Tuesday, May 10, 2022

A "Blockchain Certificate of Deposit"

Front
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:
Back
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.

8 comments:

  1. 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!

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  2. Gilad Edelman interviews David Gerard in Welcome to the Zombie Cryptocalypse. At the tail there's an important point:

    "Edelman: Most people don't own any crypto, and yet you have Fidelity offering Bitcoin in 401(k)s, you have Wall Street institutions investing increasingly in crypto. How much could a crypto collapse affect the broader economy?

    Gerard: The main thing you have to worry about is that these bozos really want to get their tendrils into the world of real money. I think for a lot of them, that's the endgame: get it into people's retirement accounts. Now, the Department of Labor actually issued a notification in March warning financial advisers not to tell retirees to put their 401(k) into crypto. And Fidelity went and offered this product anyway. They really, really want to get into important products, because that way, when it collapses, they're looking to the government becoming the bag-holder of last resort. And this is something to be fought against strenuously. It hasn't happened yet, but we need to fear it."

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  3. They Lost Major Coin—and Now the Tax Bill Is Due by Emily Shugerman describes one of the risks of "investing" in cryptocurrencies:

    "Riding high off a record year of growth, many cryptocurrency investors filed tax returns on mind-boggling gains this spring—some in the range of 20 to 30 times their original outlay. But now it’s time to settle up with the IRS, and there’s a problem: The money isn’t there anymore.

    The crypto market endured its worst crash in years this month, wiping out more than $400 billion in value in a matter of weeks. Message boards were flooded with comments from people saying they’d lost their entire life savings, and others who worried they could lose their homes. Tax attorneys who specialize in crypto told The Daily Beast they, too, were inundated by calls, from people who had lost more than they owed in taxes."

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  4. It isn't just US crypto-bros who have tax issues. David Gerard reports that:

    "Do Kwon owns 92% of Terra’s Singapore entity and he’s a Korean resident, so South Korea’s National Tax Service views Terra as an indirect Korean entity.

    The National Tax Service says that Terraform Labs needs to pay more than 100 billion KRW (about $35 million) in taxes. South Korea also wants 4.66 billion KRW from subsidiary Terra Virgin, Do Kwon, company chairman Shin and company CEO Han, and an additional corporate tax of 44,478 billion KRW on Terra Virgin.

    There’s also a $790 million tax bill for the company’s transfer of “$3.5 billion” in bitcoins to Luna Foundation Guard — which is considered a gift for tax purposes."

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  5. David, it would behoove you to look at the smart contract code of HEX before trying to compare it to the Charoenwong, et al article. The premise of your argument suffers a serious fallacy, which I'll address here:

    HEX offers APY in more HEX, not USD. So whether the risk free rate can be manifested in is not at all applicable because the USD value of HEX is subject to independent market supply and demand.

    But HEX yield is paid solely in more HEX: The smart contract inflates the token supply and pays the inflation as yield to the users who stake their HEX using the smart contract. The amount of yield they earn is a function of the duration of their stake and the quantity of HEX they stake. The yield is modeled after the traditional bank CD, and the system was designed to always reward longer stakes than shorter compounding ones. This convexity property (L(x)+L(y)< L(x+y)) was actually subject to a tokenomics audit you can read here: https://hex.com/docs/HEX%20Economics%20Audit%20by%20CoinFabrik.pdf

    To give a better intuition for the why of HEX: The whole system is analogous to a financialized bitcoin: in Bitcoin, miners are incentivized to secure the network with bitcoin inflation block rewards, but are forced to sell some of the BTC to pay for server costs, energy consumption, etc. HEX was born from the realization that with Ethereum taking care of network security, one could design a better store of value by creating a token that pays participants to delay gratification by locking up their tokens for a duration, and receiving the inflation as a yield.

    Long story short, Turing completeness has no bearing on the system design of HEX, and does not invalidate the result from Charoenwong, et al.

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  6. Jordan, you completely missed the point of this post. HEX is being marketed via flyers as an investment similar to a Certificate of Deposit. That is, a safe, low-yield investment in dollar terms. In dollar terms, which is what matters to the retail investors to whom HEX is being marketed, HEX has declined 86% from its peak last September. That is not the behavior anyone would expect from a product marketed as a Certificate of Deposit. HEX is being fraudulently marketed as a safe, high-yield product, which is impossible.

    Declining by 86% in 9 months is not "a better store of value" by any stretch of the imagination.

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  7. Olga Kharif's Memories of Bitcoin-Beating Returns Keep Hex Holders Hanging On is well-timed to demonstrate the level of denial in the cryptosphere:

    "Even though the coin is among the thousands that trade at just a few cents, it has developed an outsized profile. Hex’s creator, who goes by Richard Heart, has positioned himself at the center of the hype, projecting an over-the-top presence on social media with his designer track suits, expensive jewelry and luxury vehicles. While Heart projects endless optimism amid aggressive marketing, which includes old-fashioned direct-mail promotions, the value of the token has tumbled more than 90% from its all-time high in September."

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