.1BTC (In November 2020 it was 6% on up to 0.25BTC). Surely not a fly-by-night operation. They state:
BlockFi Interest Account clients can add their crypto and earn interest in crypto. Paid out at the beginning of every month, the crypto interest earned by account holders compounds, increasing the Annual Percentage Yield (APY)* for our clients. BlockFi uses a tiered Interest Structure. Click here to learn how our tiers work. Rates are effective May 1, 2022.

BlockFi Interest Accounts (BIAs) have not been registered under the Securities Act of 1933 and may not be offered or sold in the United States, to U.S. persons, for the account or benefit of a U.S. person or in any jurisdiction in which such offer would be prohibited.
Why is their interest rate less than 10% of Hex.com's, and about that of a bank CD, and why the restriction against sales in the US? In Grayscale Bitcoin Trust I quoted Amy Castor's Welcome to Grayscale’s Hotel California:
Crypto lender BlockFi’s reliance on the GBTC arbitrage is well known as the source of their high bitcoin interest offering. Customers loan BlockFi their bitcoin, and BlockFi invests it into Grayscale’s trust. By the end of October 2020, a filing with the SEC revealed BlockFi had a 5% stake in all GBTC shares.
Customers loaned BTC to BlockFi, so BlockFi has to give them BTC back. But it can't get the BTC it used to buy GBTC back, they're in the Hotel California. So BlockFi needs to sell the GBTC in the market to get cash to buy the BTC to give back to their customers:
Here’s the problem: Now that GBTC prices are below the price of bitcoin, BlockFi won’t have enough cash to buy back the bitcoins that customers lent to them. BlockFi already had to pay a $100 million fine for allegedly selling unregistered securities in 2021.
So even a shady operation like BlockFi can offer only low single-digit APYs.

A Certificate of Deposit is an effectively risk-free product with a guaranteed positive interest rate. Is it even possible to use DeFi to implement such a product? Fortunately, a recently published paper answers exactly that question. The abstract of Positive Risk-Free Interest Rates in Decentralized Finance by Ben Charoenwong, Robert M. Kirby and Jonathan Reiter reads:
Decentralized Finance (DeFi) aims to use advancements in both computation and cryptography to tackle standard economic problems. It must, therefore, operate within the intersection of constraints required by both the computer science and economic domains. We explore a foundational question at the junction of those fields: is it possible to generate a positive risk-free yield via smart contracts? We show using a stylized model representing a large class of existing decentralized consensus algorithms that a positive risk-free rate is not possible. This places strong bounds on what decentralized financial products can be built and constrains the shape of future developments in DeFi. Among other limitations, our results reveal that markets in DeFi are incomplete.
Charoenwong et al write:
Our main finding is that a general Turing-complete smart contract language is incom-patible with decentralized risk-free positive yield. The result follows from both Turing-completeness and decentralization properties. The former means a smart contract cannot be proven to halt while the latter means allowing an authority to intervene to halt the program is unacceptable as a solution. ... Furthermore, when coupled with the well-known Mundell-Fleming impossibility result, an economy without a positive risk-free rate faces additional macroeconomic policy constraints.
The "impossibility result" is:
The Mundell–Fleming model has been used to argue that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy.
Charoenwong et al claim their main contribution is:
to show what classes of products cannot work – what cannot be copied wholesale from TradFi – and to cast recent advances in DeFi through the lens of an economic model that is based on computational theory. We show that smart contacts are not alchemy: they cannot generate yield out of nothing. Until someone designs a smart contract infrastructure more powerful than a Turing machine, it will not be possible to enforce risklessness with only code in a complex decentralized system.
Specifically, the product they prove cannot work is a Certificate of Deposit, a risk-free investment with a guarateed positive interest rate.

I have filed a complaint (complaint-56777) about this with the California Department of Financial Protection and Innovation.


jon reiter said...

Fascinating. In general words like "deposit" are tightly constrained in traditional finance. One would imagine that is a straightforward case. And the idea of pursuing something on the basis of cs theory...if nothing else, that truly is an innovation in finance!

David. said...

Rachel Monroe's Coffeezilla, the YouTuber Exposing Crypto Scams is a good backgrounder on Coffeezilla's YouTube channel.