"A new Trail of Bits research report examines unintended centralities in distributed ledgers

Blockchains can help push the boundaries of current technology in useful ways. However, to make good risk decisions involving exciting and innovative technologies, people need demonstrable facts that are arrived at through reproducible methods and open data.

We believe the risks inherent in blockchains and cryptocurrencies have been poorly described and are often ignored—or even mocked—by those seeking to cash in on this decade’s gold rush.

In response to recent market turmoil and plummeting prices, proponents of cryptocurrency point to the technology’s fundamentals as sound. Are they?

• Read the report
• Listen to our podcast about this report
• Follow along on Twitter
  

Over the past year, Trail of Bits was engaged by the Defense Advanced Research Projects Agency (DARPA) to examine the fundamental properties of blockchains and the cybersecurity risks associated with them. DARPA wanted to understand those security assumptions and determine to what degree blockchains are actually decentralized.

To answer DARPA’s question, Trail of Bits researchers performed analyses and meta-analyses of prior academic work and of real-world findings that had never before been aggregated, updating prior research with new data in some cases. They also did novel work, building new tools and pursuing original research.

The resulting report is a 30-thousand-foot view of what’s currently known about blockchain technology. Whether these findings affect financial markets is out of the scope of the report: our work at Trail of Bits is entirely about understanding and mitigating security risk.

The report also contains links to the substantial supporting and analytical materials. Our findings are reproducible, and our research is open-source and freely distributable. So you can dig in for yourself.

Key findings

• Blockchain immutability can be broken not by exploiting cryptographic vulnerabilities, but instead by subverting the properties of a blockchain’s implementations, networking, and consensus protocols. We show that a subset of participants can garner undue, centralized control over the entire system:
  
  
  • While the encryption used within cryptocurrencies is for all intents and purposes secure, it does not guarantee security, as touted by proponents.
    
    
  • Bitcoin traffic is unencrypted; any third party on the network route between nodes (e.g., internet service providers, Wi-Fi access point operators, or governments) can observe and choose to drop any messages they wish.
    
    
  • Tor is now the largest network provider in Bitcoin; just about 55% of Bitcoin nodes were addressable only via Tor (as of March 2022). A malicious Tor exit node can modify or drop traffic.
    
    
• More than one in five Bitcoin nodes are running an old version of the Bitcoin core client that is known to be vulnerable.
  
  
• The number of entities sufficient to disrupt a blockchain is relatively low: four for Bitcoin, two for Ethereum, and less than a dozen for most proof-of-stake networks.
  
  
• When nodes have an out-of-date or incorrect view of the network, this lowers the percentage of the hashrate necessary to execute a standard 51% attack. During the first half of 2021, the actual cost of a 51% attack on Bitcoin was closer to 49% of the hashrate—and this can be lowered substantially through network delays.
  
  
• For a blockchain to be optimally distributed, there must be a so-called Sybil cost. There is currently no known way to implement Sybil costs in a permissionless blockchain like Bitcoin or Ethereum without employing a centralized trusted third party (TTP). Until a mechanism for enforcing Sybil costs without a TTP is discovered, it will be almost impossible for permissionless blockchains to achieve satisfactory decentralization.

Novel research within the report

• Analysis of the Bitcoin consensus network and network topology
• Updated analysis of the effect of software delays on the hashrate required to exploit blockchains (we did not devise the theory, but we applied it to the latest data)
• Calculation of the Nakamoto coefficient for proof-of-stake blockchains (once again, the theory was already known, but we applied it to the latest data)
• Analysis of software centrality
• Analysis of Ethereum smart contract similarity
• Analysis of mining pool protocols, software, and authentication
• Combining the survey of sources (both academic and anecdotal) that support our thesis that there is a lack of decentralization in blockchains
  
  

The research to which this blog post refers was conducted by Trail of Bits based upon work supported by DARPA under Contract No. HR001120C0084 (Distribution Statement A, Approved for Public Release: Distribution Unlimited). Any opinions, findings and conclusions or recommendations expressed in this material are those of the author(s) and do not necessarily reflect the views of the United States Government or DARPA."

For original post, please visit: 

https://blog.trailofbits.com/2022/06/21/are-blockchains-decentralized/  

By Olga Kharif

"A closer look at the LooksRare platform that has quickly become the leading NFT marketplace by trading volume shows that most of the activity is actually users selling tokens to themselves to help earn rewards in the form of more coins. 

The platform was launched in January by two anonymous co-founders -- who go by Zodd and Guts -- as an alternative to market leader OpenSea during the height of the NFT boom."....

For full post, please visit:

https://www.bloomberg.com/news/articles/2022-04-05/hottest-nft-marketplace-is-mostly-users-selling-to-themselves 

UPDATE: Since the publication of this article, Helium has removed logos for Lime and Salesforce from its website.

"Helium is often heralded as one of the largest success stories in the Web3 space, even landing a coveted article in The New York Times earlier this year. Since 2019, the decentralized wireless network service, which bills itself as a peer-to-peer network for the Internet of Things, has touted rideshare company Lime as one of its marquee clients, claiming the company uses its service to geolocate rentable escooters. There are numerous mentions of this partnership on its website, along with the presence of Lime's company logo, and in press coverage with various news outlets.

There's just one problem: That partnership never really existed.

"Beyond an initial test of its product in 2019, Lime has not had, and does not currently have, a relationship with Helium." Lime senior director for corporate communications Russell Murphy said to Mashable.

According to Murphy, there was a "brief test of [Helium's] product that didn’t last beyond a month or two" in the summer of 2019. There has been no contact between Helium and Lime since then. Details surrounding what the test actually entailed are unclear, as Helium's primary contact at Lime left the company more than two and a half years ago. However, Murphy says that, as a condition of the trial, Lime had requested that its name not be used by Helium in promotional material.

On Helium's website, Lime is featured prominently, alongside Salesforce, as one of the biggest companies that uses Helium's service, and certainly the biggest in the IoT space. Beyond merely stating its service "is used by" Lime, Helium also boasts that it is "trusted by" Lime on its "Enterprise" webpage. In a post on Twitter from May 2021, Helium mentions how it is "trusted by users" and, again, includes Lime's logo on a list of its customers — but curiously omits directly tagging Lime's Twitter account.

Despite the omnipresence of this supposed partnership, executives at Lime, who were aware of this misrepresentation, had declined to take action, legal or otherwise.

"Helium has been making this claim for years and it is a false claim," Murphy said.

Now, however, Mashable has learned that Lime is preparing to send a cease and desist to Helium over its use of Lime's name and logo on its website, and in its marketing."... 

For full post, please visit: 

https://mashable.com/article/helium-lime-web3-crypto 

By Bruce Schneier
"Earlier this month, I and others wrote a letter to Congress, basically saying that cryptocurrencies are an complete and total disaster, and urging them to regulate the space. Nothing in that letter is out of the ordinary, and is in line with what I wrote about blockchain in 2019. In response, Matthew Green has written—not really a rebuttal—but a “a general response to some of the more common spurious objections…people make to public blockchain systems.” In it, he makes several broad points:

1. Yes, current proof-of-work blockchains like bitcoin are terrible for the environment. But there are other modes like proof-of-stake that are not.
2. Yes, a blockchain is an immutable ledger making it impossible to undo specific transactions. But that doesn’t mean there can’t be some governance system on top of the blockchain that enables reversals.
3. Yes, bitcoin doesn’t scale and the fees are too high. But that’s nothing inherent in blockchain technology—that’s just a bunch of bad design choices bitcoin made.
4. Blockchain systems can have a little or a lot of privacy, depending on how they are designed and implemented.
   
   

There’s nothing on that list that I disagree with. (We can argue about whether proof-of-stake is actually an improvement. I am skeptical of systems that enshrine a “they who have the gold make the rules” system of governance. And to the extent any of those scaling solutions work, they undo the decentralization blockchain claims to have.) But I also think that these defenses largely miss the point. To me, the problem isn’t that blockchain systems can be made slightly less awful than they are today. The problem is that they don’t do anything their proponents claim they do. In some very important ways, they’re not secure. They doesn’t replace trust with code; in fact, in many ways they are far less trustworthy than non-blockchain systems.

They’re not decentralized, and their inevitable centralization is harmful because it’s largely emergent and ill-defined. They still have trusted intermediaries, often with more power and less oversight than non-blockchain systems. They still require governance. They still require regulation. (These things are what I wrote about here.) The problem with blockchain is that it’s not an improvement to any system—and often makes things worse.

In our letter, we write: “By its very design, blockchain technology is poorly suited for just about every purpose currently touted as a present or potential source of public benefit. From its inception, this technology has been a solution in search of a problem and has now latched onto concepts such as financial inclusion and data transparency to justify its existence, despite far better solutions to these issues already in use. Despite more than thirteen years of development, it has severe limitations and design flaws that preclude almost all applications that deal with public customer data and regulated financial transactions and are not an improvement on existing non-blockchain solutions.”

Green responds: “‘Public blockchain’ technology enables many stupid things: today’s cryptocurrency schemes can be venal, corrupt, overpromised. But the core technology is absolutely not useless. In fact, I think there are some pretty exciting things happening in the field, even if most of them are further away from reality than their boosters would admit.” I have yet to see one. More specifically, I can’t find a blockchain application whose value has anything to do with the blockchain part, that wouldn’t be made safer, more secure, more reliable, and just plain better by removing the blockchain part. I postulate that no one has ever said “Here is a problem that I have. Oh look, blockchain is a good solution.” In every case, the order has been: “I have a blockchain. Oh look, there is a problem I can apply it to.” And in no cases does it actually help.

Someone, please show me an application where blockchain is essential. That is, a problem that could not have been solved without blockchain that can now be solved with it. (And “ransomware couldn’t exist because criminals are blocked from using the conventional financial networks, and cash payments aren’t feasible” does not count.)

For example, Green complains that “credit card merchant fees are similar, or have actually risen in the United States since the 1990s.” This is true, but has little to do with technological inefficiencies or existing trust relationships in the industry. It’s because pretty much everyone who can and is paying attention gets 1% back on their purchases: in cash, frequent flier miles, or other affinity points. Green is right about how unfair this is. It’s a regressive subsidy, “since these fees are baked into the cost of most retail goods and thus fall heavily on the working poor (who pay them even if they use cash).” But that has nothing to do with the lack of blockchain, and solving it isn’t helped by adding a blockchain. It’s a regulatory problem; with a few exceptions, credit card companies have successfully pressured merchants into charging the same prices, whether someone pays in cash or with a credit card. Peer-to-peer payment systems like PayPal, Venmo, MPesa, and AliPay all get around those high transaction fees, and none of them use blockchain.

This is my basic argument: blockchain does nothing to solve any existing problem with financial (or other) systems. Those problems are inherently economic and political, and have nothing to do with technology. And, more importantly, technology can’t solve economic and political problems. Which is good, because adding blockchain causes a whole slew of new problems and makes all of these systems much, much worse.

Green writes: “I have no problem with the idea of legislators (intelligently) passing laws to regulate cryptocurrency. Indeed, given the level of insanity and the number of outright scams that are happening in this area, it’s pretty obvious that our current regulatory framework is not up to the task.” But when you remove the insanity and the scams, what’s left?

EDITED TO ADD: Nicholas Weaver is also adamant about this. David Rosenthal is good, too."

For full/original post, please visit:

https://www.schneier.com/blog/archives/2022/06/on-the-dangers-of-cryptocurrencies-and-the-uselessness-of-blockchain.html 

By Leo Saraceno

"London, UK -  Social validation for identity is becoming increasingly popular due to its game theoretical security properties. A concept gaining traction called “Soul Bound” tokens expands the concept of digital identity significantly, and reveals the dangers of interoperable digital identity.

In a May 2022 paper titled Decentralized Society: Finding Web3’s Soul Vitalik Buterin, Glen Weyl and Puja Olhaver describe the potential of “Soulbound tokens”. Their significance as plumbing for the crypto hive minds proposed by Melianie Swan, sinks in as we investigate the details.

"In this paper, we illustrate how non-transferable “soulbound” tokens (SBTs) representing the commitments, credentials, and aliations of “Souls” can encode the trust networks of the real economy to establish provenance and reputation."

Potential examples of Soulbound tokens are verifiable credentials such as learning badges, teaching certificates, employment history, works of art, photography, writings, ect. The key feature is that they are non transferable and are issued or revoked by an entity. For learning credentials this entity would be a trusted education institution, but for personal writings or works of art you would issue these yourself. 

By having these tokenized credentials you build trust and reputation. 

"More importantly, SBTs enable other applications of increasing ambition, such as community wallet recovery, sybil-resistant governance, mechanisms for decentralization, and novel markets with decomposable, shared rights. We call this richer, pluralistic ecosystem “Decentralized Society” (DeSoc)—a co-determined sociality, where Souls and communities come together bottom-up, as emergent properties of each other to co-create plural network goods and intelligences, at a range of scales.

Some of the phraseology sounds meaningless, but will become more clear when we explore the applications of Machine Learning in this environment of soul bound and community linked identity. 

The phrase “decentralized society” itself is highly weaponized, but in the technology space decentralization means building robustness into a network. A centralized network is vulnerable to attack at single points of failure, decentralized networks offer resilience through complexity. If you are designing networks for global domination you cannot risk collapse due to one building or satellite blowing up. 

Even if the power or security of the network is highly decentralized, the mere creation of a standard universal network serves the same purpose as having centralized control. In other words, creating a universal standardized system means centralizing thought into one controlled and known set of patterns. Understanding this is key in order to explain why standardized technology networks violate Free Will. 

Socializing Identity for Machine Computation

Many projects, such as Celo’s UBI project, Impact Markets, implement “Proof of Personhood” protocols to prevent people from creating multiple blockchain identities to take advantage of a service like UBI.

"Proof of Personhood protocols (PoP) aim to provide tokens of individual uniqueness, to prevent Sybil attacks and allow non-nancialized applications. To do so, they rely on approaches such as global analysis of social graphs, biometrics, simultaneous global key parties, or some combination thereof. 

However, because PoP protocols seek to represent individual identities—-focused on achieving global uniqueness—rather than social identities mapping relationships and solidarities, PoP protocols are limited to applications that treat all humans the same. Most applications we are interested in—such as staking reputation—are relational and move beyond being a unique human to being a differentiated human."
 

Since Soulbound tokens build a person’s trust and reputation scores through education, employment, religion and any other type of association, they expect it to become the foundation for the social credit system. Instead of just identifying an individual person they are able to differentiate people based on these relationships, which is essential for the debt markets and social impact finance.

"Imagine a world where most participants have Souls that store SBTs corresponding to a series of aliations, memberships, and credentials. For example, a person might have a Soul that stores SBTs representing educational credentials, employment history, or hashes of their writings or works of art…

An ecosystem of SBTs could unlock a censorship-resistant, bottom-up alternative to top-down commercial and “social” credit systems. SBTs that represent education credentials, work history, and rental contracts could serve as a persistent record of credit-relevant history, allowing Souls to stake meaningful reputation to avoid collateral requirements and secure a loan."

The loans themselves will also constitute soulbound tokens, recording your debt arrangements in perpetuity.

"Loans and credit lines could be represented as non-transferable but revocable SBTs, so they are nested amongst a Soul’s other SBTs—a kind of non-seizable reputational collateral—until they are repaid and subsequently burned, or better yet, replaced with proof of repayment."

Using Soulbound tokens for social credit profiles, as well as representing active loans, increases machine visibility to the webs of human relationships, enabling more robust algorithms calculating risk. 

"The ease of computing public liabilities with SBTs would open-source lending markets. New correlations between SBTs and repayment risk would emerge, birthing better lending algorithms that predict creditworthiness and thereby reduce the role of centralized, opaque credit-scoring infrastructure.

Instead of just entangling people within the thrall of global capital, they want people to incur debt relationships within their own community. 

"Better yet, lending would likely occur within social connections. In particular, SBTs would oer a substrate for community lending practices similar to those pioneered by Muhammad Yunus and the Grameen Bank, where members of a social network agree to support one another’s liabilities." 

Soulbound tokens derive their name from the popular video game World of Warcraft, which offers players “soulbound” items as part of thier in-game experience.

In addition, they want to use all these different soul bound tokens as a private key recovery system. One of the bigger problems with digital identity in general is how to “login” and how to recover your identity if you lose your password. In the blockchain universe your password is called a private key. 

They point out issues with social recovery of private keys and propose an alternative where our memberships in organizations and communities can facilitate identity recovery.

"A more robust solution is to tie Soul recovery to a Soul’s memberships across communities, not curating but instead drawing on a maximally broad set of real-time relationships for security. Recall that SBTs represent memberships to different communities. Some of these communities—like employers, clubs, colleges, or churches—might be more o-chain in nature, while others—like participation in protocol governance or a DAO—might be more on-chain. In a community recovery model, recovering a Soul’s private keys would require a member from a qualified majority of a (random subset of) Soul’s communities to consent."

Rights to our “souls” are governed by a subset of accrued relationships over time. High profile institutions with robust security would likely play an outsized role in identity recovery.

Moving from Artificial to Plural Intelligence

The implication of codifying social relationships is the merger of AI computation with social prediction markets. They first note how these two paradigms are limited in opposite ways. AI does not take into account economic incentives and predication markets ignore computation models. They expand:

"An example of plural network goods that are of increasing salience in a digital world are predictive models built on user data. Both artificial intelligence (AI) and prediction markets seek to predict future events based on data primarily elicited from people. But both paradigms are limited in different and nearly opposite ways. The dominant paradigm in AI eschews incentives, instead hoovering up (public or privately surveilled) data feeds and synthesizing them into predictions through proprietary large-scale, non-linear models—harnessing the default web2 monopoly on “usus” without any “fructus” owing to data laborers. Prediction markets take the opposite approach, where people bet on outcome in the hopes of financial gains, relying entirely on economic incentives of financial speculation (“fructus”) without synthesizing the beliefs of bettors to produce composable models

A more productive paradigm is to eschew these extremes, and instead draw on the virtues of both, while compensating for their weaknesses and enriching their breadth. We propose thoughtfully combining the complexity of non-linear AI models with the market incentives of prediction markets to transform passive data laborers into active data creators. With such provenance-rich information rooted in the sociality of data creators, we illustrate how DeSoc can unlock plural network(ed) intelligence more powerful than either approach."

This model of combining prediction markets with AI models for use in blockchained social impact finance is already live. Alphabonds are currently in pilot with projects associated with UBS and Blackrock. The existence of soulbound tokens representing the various types of social relationships between people helps feed the AI informing impact investors how to bet on the success of a certain outcome. 

"Research suggests that while prediction markets generally outperform simple polling, they don’t outperform sophisticated team prediction polling, where people have incentives to share and discuss information. Under team deliberation models, members can be weighted based on factors like past performance and peer evaluation, and the team participates in semi-structured discussions to pool information that can’t be encapsulated simply in a buy or sell contract.

Whereas prediction markets elicit one number—the price of a contract—quadratic polling elicits each participant’s exact belief about the probability of an event. SBTs enable further computation over those beliefs in social context of the education credentials, memberships, and general sociality of a participant to develop better weighted (or non-linearly synthesized) predictive models, likely surfacing expert predictors at novel, unforeseen intersections"

This is the basis for “Plural Intelligence” converging social prediction with artificial intelligence. They argue that in the current system, AI models view content creators as separate from their social context. Soul bound tokens show the algorithms the social context of data creators, while also enabling “governance rights” to how the collective social data is monetized. AN illusion of control and some of the profit is part of convincing the public to engage in the system, teaching the machines.

In reality almost no data is solely about individuals, all data corresponds to other people and groups as well. For example, your DNA gives information about your family, not just yourself. Soul bound tokens are a way of representing the social identity of data.

"Most surveilled data creators aren’t aware of their role in creating these models, retain no residual rights, and are viewed as “incidental” rather than as key participants. Moreover, data hoovering divorces models from their social context, which masks their biases and limitations and undermines our ability to compensate for them. These tensions have increasingly come to the fore with growing demand for data availability, new initiatives like “data sheets for data sets” that document data provenance, and privacy-preserving approaches to machine learning."

Data provenance refers to information about the data such as how it was collected, where it was collected, any changes and sorts of meta-data. Soul bound tokens help represent and standardize the metadata, create economic incentives and governance rights.

"Such approaches require giving meaningful economic and governance stakes to those who generate the data and incentivizing them to cooperate in producing models more powerful than what they could build alone. SBTs offer a natural way to program economic incentives for provenance-rich data while at the same time, model-makers can track the characteristics of the collected data and their social context—as reflected by SBTs—and contributors that offset biases and compensate for limits."

These economic and governance rights are called data “cooperatives”. They want as much human interaction with machine intelligence as possible. Computing different perspectives from the same set of data is important in the ambition of making AI “think” more like humans. They call it “Plural Intelligence”. While most people do not think AI and computer networks can gain their own soul, if they are tightly integrated with Minds connected to Spirit, the computers can certainly access aspects of that incredible potential.

"SBTs can also program bespoke governance rights to data creators, allowing them to form cooperatives that pool data and negotiate uses. This bottom-up programmability by data creators enables a future of plural intelligences, where model-makers can compete to negotiate uses over the same data to build different models. Thus, we move away from a paradigm of a detached monolithic “artificial intelligence” free from human origins, hoovering up provenance-free surveilled data to instead a Cambrian explosion of cooperatively constructed plural intelligences rooted in social provenance and governed by Souls."

Human and machine individuality is fuzzy as the metaverse expands. When trying to understand these designs, distinguishing between people and machines isn’t very helpful. These “plural intelligence” models eventually accrue their own soul bound tokens, building their own relationships “embedded in human sociality”. Clearly these are transhuman designs.

"Over time, just as SBTs individuate a Soul, they also come to individuate models—embedding data provenance, governance and economic rights directly into the model’s code. Thus, plural intelligences—like humans—build a Soul embedded in human sociality. Or depending on how you look at it, humans evolve over time embedded in plural intelligences—each with a unique Soul, complementing and cooperating with other Souls."

If the transhuman ideology was not clear enough here’s another passage citing the founder of the ARPANET.

"Through composing networks and coordination, DeSoc emerges at the intersection of politics and markets—augmenting both with sociality. DeSoc empowers the vision of JCR Licklider—founder of ARPANET that created the internet—of “man-computer symbiosis” in an “intergalactic computer network” with dramatically increased social dynamism built on trust."

https://siliconicarus.org/2022/05/30/interoperable-identity-tokens-and-the-war-for-our-soul/ 

"In 2021, an investment firm bought 2,000 acres of real estate for about US$4 million. Normally this would not make headlines, but in this case the land was virtual. It existed only in a metaverse platform called The Sandbox. By buying 792 non-fungible tokens on the Ethereum blockchain, the firm then owned the equivalent of 1,200 city blocks.

But did it? It turns out that legal ownership in the metaverse is not that simple.

The prevailing but legally problematic narrative among crypto enthusiasts is that NFTs allow true ownership of digital items in the metaverse for two reasons: decentralization and interoperability. These two technological features have led some to claim that tokens provide indisputable proof of ownership, which can be used across various metaverse apps, environments and games. Because of this decentralization, some also claim that buying and selling virtual items can be done on the blockchain itself for whatever price you want, without any person or any company’s permission.

Despite these claims, the legal status of virtual “owners” is significantly more complicated. In fact, the current ownership of metaverse assets is not governed by property law at all, but rather by contract law. As a legal scholar who studies property law, tech policy and legal ownership, I believe that what many companies are calling “ownership” in the metaverse is not the same as ownership in the physical world, and consumers are at risk of being swindled."... 

For full post, please visit: 

https://theconversation.com/amp/can-you-truly-own-anything-in-the-metaverse-a-law-professor-explains-how-blockchains-and-nfts-dont-protect-virtual-property-179067  

By Charlie Warzel, The Atlantic

"What I find most concerning about crypto/Web3 is that a great deal of the projects I’ve seen add unnecessarily complex financial elements to areas of our lives that didn’t have them before. Crypto critic Dan Olson recently described this ethos as the construction of an internet where “everything that can be conceptualized as valuable can be numeralized.” “Play to win” games like Axie Infinity, for example, are a dystopian vision of leisure that replicate exploitation we’re used to seeing in real life. I find myself more alarmed about the crypto’s hyper-financialized vision of the world each day but I also lack some of the historical knowledge necessary to offer a strong financial critique of the space. Which is why I was deeply fascinated when I came across an essay by American University law professor Hilary J. Allen titled “DeFi: Shadow Banking 2.0?”

Allen studies financial crises—specifically, threats to financial stability and the ways in which financial fallout affects regular people, not just institutions—and she has testified before the House Financial Services Committee. Her recent essay focuses on the financial innovations (money market mutual funds, credit default swaps, mortgage-backed securities) that ultimately led to the 2008 crisis and draws parallels between those and some of the tools and dynamics in the world of crypto and decentralized finance (DeFi). DeFi, she argues, is repeating many of the mistakes of the past.

What follows is one of the most fascinating and eye-opening conversations I’ve had about crypto. We cover America’s casino mindset, the echoes of the financial crisis she’s sensing right now, how to regulate crypto, and how to innovate without exploiting others. Allen offers a lacerating but level-headed criticism of the space that is well worth your time.

Charlie Warzel: Your essay is about DeFi, or decentralized finance. Like a lot of terminology in the crypto space, DeFi is pretty broad and vague but also very much accepted in the lexicon. How do you define it?

Hilary J. Allen: Like any evolving space, the terminology is hard to pin down. People inside the crypto world have different definitions for DeFi and would probably argue with mine. But the way I think of DeFi is as a way to describe any analogue of traditional financial-service transactions—loans, deposits, etc.—that are provided using technological tools like the blockchain or facilitated through smart contracts or stablecoins. The technology is what is different, but the financial transactions are very much similar to traditional finance.

Warzel: And the idea—at least in theory—is that DeFi tools eliminate the need for the centralized authority, which is usually regulated banks and other intermediaries that do all kinds of things: from holding and transferring money to charging transaction fees, etc.?

Allen: Right.

Warzel: Of course, your essay argues that DeFi doesn’t really deliver on this promise. You write that, “DeFi doesn’t so much disintermediate finance as replace trust in regulated banks with trust in new intermediaries who are often unidentified and unregulated.” This is a growing critique of much of the Web3 movement—the idea that a lot of blockchain-based apps and tools are not actually decentralized. And that, for Web3 applications to scale, they’ll have to rely on the same types of platform structures that exist now. An example of this outside of the DeFi space is that, for NFTs to work, you need a centralized marketplace like OpenSea.

But what I found interesting is that your critique goes a step further. You argue that part of the decentralized finance ecosystem looks to you like it “mirrors and magnifies the fragilities of shadow banking innovations that resulted in the crisis of 2008.” Can you walk me through your argument here a bit? [For readers interested in a synopsis of Allen’s essay, Cory Doctorow has a truncated recap here.]

Allen: Sure. As somebody who studied the 2008 crisis in great detail, I’m always looking for parallels. So when I’m looking at the building blocks of the 2008 crisis, I’m thinking of things like mortgage-backed securities and credit default swaps. These financialized tools created additional complexity and rigidity and leverage into the financial system that ultimately led to collapse. And I see similarities with what’s being built in DeFi spaces—what unites them is their opacity and complexity and the way that it is potentially destabilizing.

Warzel: Right. The idea is that these financial innovations were essentially workarounds that allowed banks and stakeholders to skirt limits or some regulatory aspects. Or that they were such an abstraction that they were difficult for even bankers to follow — that the complexity of these instruments obscured exactly what people were buying and if it was garbage or not. In the essay, the three financial innovations you see parallels to are money market mutual funds, credit default swaps, and mortgage-backed securities. Can you go through them at a high level?

Allen: Money market mutual funds were created to be a functional equivalent of deposit accounts but in fact are an abstraction: a special accounting treatment that allows a share in a fund to be consistently valued at one dollar. But a share in an MMF is actually a share in a pool of assets with fluctuating prices, and so its value changes constantly. If the value of an MMF share deviates too far from one dollar, shareholders will find their shares revalued below one dollar. When this happened in 2008 and investors pulled out of MMFs, it was analogous to the traditional bank runs. Basically, the financial crisis was made worse by runs on money market mutual funds.

There are—and I’m far from the only person to note this—striking similarities between MMFs and stablecoins, like Tether, which is pegged to the dollar and supposedly backed by the dollar.  But there are a lot of allegations that Tether is not backed as it claims and is fraudulent. Other stablecoins offer their own complexities. I’m maybe less convinced in those parallels than some. But if something were to shake confidence in stablecoins and holders rushed to exchange them back to fiat currency, there could be a similar kind of run dynamic. And, if stablecoin issuers become interwoven in the real economy, it could introduce risk into the broader system.

Now, with credit default swaps, the parallel is leverage. CDSs created a new, initially unlimited way to create leverage, which is another way of saying they used debt to acquire financial assets. In DeFi, you see similar dynamics, especially that tokens can be created out of thin air. Those tokens could then be used as collateral for loans that can then be used to acquire yet more assets. It’s somewhat striking, the parallel.

Warzel: How about the mortgage-backed-security parallel?

Allen: Here, I focus on the rigidity. The idea is that when you have these financial products, they’re designed to be very hard to alter. That’s great most of the time, but things begin to fall apart if something unexpected happens. This was a real problem in the financial crisis. The obvious parallel here is with DeFi’s smart contracts. The whole selling point is that with smart contracts, you set the parameters up at the outset. Things happen quickly and are automated. There’s no opportunity for human intervention, though I’d argue that is overstated to some degree. I’m concerned about that.

Warzel: I understand in theory—but could you give me a real-world example of this happening?

Allen: See, so this is a great question. And, if I’m being very honest, I don’t have a great example of this happening. A lot of times in traditional finance and DeFi, these things work okay. Now, there’s all kinds of potential problems with smart contracts, like vulnerabilities and hacks. But—assuming we don’t have those problems, and assuming the contracts execute as intended—this system only becomes undesirable in the “1 percent of the time” case.

This is sometimes a challenge to illustrate. So in my book I explain what would happen if the credit default swaps that AIG issued to Goldman Sachs had taken the form of smart contracts. AIG overextended—it issued too many CDSs, thinking it’d never have to pay out. And because it was so deluded into thinking it wouldn’t have to pay out, it didn’t look at the margin requirements, which are the contracts AIG and Goldman signed. The contracts they used basically gave Goldman carte blanche to dictate what the margin requirements would be, should the underlying bonds be downgraded. Now, what actually happened when the time came is that Goldman came to AIG and said, “We want X terms.” AIG said, “We’re not paying that much; we can’t.” See, AIG negotiated it down. That was in 2007. And, when 2008 came and there were all these margin calls for AIG, it had time to wait on the contracts—because they weren’t smart contracts that automatically executed. They were facilitated by human beings. This gave time for the government to intervene and to avoid a complete financial meltdown.

Now, what if all those contracts had been totally automated? If the margin calls were automated via a smart contract, it would have spun them into insolvency well before any possibility of government bailout.

Warzel: That makes a lot of sense to me, and that rigidity and taking humanity out of the system sounds like a huge potential risk. But, playing devil’s advocate, I’m sure the crypto contingent would say that your story is proof that a smart contract system is superior because it doesn’t give time for intervention and, specifically, bailouts to overleveraged, irresponsible banks. What would you say to people who hear that story and say that smart contracts “sound like a feature, not a bug”?

Allen: I’ve definitely heard that a selling point of DeFi is that it gets rid of the need for bailouts. And yes: I’ve had people accuse me on this point of shilling for big banks, and it’s just not true. If you’re asking me to choose, I’d absolutely rather see a bailout that prevents broader, sustained economic chaos than not. And the reason for that isn’t because I care about protecting executives at banks. In all my work, I’m speaking for the people downwind of all of this. The already vulnerable people who end up being hurt the most by financial collapse. In the case of DeFi being interwoven with our greater economy, these would be the people who are not investing in crypto but could still be hurt by a collapse. That’s the viewpoint I represent. And for those people, bailouts are the best outcome, even if they’re unpopular.

Warzel: One thing that Web3 and crypto proponents like to tout is that it democratizes finance—that a broader scope of people (usually framed as either unbanked or those without outsized means) who’ve been shut out of more traditional financialized elements of the economy can just plug in, get a wallet, and play like others do. What you’re arguing though is that, if you’re looking to protect the most financially vulnerable, then these regulatory frameworks are more important than access. Is that how you’d describe it?

Allen: The rhetoric around crypto and access reminds me of something similar to the rhetoric around mortgages in the lead-up to 2008. Again, there are striking similarities. With subprime mortgages, the line was that it increased the opportunity for more people to own homes. But that rhetoric is sometimes used to hide predatory practices.

Let’s go back to credit default swaps and this idea of multiplying the amount of risk in the system by allowing essentially unlimited bets on the performance of a single bond. I worry in DeFi what’s being constructed is essentially the unlimited ability to create financial products and borrow against them. We are increasing the amount of risk—because the assets are essentially anything that somebody with programming knowledge who can mint a new coin can make up. You don’t necessarily have to tie these assets to something physical: like, say, a house somewhere in the world.

Warzel: I want to go back to the bit about complexity. I find almost all the decentralized applications I encounter just largely inaccessible, especially to the layperson. Specifically when it comes to decentralized finance, I find that it’s often extremely hard to figure out what a given project does. Before our talk I was searching around for interesting projects in the space, and here’s the definition I got from a website about one particular project:

"Simply put, Colony is an entourage of smart contracts that provide the framework for an organization’s essential functions. Apart from funding, this project caters to online organizations’ ownership, structure, and authority."

That is extremely, comically vague. I’m wondering if you could talk some more about the use of complexity as a shield.

Allen: Complexity is weaponized in some of these instances to deflect scrutiny. This is an old trick from the financial industry: Make things more complex. In DeFi, you have financial complexity overlaid with technical complexity, too—so there is, really, just the thinnest subset of people who can do both. And those people will be paid a LOT of money to participate and build these tools. And when the slice of people is so small and they’re so handsomely rewarded, there’s not going to be many savvy watchdogs—there’s less incentive to be a policeman on the beat. It’s much easier to just go work on a project.

And even if the complexity is not purposely weaponized, I think there’s a reason for pause. The literature on complexity science and the interactions in complex systems is something we should all be paying more attention to. There’s this idea of “normal accidents”—that once you have a complex system, things are bound to go wrong in ways we can’t anticipate. Partly for those reasons, and partly for the fact that regular consumers and regulators aren’t going to understand this, I vote for simplicity.

Warzel: There’s this frustrating interplay here for critics, I think. You can say, “I don’t think this thing makes a whole lot of sense” or “It seems to me like this doesn’t really do…anything new?” And it is met by proponents with a sneering “You just don’t get it.” When in reality, I think maybe the bigger problem is that there’s not a lot to “get.”

Allen: This is what I find so frustrating about the financial-inclusion narrative. Let’s start with a problem and solve it. If the problem is that people need money quicker and need payments more cheaply and more return on savings, who would move from that problem and build stablecoin-backed sets of volatile, highly leveraged assets that are themselves complex systems, managed by a decentralized autonomous organization [DAO]? You wouldn’t do that. You’d say: Okay, let’s look at Brazil’s real-time payments system, or Australia’s. That’s part of my frustration with the crypto complexity—it is complexity that ends up making a system more fragile. Complexity may be worth it sometimes. But if it doesn’t solve the problems we actually need to solve, then I don’t know why we go with all of this.

Because the complexity of the crypto world is only justified by the idea of decentralization. That was the intellectual power of the Satoshi Nakamoto white paper. [Nakamoto is the apparent pseudonym of Bitcoin’s creator.] It was this idea for how to transfer value without a trusted intermediary. That was the appeal. But everything that’s been built on the back of the blockchain since seems to be trying to deal with the idea that this decentralization is purposefully wasteful, slow, and complicated. Now, in order to get rid of intermediaries, they’re using intermediaries. They’re losing the decentralization, but they’re keeping the complexity.

Warzel: I think that’s a powerful way to frame it. In a way, it’s almost like using the initial founding vision as marketing material for new products that undermine the initial vision.

Now, I consider myself a crypto skeptic, but I do want to continue playing devil’s advocate. One argument you hear from crypto proponents occasionally is that yes, the system that they’re building might have its own flaws, but that the new rules are being dictated by different players. I’ve also heard a lot of true believers argue that, with different DeFi projects, people are able to invest but also get a say in the governance, which is better than an old model of a bank or company setting all the rules. How do you respond to that governance argument?

Allen: A lot of the power of DeFi and crypto comes from a lot of real and powerful critiques of our system. Banks performed abysmally in 2008 and haven’t changed that much as a result. I understand the distrust, I understand the need and want for solutions. I just don’t think DeFi will get us there. If you own one share in JP Morgan, you don’t own them. You can’t actually control how they operate. Similarly, if you have one governance token in a DAO, you won’t control or meaningfully influence how the DAO operates. Because this is a system where, already, you see founders are keeping tokens. The concentration of wealth in crypto is already totally lopsided. So the idea of the little people having a say is really marketing at best and deceptive at worst. It’s just…not how it’s going to work.

One of the points I’m trying to make in that essay is that, where there’s money to be made from intermediaries establishing themselves, intermediaries will appear. If there’s money to be made by controlling a DAO and the DeFi protocols it administers, then somebody will be in there making a majority of that money. And those will be the people who’ve been in the ecosystem from the beginning. That means those in the venture-capital firms. They’ll make a ton off this. To suggest that what I’m describing is democratizing the ability to control how our financial system works is totally disingenuous. Because we haven’t changed the underlying incentives of the financial system. We haven’t changed any of the structural or political issues…

Warzel: We’ve just put them on the blockchain!

Allen: …and it could be worse in this new iteration if we don’t have the regulatory mechanisms.

Warzel: Yes, I wanted to get to this. You argue it’s time now to bake in regulatory processes rather than wait until crypto gets more interwoven into the financial system. I know the Biden administration issued an executive order on crypto, but it was very vague—a sort of “We have our best people on this” type of thing. But, say you are king of the world for a day. What would you do, regulations-wise?

Allen: The first order of business is to create a Glass-Steagall system for crypto. Glass-Steagall is the legislation put in place after the Great Depression to separate banking and securities. What I’m suggesting is that banking and crypto be kept separate—so that if there’s an implosion of the crypto world (for me it’s a when, not if), the consequences stay largely in the crypto system, but wouldn’t have spillover effects to the broader economy. In the early 2000s, when the dot-com bubble burst, we didn’t have a broad-based, 2008-style recession. That is, in part, because banks didn’t have huge exposures to internet companies like they did to the mortgage sector. It contains the potential fallout.

In some ways, I think there could be a lot of political support for something like this. Because people who have support for crypto see it as an alternative to the banking system. If you truly believe that, then you should not integrate it with our current banks. You should keep them separate, so that if crypto succeeds, then it could maybe live up to its promise. And if it doesn’t, the banks won’t be taken down by it. And it makes the economy as a whole more robust.

Warzel: You argue in your essay that, essentially, we need to slow down DeFi, and that critics are going to see this as an attack on innovation. I find this is a huge tension right now, especially between, say, Silicon Valley and people who are critics of new technology. There’s an argument that building new things is a universal good and that critics are jeopardizing progress. The builders argue that, yes, there may be problems that arise, but the most important virtue is to keep pushing forward. I should be clear I think this is a pretty facile premise, but it puts critics in a difficult position. For example, I’m not anti-progress or anti-innovation. But I’ve also spent enough time in the “move fast and break things” world to understand what happens when we build without an eye toward what our tools might do if they succeed. As a very clear critic of crypto, how do you hold all this in your head?

Allen: For me, it’s about incentives and negative externalities. What are the incentives for innovation? What are the social problems? We won’t solve any of it if the only motive for building is profitability and shareholder value.

What the broader public is looking for are win-win situations. We don’t mind rewarding people for building great things. That’s how this works. But win-win outcomes require a bit of guidance, regulation, and oversight to make sure that the tech is providing social outcomes as well as profits.

In the absence of any constraint, innovation will be profit-mining and seek to maximize those profits. When I push back on crypto people, some say: “Don’t tell me how to invest my money. I will take on the risk if I want to.” And I’m tempted to say, “Okay; that’s fine. Or it would be if it was only you we are talking about.” But it’s never only just one person. It’s so much bigger. There are so many consequences for others. There are the environmental externalities, like the energy that comes from mining. There are national-security issues, like the potential for sanctions evasions. My expertise is in the area of financial crises, so that’s where I look. And here, I say that of course you can invest where you want—but if you invest in ways that add great fragility and instability into our systems and it ends up blowing up the economy, it will ultimately hurt people who never invested. Innovation is not an unqualified good.

Warzel: Before I let you go, you mentioned before we began this interview that you’ve been studying crypto’s evolution since 2015, and that each time you’ve written about it, it seems more of the things you were concerned about have come to pass. I am curious about the crypto-hype moment we’re in right now, and the ways that it seems more entrenched than it did during, say, the 2017-2018 run. It’s especially interesting to me because, like I said, beyond buying and selling a coin on an exchange like Coinbase, so much of Web3 is deeply inaccessible to most people. Why do you think so many people have gotten involved? Is it just part of a casino mindset—that it’s easier than ever, and there’s a lot of flashy apps that lead people here? Or is there something deeper?

Allen: The casino mindset is huge. But that is linked to broader structural problems. People think the system is rigged, and they’re not wrong. When people think the system is rigged, they say, “Well then, why not bet?”

I’m on Amtrak a lot these days, and I looked up recently and realized I was surrounded by sports-betting ads and crypto ads. When it feels like you can’t get ahead the normal way, people start gambling more. Just in general, society is gambling more. I think it’s part of that. But financial inclusion is a deep-seated structural problem, and it needs solutions that are structural. There’s a way for technology to assist here. But I don’t think what we’re seeing is the answer."

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