Finance from First Principles

Physics is the law, everything else is a recommendation

-Elon Musk

The right to transact is pre-government.

A hunter-gatherer in the amazon does not have to submit a Reg A offering when he shares the future expectation of his profitable hunt with his tribe. Native Americans did not consult the SEC, CFTC, or FTC before selling the island of Manhattan to the Dutch.

Financial markets at the heart of the global economy are most commonly associated with speculation, but its most important yet overlooked function is that of capital formation. Entrepreneurs and investors use capital markets to finance their firms. Investors and institutions rely on capital markets to capture opportunities. Efficient markets lead to very real outcomes such as jobs being created, unicorns being built, and GPs earning carry.

Throughout history, the evolution of financial markets can broadly be demarcated by its technological medium. The change from one generation to another is marked by stepwise improvements in (faster) speed of transactions, (cheaper) cost of distribution, and (broader) access to markets.

• Finance 0.0: You trade wheat for some of your neighbor’s upcoming barley harvest and record the unregistered futures transaction on a clay tablet.
• Finance 1.0: You trade spices for Guilders to FOMO illegal security certificate offerings in the unregistered Dutch East India Trading Company.
• Finance 2.0: You login to eTrade to YOLO your life savings in the Dotcom Bubble.
• Finance 3.0: You trade tokenized assets on chain with instant finality.

In every other sector of the modern economy, newer, better, and faster technology stacks tend to get adopted rapidly.

So one has to ask: Why hasn’t stepwise improvements in Finance gained widespread adoption?

For the past two centuries, as financial markets evolved from Finance 1.0 to Finance 2.0, large institutions, investment banks, broker-dealers, prime brokers, transfer agents, custodians, and investors all evolved into specific roles within the broader financial system within tight parameters determined by financial regulations.

Finance 3.0 throws a wrench into the existing system. Self-custodial, peer-to-peer paradigms of crypto-networks fundamentally disintermediates most rent-seeking middlemen institutions that currently dominate the market. From that perspective, most of institutional resistance to Finance 3.0 has to do with fundamental changes which would make much of the existing financial infrastructure obsolete. I won't belabor the deeper issue of regulatory capture.

Many of the existing U.S. security regulations, such as rule 144, purportedly exist to protect investors yet are outright nonsensical if examined from common sense.

The most cited Supreme Court ruling on the matter of securities especially as it pertains to crypto, the Howey test, from S.E.C. v. W.J. Howey Co, was made in 1946. Howey sold land with the promise of a future profitable Orange orchard enterprise contingent on his efforts. The Supreme Court ruled such an arrangement constituted an investment contract, and the judgment has been cited since.

How is this relevant? One might ask. How does a contract made on some old orange orchard relate to magic internet money trading on global blockchains? No one else seems to know either. But the current system has created an oligopoly that writes checks that pay for lobbyists in DC.

Bear in mind, that 1946 predates the transistor and much of what we consider to be modernity. The judges of Howey had no conception of the internet, much less tokenized abstractions of value that can be sent across the globe instantly without an intermediary. Written code that can be programmatically composed with more software for leverage, rehypothecation, and more use cases would have seemed magical.

But by the principle of stare decisis, all somewhat remotely financial software in the U.S., even if it’s in the form of Jpegs and magic internet coins, need to comply with said law written 78 years ago, or face the wrath of some bureaucrat tasked with protecting yours truly from the danger of putting $50 in HarryPotterObamaSonic10Inu. I feel safer already.

Initial Public Offering (IPO) vs Initial DeFi Offering (IDO)

The U.S. IPO market was $26.8 Billion in 2023, with the largest and most notable listing being ARM Holdings at $5.2 Billion Marketcap. At the time of writing, Dymension (http://dymension.xyz), a Cosmos-based startup offering rollups as a service, has an airdrop token $DYM trading at $6 Billion FDV( Fully diluted value).

How is a $DYM, a token for a startup whose software has but a couple dozen users, valued more than ARM Holdings, at least on paper? The answer is crypto’s speculative premium. With crypto lacking in market depth and liquidity compared to traditional venues, pumping and dumping tokens is infinitely easier.

Yet historically, for organizations looking to raise large amounts of capital (7 figures +), there was no better legal alternative until very recently. DeFi mechanisms only recently matured sufficiently to handle multiple types of transactions.

If one examines both offering methods from first principles, which is from the perspective of the customer, then these two asset distribution methods are functionally equivalent, albeit with different methods:

• Both enable capital formation for their respective issuers
• Both distribute stakes in a company to an audience in a manner conducive to secondary trading.
• Both enable price discovery, trading, and rehypothecation, albeit by different means

Solving real problems

The fundamental value proposition of markets is to facilitate transactions between buyers and sellers. The fundamental value proposition of DeFi markets is that it can do so cheaper, faster with more programmatic flexibility than any existing alternative.

Key Advantages of DeFi over TradFi

1. Speed of execution and settlement:

   
   

   In private markets, firms and financial managers spend weeks if not months circulating PPMs to raise funds and financing for their projects. OTC/ secondary / private market assets take much longer to transact than your typical public security.

   
   

   Traditional security offerings settle T+N on exchanges and dark pools, with opaque backend transfers between broker-dealer and custodians.

   
   

   VS

   
   

   Next block settlement for all digital assets. Yet every day, hundreds if not thousands of new tokens “go public” on chain to reach hundreds of Millions in market cap.

   
   

   What would take months with traditional fundraising has now been reduced to a few lines of code.

2. Cost:

   
   

   Companies that intend to go public will need to pay accountants, auditors and investment banks millions of dollars in fees to conduct an IPO roadshow. Even private tenders cost upwards of 5 figures for legal fees.
   
   ARM Holdings paid Millions of dollars to lawyers, auditors and investment banks to conduct its initial public offering.
   
   VS
   
   DYM had software engineers and audit costs prior to their token distribution, which was free.

3. Uptime

   
   

   TradFi brokers have 9-5 business hours.
   
   VS

   
   Blockchains and Internet Native Capital Markets run 24/7/365.

4. Fractional investment

   
   

   DeFi tokens are typically fractional, which means you can buy 0.000000123 of a token.
   
   VS
   
   Traditional markets, especially illiquid instruments typically require 6-7 figure check sizes.

5. Access and Distribution

   
   

   Traditional markets require a broker/dealer. Private markets require knowing the right parties/private brokers.
   
   VS
   
   Anyone in the world with access to a crypto on-ramp can participate in DeFi. ICOs/IDOs/LBPs already raise Millions daily, their cap table spans the entire internet.

6. Composable with more DeFi apps

   
   

   Traditional securities exists as a data entry in a Fortran Database on a custodian’s back end.
   
   VS
   
   DeFi tokens are programmatic entities that can be extended with unlimited use cases.

That’s not to say DeFi in its current form doesn’t come with an entire list of flaws.

Shortcomings of the current state of DeFi:

1. Lacking in Legal Recourse and oversight:

   
   

   DeFi tokens generally lack legal recourse and protections traditional securities offer investors. As a result, crypto is rife scams, frauds, and implosions.

   
   

   Investors who lose their money typically lack any kind of clawback mechanism.

   
   

   All this can be safeguarded with proper due diligence, but the inherent risks deter unsophisticated investors.

2. Complex tokenomics obscure true risks:

   
   

   Crypto projects trend towards over engineered designs that obscure true risks associated with a product. The most infamous being Luna’s Anchor marketing its algorithmic stablecoin 1UST = 1USD.

   
   

   Clearly, transparent disclosures around battle tested frameworks should be practiced.

3. Smart Contract and Self Custodial Risk

   
   

   Contracts and wallets can get hacked. Self custody is vulnerable to phishing and other idiosyncratic risks.
   
   That users need to worry about these factors limit the potential user base to sophisticated, technically literate people.

Yet in spite of its many shortcomings, DeFi offers something modern finance cannot:

Internet native capital formation to a global audience at crypto speeds.

In Finance 3.0, everyone on earth can be an issuer, and everyone else can be an investor. The entire universe of financial assets, from equities, to debt, corporate bonds, to derivatives like futures, options, exotics, credit default swaps, collateralized debt obligations etc, can all live on chain, be traded 24/7 and composed infinitely.

The technological potential is clear. What’s currently lacking is infrastructure and frameworks that allow everyone to do this in a safe manner.

DeFi needs its native set of best practices, tools and compliance framework. Where can we start? What would a modern financial system look like if designed from first principles?

Replacing Traditional Finance

In order to be successful, an idea has to be 10x better than what already exists.

-Elon Musk & Peter Thiel

DeFi User Experience is often lampooned for being absolutely terrible, and rightly so.

Yet key changes are on the horizon that will enable DeFi UX as seamless as traditional Web2 brokerages such as Interactive Brokers, Robinhood or Vanguard.

Account Abstraction

AA frameworks such as Web3Auth, Biconomy or Arcana enables social or email logins, gas sponsorship, and single session signatures. These features bring DeFi app experiences up to par with Web2.

Chain Abstraction

We are a few years away from chains being a banality. From the perspective of UX, it should not matter which chain an item is on. Chain abstraction would enable traders and apps to focus on the execution of a transaction, instead of which chain, what gas, and what bridge.

Inching Towards Common Sense DeFi Legal Frameworks

A share, traditionally represented as a stock certificate, is an abstraction of value.

There is no difference practically and conceptually between a DeFi token and a security that exists on some Prime broker’s database, except in legal distinction.

To gain widespread adoption, DeFi requires common sense legal frameworks built upon first principles instead of force fitting traditional security laws onto tokens.

Some of my personal suggestions:

1. Recognize DeFi tokens as shares or legal claims, or currency where applicable. Forward thinking jurisdictions already take this stance, including but not limited to:

   
   

   1. Dubai VARA
   2. Bermuda VASP
   3. Hong Kong
      
      

2. Recognize smart contracts as legally binding issuance trading and settlement mechanisms.

   
   

3. Recognize DAOs and blockchain native organizations

   
   

   Part of what made Silicon Valley a startup Mecca was the ease of which anyone can spin up a Delaware C Corp and receive SAFEs from VC investors. As we build the internet native financial system, we should aspire to replicate Corporate Laws in a DeFi native manner.
   
   The Blockchain LLC, or the Internet C Corp. Entities tied to a smart contract/multisig wallet that’s tied to a national registry. Create a company and start accepting Stablecoins in 5 mins.

   
   

4. Create a new definition of crypto asset distinct from current concepts of a “security”.

   
   

5. Fiat Integration

   
   

   Allow Banks, and financial instruments to use and hold crypto assets/DeFi as recognized assets on their balance sheet.
   
   Recognize DeFi protocols as legitimate businesses.

   
   

6. Room for Experimentation

   
   

   Allow room for innovative models to emerge.

While many of you have been anticipating crypto adoption for the past 10 years, I am less optimistic.

Change comes one funeral at a time. The transition from Finance 2.0 to Finance 3.0 most likely requires a generational change of guard at all levels of society.

Yes, to put it bluntly, the retirement of the current generation of lawmakers is a fundamental prerequisite for mainstream crypto adoption.