Blockchain technology has enabled significant changes to the global capital markets. Many commentators have exclaimed that there are truly new activities occurring on blockchain rails. This is not the case however – all blockchain DeFi activities map back to existing finance activities, though the DeFi activities may be performed differently than in traditional finance.
To better understand this, consider something we call the “Mirror Hypothesis.” The Mirror Hypothesis posits that for every traditional financial activity, there exists or will exist a blockchain-based counterpart powering that same activity or behavior, even if it exists in different forms. Further the Hypothesis notes that activities that launch in DeFi without a proven traditional counterpart, will struggle. This hypothesis not only underscores the adaptability of blockchain technology but also highlights the potential for innovation within established financial frameworks.
Understanding the Mirror Hypothesis
The Mirror Hypothesis posits that blockchain technology replicates traditional financial instruments and processes in a decentralized environment. This replication is not merely a one-to-one copy but often involves reimagining and restructuring these financial opportunities to leverage the unique advantages of blockchain. Despite these changes in structure, the fundamental functions and goals of these financial instruments remain consistent with their traditional counterparts. And while access to a given financial instrument may be greatly expanded (whether in a compliant manner or not), it is important to note that the underlying financial activity and demand for it will always matter to the long-term popularity of the activity in blockchain.
Mirror Hypothesis: All long-term successful blockchain financial protocols are reflections of traditional finance actors and activities. Traditional finance systems are or will be reflected in blockchain technology. Blockchain systems with no analogue will not succeed long-term.
- Corollary: All tokens represent some component of a traditional financial system, though the tokens and associated ownership and financial activities may be organized differently between traditional and blockchain financial markets.
Consider, for example, a checking account, a financial instrument that allows a user to save money in a stable reference currency. This account holds the value stored in that reference currency stable and allows the user to easily transact with the funds by drawing a check. Funds that are transferred between accounts at the same bank never leave the bank. Funds that go inter-bank are transferred via SWIFT or other rails.
Based on the statements of the Mirror Hypothesis, we should expect to find a blockchain protocol that maintains a stable value of assets deposited in a reference currency and allows for easy transfers. USDC is a good example of such a reflection. The token USDC can be understood as a checking account. Instead of funds being deposited in a bank, an authorized user buys USDC from Circle. Transfers of USDC on-chain reflect transactions between account holders of the same bank. Off-ramp transactions are simply inter-bank transfers (which happen to interact with the existing financial ecosystem.
Applying the Mirror Hypothesis
The Mirror Hypothesis is powerful because of what it tells us about what can be successful in blockchain and what will fail to succeed long term. Specifically, if there is no successful example of a particular type of product in the traditional finance ecosystem, there will be no long term success in the blockchain markets. Let’s consider two protocols: Terra / LUNA and Uniswap.
Terra / LUNA built an ecosystem around an unbacked financial instrument equivalent to a bank account. The Mirror Hypothesis suggests that if there can be a successful unbacked financial instrument that looks like a bank account, we should be able to see it in the traditional financial ecosystem. Unsurprisingly, we find few examples of these instruments that go anywhere: Ponzi schemes (generally), Bernie Madoff’s fund, and others of this sort. (Note: Some will suggest that the US Dollar is an unbacked financial instrument. We disagree – the US Dollar is backed by the requirement that taxes be paid to the US Government in US Dollars and the threat of force for not paying taxes.) Banks even are backed by the assets they hold (i.e., loans) and further by the US Government.)
Uniswap has created an exchange platform for exchanging tokens (ignore for a moment what any token financial instrument itself is). We should be able to use the Mirror Hypothesis to identify a reflection of an exchange in traditional financial markets if we think Uniswap will be successful long term. Surprise surprise, we can find this – the New York Stock Exchange for example.
Applying the Corollary to the Mirror Hypothesis
The Corollary states that all tokens relate to an equivalent activity in traditional financial markets, whether or not the activity or token is described that way or the activity is organized differently.
Digging into a given protocol allows us to see how its tokens are reflections of traditional finance. Again, consider Uniswap. The Uniswap ecosystem consists of two primary tokens: UNI and Uniswap liquidity tokens (“LTs”). Starting with UNI – this token is often described as the governance or protocol token – holders get to vote on matters of protocol governance. In the traditional financial sector, the NYSE issues stock. Its shareholders get to vote on governance topics including its CEO and board of directors. UNI is a reflection of corporate stock.
LTs also have reflections. LTs represent capital deployed in the activity of market making on Uniswap for specific tokens. Similarly, at the NYSE, some of its members are market makers. These market maker entities have capital and deploy that capital into making markets in the shares of different companies. The LTs are reflections of market maker capital, in a more specific and defined format and organized differently.
Implications for Regulation
While all DeFi protocols are reflections of traditional finance activities and businesses, regulators for DeFi should not attempt to apply the Mirror Hypothesis and simply port over regulations from one space to another. Regulatory frameworks designed for traditional financial activities often do not seamlessly apply to their blockchain counterparts. Regulators who apply the “same activity, same risks, same rules” principle will often find better rules and investor protection by considering a “same risks, equivalent mitigations” approach. This is because while the Mirror Hypothesis suggests the behaviors will exist, they may not appear in the same form and thus might not fit existing rules.
For example, while Uniswap LTs may provide the capital for market making services on the platform, the risk of an LT is less like the risk of investing capital or making a loan to a market maker business and more like the risk of an option on the underlying token. This approach calls for Uniswap LTs to be regulated as options on securities or commodities, whichever the underlying token is. Similarly, USDC tokens rather than being treated as debt securities of an issuer may be better treated as bank deposits and regulated accordingly.
Where Innovation Will Occur Going Forward
The Mirror Hypothesis offers a valuable framework for understanding how blockchain technology is transforming global capital markets. It also allows an observer to scan for elements of the traditional financial markets not yet in blockchain: what is not present and can be built, what could be simplified, what can be offered that is similar to existing products.
Ethena is an example of this – existing financial markets have long had hedge funds that earn returns from delta neutral positions. Building a copy of such a fund in blockchain is completely predictable through application of the Mirror Hypothesis – as is Ethena’s (or a similar business’) long-term success as a hedge fund. However, the USDe token is unlikely to long-term serve as a USDC replacement because there is no example of a unit of account and storage that has been long-term successful and whose supply expands and contracts rapidly as interest rates vary. USDe is more akin to a variable rate CD or hedge fund share – and we do not see those regularly used for any transactions other than investments.
Protocol investors should be looking for successful analogs in the traditional financial ecosystem to confirm whether they are investing in the next UNI or the next LUNA token.
