English born, Nic Carter is founding partner at Massachusetts-based Castle Island Ventures, an early stage crypto venture capital firm. He also is chairman and founder at Coin Metrics, a data and analytics firm.
In this conversation, we discuss the ways that the crypto crash is aligning with broader macro trends, how venture capital is adjusting to these new market conditions, what DeFi (decentralized finance) may look like once all the dust settles, and how regulators are likely to react to all this leverage and risky trading.
Forbes: What is your assessment of the current market downturn?
Carter: Well, it’s not just a crypto only thing; it’s carnage across all asset classes. If you look, asset classes are meant to be uncorrelated from each other. That’s not happening right now. Some people think it’s just crypto selling off or alongside risk assets. But that’s not true. Sovereign debt and Treasurys are selling off against stocks at the same time—that’s not really meant to happen. They’re meant to be inversely correlated. So we not only appear to be headed for a very sharp recession, we may possibly experience a depression, if we continue on with liquidity being pulled out of the system. But also there’s a question of the solvency of nation states. So we also appear to be heading for a sovereign debt crisis.
Forbes: Many Wall Street bankers, analysts, etc., are still downplaying the likelihood of a recession or are suggesting that if we have one, it’ll be relatively short lived. You talked about a depression. Why do you feel so strongly about this?
Carter: I think the Fed is embarrassed. They got things wrong, objectively speaking. It wasn’t just the Fed’s fault, it was, frankly, Congress for passing this enormous stimulus in 2020 and another one, which was unnecessary. It was also the collective fault of this administration and its predecessors for de-emphasizing energy and making it difficult to extract energy out of the ground, which is what ultimately, disinflation is based on. Those are just accumulated issues that we have to deal with.
Now, the Fed really wants to tackle them and their chosen method is to hike interest rates and basically retard private sector activity. Someone compared that to giving yourself a root canal with a shotgun, which I think is apt; it’s not very precise. You can get inflation down to zero if you want; you could set off nuclear bombs over all the major U.S. cities, and that would probably destroy a lot of demand, too. Hiking interest rates to whatever will make it impossible for the architecture finance work—we were in an extremely fragile, highly indebted system. So that will further impair the supply chain, that will crowd out private sector investment and it will make it much harder for the government to service its own debt. I think that’ll be the sticking point when the Treasury market starts to deteriorate, maybe the Treasury market starts to call the government’s bluff and yields spike even further. If you look at any of the economic indicators, whether it’s the mortgage-backed security market or its two-year yields, the rapidity of the move there indicates a vote of no confidence in the U.S. government or if you look at what’s happening in Japan or Europe, or at consumer confidence. A lot of these metrics are literally the worst since records began.
It’s clear we’re moving into stagflation. Traditional Keynesian economics does not have an answer for stagflation, which is why we had the rise of the monetarist movement in the 1970s. Ultimately, the problem of inflation is much more deep seated than short-term trends and factors and does have to do with deglobalization and a fundamental energy shortage, and neither of those things are going to be solved. So if I did make a guess, or draw that analogy, I’d say we’re in the equivalent of 1969/1970, where there was an inflationary spike, the Fed rose rates with a brief recession, inflation came down successfully and then skyrocketed to new highs later in the 1970s as the energy crisis was unabated. I would say it’s going to be the same thing here. Not that the ‘70s are a perfect template for where we are, but I think that’s basically what’s going to happen. But the recession won’t tackle the underlying problem, which is that our dollar is buying less and less real resources, because the real resources are getting harder to extract and our dollars are buying less and less products, because the products are getting harder to get. I think it’s going to be a decade of stagflation and I don’t think a recession actually whips inflation here.
Forbes: Aside from everything going down at the moment, what are some of the interesting trends that you’re seeing in crypto?
Carter: It’s hard to decouple your focus from the immediate dramatic trends, which is that every treasured institution in crypto is being plundered or destroyed right now. All these stalwarts of the industry are just being taken to the cleaners. Terra was the fourth biggest project, and it, along with its algorithmic stablecoin, was destroyed. Three Arrows, apparently the biggest proprietary fund, I believe in the whole crypto industry, who knows exactly what’s happening there but Voyager Digital said it may issue a notice of default if the fund fails to make a loan repayment. Then Celsius, probably the biggest or second biggest retail lender in the crypto space is probably out of business. So basically the whole structure of leverage and lending, the connections between DeFi and CeFi yields, is being interrogated very harshly by the market. And the market doesn’t like the answers it’s getting. So the shadow banking structure that’s been built up in crypto in the last two, three years, is being eviscerated. I think out of that there will be a DeFi that exists on the other side. I think it will be predicated not on this fake Ponzi game of circularity and rehypothecation and securitization, but it will have to be based on real economic yield. So not just yields the way that DeFi people refer to it, which is they never use the term correctly, they’re never referring to real yields. The yields in DeFi are going to have to be based on real economic activity.
Forbes: A lot of the issues with DeFi had been talked about for months, and sometimes years. I remember surveys coming out about DeFi, suggesting that 70% to 80% of all activity is purely speculative. Celsius, obviously, had a lot of issues with losses stemming from DeFi hacks and some for token management themselves. Why is it sometimes hard for people to look past this? Is it just greed? Is it faith that there are some people in crypto that know what they’re doing? Why did this bubble become so big when there definitely seemed to be certain obvious problems?
Carter: Great question, I do wonder about this myself. I wrote a paper a while back. I like to think of myself as realistic, and I’ve tried to be critical of the industry in particular DeFi, which I think should be held to a high standard because what it seeks to accomplish is very important. I believe in DeFi, which is basically disintermediated, transparent finance. However, it’s done a terrible job of executing on its core objective. It’s executed on the wrong things, so you’ve had a lot of building but not a lot of thinking. So I’ve been a critic; I wrote a paper last year, two years ago called The Paradox of DeFi with Linda Gerring, who was a Georgetown professor at the time. We ran through all these failure modes in DeFi. And what’s incredible is if you fast forward to today, all those failure modes—most of them were theoretical at the time we wrote the paper—have been hit. Fintech apps, putting client deposits in risky DeFi protocols—that happened with UST and with Anchor, those people got wiped out. Governance attacks that are utilizing flash loans, that was theoretical when we wrote the paper then it happened. Admin key exploits, that wasn’t theoretical, but we were I think the first people in the literature to mention that and now it’s an enormously prevalent part of the DeFi sector now. So all these issues were foreseeable, they were, for the most part, obvious, I’d say to industry practitioners. The incentive was not to say anything about it because you would become persona non grata in the industry. It’s this weird paradox where the only people that know enough of the subject matter to really be critical in the ways that count, not the skeptic outside of the industry. The only people that really have subject matter expertise are the people active in the industry. The financial incentive is such that you don’t really want to be critical, you want to believe in this utopian vision of DeFi, align with the hashtag builders and things like that. It’s only when things really hit the fan when it becomes clear that folks that are praised as these highly innovative builders, they’re actually creating Ponzi structures that destroyed tens of billions of dollars of retail wealth unnecessarily. It’s only then that people have the courage to be critical. So we had to wait for this to happen and we had to sacrifice your idols. Now it’s okay, everybody’s super critical; really tough. But it took a long time for that to happen.
Forbes: Let’s turn now to investors. A common saying, especially during bear markets, in crypto and in the broader macro community is that this is where fortunes can get made. A lot of the big companies today were created during the ICO winter. What do you say to people asking where they should put their money today?
Carter: As far as we’re concerned, we’re just going to continue to execute on our stated strategy, which is early stage venture. A lot of generalist funds will turn off their crypto strategy. I’ve already heard from some of the largest generalist funds in the world that they have redirected their attention away from crypto, if they are still active. A lot of crypto funds you’ll find won’t do another deal for the rest of the year because they’re too spooked by market conditions, they don’t want to catch a falling knife.
Here’s the interesting thing about liquidity crises, and we’re not really in one yet, but we may be trending that way. Everybody thinks that they would be the one to counter trade and buy the dip. But that’s the thing—you don’t have liquidity during a liquidity crisis, so you can’t decouple yourself from the market environment. So unless you’ve really, really prepared for it, and it’s always costly to do that, you’re going to be just as screwed as everybody else. You won’t have the dry powder to buy when liquidity dries up. And that’s why things can get really bad because you don’t have this buyer as a last resort. If you look at some of the crypto funds right now, the hedge funds, they’re going to be dealing with redemptions, obviously, and then the venture funds, they’re going to be dealing with LPs that tell them to not make capital calls. So it’s not like the venture funds have all the capital laying around on day one. And, guess what, the LPS might be distressed, and they may not want to be allocating more to crypto or an early stage venture, even if they sign the limited partnership agreement, they have a legal obligation. They might call the fund and say “hey, why don’t you actually curtail the fund size, we’ll back you to the next fund, take a breather, take the year off.” Or they’ll say something like “just don’t call capital this year.” All the dry powder that you see on the sidelines, all these funds that were raised that may not actually be deployed, and similar things happened in ‘08 and ‘01 in venture. So I’m confident we’re going to continue to be active and keep doing our jobs. I think there’s plenty of very interesting things out there, especially as valuations have come down. I think you’ll see less activity and that dip buying may be institutionally constrained.
Forbes: I was going to ask about the ability, potentially of venture funds that raise billions in dry powder—their ability to perhaps sustain some of this or would they be forced into dealmaking to make use of that capital? It sounds like you’re skeptical of that.
Carter: Yes. It may be illusory. You may see a fund that announces that there is a billion and a half dollars or something like that, but that may not actually be available in practice. So that’s kind of the interesting thing.
Forbes: Stepping aside from institutions, a lot of my subscribers are retail investors. Do you have any thoughts on potential ways that they might be interested in purchasing tokens? What could be a smart approach?
Carter: I would say right now your best position is actually cash. Believe it or not, you want to be dynamic. Traditionally, you have to think about the whole universe of assets, you could be buying, not just crypto. So you have to think about the relative value between crypto and fixed income and equities and property commodities. I haven’t really seen enough of a drawdown in traditional markets where I would even consider buying public equity. I think under a $1 trillion market cap for all cryptocurrency seems pretty cheap—obviously, we don’t have an underlying valuation methodology. Bitcoin is worth $400 billion in the aggregate, if I’m not mistaken, which is less than 1/20 of what all the gold is worth. Long term, I think bitcoin, frankly, could surpass gold in terms of its importance as a savings device in society. So I certainly find these prices attractive, especially for bitcoin, in particular, now, the alternative Layer 1s (L1s), all the Ethereum competitors and things like that, they had a big year last year. I think those narratives will be really challenged this year. They grew popular because there’s so much demand for Ethereum blockspace that that demand spilled over into other, especially Ethereum Virtual Machines (EVM)-compatible blockchains, but other blockchains that are similar to Ethereum, smart contract blockchains, there’s just not going to be that demand for blockspace for the foreseeable future. It’s a very cyclical thing. Not to mention Ethereum is progressing to the merge, moving to proof of stake and inserting this sort of staking protocol. That is really going to put a lot of pressure on all its competitors. I’d be really wary of looking down the list and looking for those hidden gems, or looking for those L1s that were really sexy names last year. I’d be super careful about that.
At a time like this, when liquidity continues to deteriorate, there’s no end in sight for the Fed hiking; things could get worse in crypto markets. We’ve definitely seen contagion from these lenders that are defaulting, these big funds that are defaulting. But there could be more, that’s not necessarily over. So I would say, number one, your best tactical position is cash and just adopting a wait-and-see attitude. You don’t have to be active all the time, sometimes your best move is just to sit on your hands. Number two, I’d look at the most liquid and highest quality names and the ones that have the least inbuilt leverage. Another problem is that a lot of these other L1s, as you go down the list, have a lot of leverage built into the valuation. So as you have deleveraging they sell off much more than bitcoin.
Forbes: Could you explain a bit more about what you mean by built in leverage?
Carter: A lot of these things are predicated on the existence of a DeFi set of defined protocols that use the base L1 asset as the underlying collateral. That’s all great, things are doing well and the total value locked in these protocols is growing. That induces the supply lock-up thing where the units of the token are locked up so then the market float contracts and that drives up the price of the token. When the market deleverages and total value locked decreases, the collateral gets spit out and emerges back onto the open market. At the same time, a lot of these protocols are venture backed, so that means that there’s vesting, so there’s a ton of supply on locks. You’ll see that massive amounts of liquidity come online just because the venture funds that invested in the protocol have to liquidate their positions, especially now. What’s going to be a huge source of selling pressure, too, is that the liquidity was locked up in these vesting for the institutional backers for these protocols, that’s going to have to be spit out back onto the market. And nobody’s going to want to hold them as we’re in this significant sell off. So you can be assured that virtually everybody that’s invested in L1s, in these various tokens, that’s an institutional allocator, they’re going to be liquidating those as soon as they invest. Anything that’s less established that was trying to establish itself through institutional backing and through the creation of a DeFi ecosystem, those I think are going to be some of the worst performers in this down market phase here.
Forbes: I want to talk about contagion, because that’s a question on everyone’s mind. I think a lot of people saw a bit of a firewall between Terra Luna and the rest of the crypto ecosystem. Obviously, there were some funds that had been reported to take massive losses and Three Arrows was one of them. But what are some of the other signs that people should look towards when they try to assess the likelihood of contagion? Or how and where it might spread?
Carter: Yeah, I was shocked about Three Arrows. The Celsius and the Terra collapses, I was not surprised by them. It was obvious that Terra was unsound and would eventually collapse. Celsius, the red flags were everywhere for years, so another one where I was certain that they were significantly impaired. Three Arrows I didn’t expect at all. I guess a few weeks ago, we sort of patted ourselves on the back as an industry and said, “hey, we weathered a $60 billion evaporation of wealth from Terra Luna, and there was no contagion.” Well, turns out there was contagion. In particular, it appears that Three Arrows was the connective tissue bridging that Three Arrows and Celsius, frankly. Because Celsius was an active participant in DeFi, they would deploy client funds in DeFi. They had a big position in Terra, which they were mostly able to liquidate. In fact, they may have caused the collapse of Terra by liquidating their position. In so doing I think they probably suffered a bit of a confidence crisis in their depositors. These things are very linked together. That was one of the big problems, that you had these centralized lenders and just crypto market participants putting a lot of liquidity in DeFi, and a lot of these DeFi structures were Ponzi structures. They were guaranteed to fail. But that didn’t stop a lot of these entities from participating in the system. There actually were a lot of interconnections, and even the centralized lenders, like Celsius, were affected. But then the other centralized lenders that are lending to some of these proprietary firms that are now potentially illiquid or insolvent, now they’re affected. Now there’s a hole in their balance sheet. So it’s hard to know where it’ll stop. Every day there’s a new lender that collapses, recently it was Babel Finance. The very largest institutions in the industry have the balance sheets to absorb this, in my opinion, so ultimately they will be fine. To be clear, there’s a difference. These entities are not homogenous, like Celsius was pretty risky. Offshore, they had an ICO-vetted token, they were affiliated with, like Moshe Hogeg, they put client funds in DeFi. That does not describe all the crypto lenders. They’re not all adhering to the same standard of risk management. There’s some that are onshore, they’re pro regulatory, and they’re very careful with their counterparties and there’s some that were just cowboy operators. So it is a matter of distinguishing those two. I think there will be more well-capitalized institutions that will be able to survive this and the offshore and the sketchier institutions will be done.
Forbes: One question that comes up now is whether or not there are responsible ways to generate some degree of passive income on crypto holdings. That’s been a popular strategy, especially during previous short-term down cycles over the last year or so to supplement income and mitigate some losses. DeFi, it sounds like, may not necessarily be the right place, some yield farming may not be the best strategy nowadays. What do you think are perhaps the best ways for investors that still want to try to generate a little bit of passive income on their holdings to do so?
Carter: In the U.S. it just depends on what’s available and basically all retail access to lending has been choked off by the SEC. So that’s just a regulatory question. The rest of the world still has plenty of options. Now, you have to be really careful with yield. Some people like to refer to options writing strategies as yield; I don’t consider that yield, you’re just transforming the riskier position. There’s a lot of providers that will let you do structured products, so they let you write options in a systematized way. Writing options is super risky, especially for retail. I mean frankly, even for someone like me, I’m not an options expert. So you’re not actually earning yield, in my opinion. You’re just dramatically altering the risk profile of your investments such that it’s positive most of the time, but then deeply negative some percentage of the time. So if you’re applying the term yield to that, that’s wrong, but that’s very common in the industry.
Similarly with staking, oftentimes what’s referred to as yield is purely nominal. Maybe there’s a 15% dilution if you just hold the token and if you stake you’re avoiding that dilution. To me, the staking looks like an anti-dilution right where you’re just treading water. If you don’t stake, you’re slowly sinking below the water level. If there’s no sort of real economic activity, if there’s no default risk that you’re underwriting, I don’t consider that a yield. Now, maybe in the case of Ethereum where stakers can capture fees, that might be a little bit different; that’d be the yield possibility in ETH 2.0. But for the most part, staking in the industry, I don’t consider that a yield either because basically everybody gets diluted and then you have the opportunity to earn some of that dilution back. The market cap, other things being equal, you’re not coming out ahead. To me real yield is predicated on real economic activity—you’re giving someone a loan, they’re undertaking some sort of risky, productive venture. There’s a risk of failure, which you get compensated for. There’s a risk of default and if that economic activity is productive, on the other end, they pay you back. So that describes a minority of the things that are called yield in crypto.
Forbes: Aside from trading, what might be one or two other sources of real economic activity using DeFi that you have your eye on?
Carter: You’re increasingly seeing some of these learning protocols putting crypto funds into just regular-old, real world lending. Goldfinch would be an example, I think the company does microfinance stuff. You’ll see different lenders start to look outside of just lending to other DeFi market participants, for instance, Maple. It is launching a mining pool focused on bitcoin miners and then from that I think they’ll branch out. So those are kind of interesting. Then mining has become much more sophisticated. Miners want to hedge out their exposure, they may just want to lock in a rate where they’re earning 20% over the next year instead of being exposed to whatever the price of bitcoin is doing. That’s an interesting model, I’d like to see more of that—protocols that exist on DeFi. The return opportunities if you want to go long, these commodities, but they are really referencing genuine economic activity and they’re creating structures that are useful for the producers and the consumers of these commodities.
Forbes: We’ve talked a lot about DeFi. Do you think decentralized governance is a misnomer or can it actually function? We are seeing liquidity crises across a number of different protocols and a curve pool is getting drained between stETH and ETH. Are you seeing anything interesting coming out of these DeFi platforms when it comes to ways that they might be working to help alleviate some of these issues right now? Or are they locked up when it comes to governance?
Carter: I would say decentralized governance is a contradictory term. If you have governance that implies centralization and in the case of an equity the shareholders are the owners of the company. They should and do exert governance—that’s their duty and that’s their right. In the case of protocol, if you have stakeholders, token holders that are exerting governance, that necessarily implies it’s not decentralized. Because crypto people are pretty ignorant about the corporate governance literature, to be honest. There’s no incentive for a large band of small token holders or shareholders to exercise governance, because governance requires costly information gathering for that to work. This is the reason things are arranged the way they are in markets. This is a reason you have lead investors and venture rounds as opposed to just like syndicates of many different participants. This is the reason you have large block holders in equity that do take charge, like whether it’s Vanguard, BlackRock or Fidelity, etc., they take charge for exercising governance. So having a highly distributed token holder base means that there’s no governance, there’s no supervision of what, in a corporate context, you call the directors and the officers, people that operate the protocol. Decentralized governance basically means governance that doesn’t work. Centralized governance, where you have one or two entities that take the charge for the information gathering and the oversight to make sure that the managers of the protocol of the system are not expropriating the system, because that’s a big part of the reason corporate governance exists, that necessarily requires centralized agents. In practice, in DeFi it’s the big venture funds that have a lot of the token exposure. They conceal their footprint because they don’t want the SEC going after them like “hey, you guys are actually secretly in charge of this.”
I’m very critical of the prevailing narratives around governance. If you want to actually exercise governance, be dynamic and have a lot of changes, then it’s going to be centralized. Maybe you will impose the veil of decentralization, you will represent that you’re decentralized, but you won’t be really. If your protocol is static and doesn’t change, then you don’t need as much governance. And that’s when you can have the full sort of true decentralization in my opinion. Like bitcoin is not changing very often, so there aren’t that many decisions to be made. Then you can genuinely represent that you’re decentralized, but I would say that’s the exception. There’s not that many protocols, aside from bitcoin, which have that genuine calcification, fossilization and can minimize governance.
Forbes: What do you think the regulatory blowback, regulatory response, to all this will be with the caveat that we’re still in the middle of this unwinding and we don’t necessarily know where the industry is going to end up just yet.
Carter: I think it’ll be harsh, aggressive and warranted, too. Frankly I think a lot of crypto market participants will welcome it at this point. If you’ve lost money in Celsius or in Terra or any token that sold off you, or lost money to DeFi hack, you’re probably going to be thinking to yourself, “a little bit of regulation is maybe not the worst thing in the world.” That’s what happens after a financial crash or crisis, you always get more regulation. That’s the way it works. It’s because there’s political will and there’s an acceptance on the part of the broader marketplace to embrace that regulation. Because you’ve been hurt. If you get robbed, you’re probably going to be saying, “where’s the police?” So that’s basically what’s going to happen here. Congress will have, I think, the political mandate and license to do something, probably it’ll be after the election in November. But the SEC will certainly feel emboldened. The other relevant regulators will as well. Maybe that’s not the outcome we wanted as an industry. But guess what, it’s the outcome we got because we were unable to self regulate, we’re unable to self police; there were no self regulatory organizations that emerged. Even the most well renowned members of the industry have proven to be completely catastrophic when it comes to risk management. So that’s the inevitable outcome here.
Forbes: Thank you.