VC Perspective: The Hyperliquid Event Exposes the Power Struggle Between CEX and DEX

Original Article Title: Exchange War Erupts: Hyperliquid vs. Binance OKX - The Chopping Block

Original Source: Unchained

Original Translation: Deep Tide TechFlow

Guests:

· Haseeb Qureshi, Dragonfly Managing Partner

· Robert Leshner, Superstate CEO Co-founder

· Tarun Chitra, Robot Ventures Managing Partner

· Tom Schmidt, Dragonfly General Partner

Key Highlights

The JELLYJELLY Crisis at Hyperliquid – How a highly anticipated DeFi project lost market trust due to using a false price oracle to rescue its treasury.

Escalation of Exchange Platform Competition – Binance and OKX listing JELLYJELLY perpetual contracts seen as a precise strike against Hyperliquid.

Is Decentralized Exchange Truly Decentralized? – The Hyperliquid incident exposed the issues of validator power centralization behind the performance of so-called "decentralization."

DNA On-Chain: Blockchain's 23andMe – Say Foundation proposes protecting genetic data through a token threshold; is this truly innovative for privacy protection, or a dystopian notion?

The Scam of Decentralized Science (DeSci) – Tarun once again critiques the DeSci concept and explains why the risk of putting genetic data on-chain is more severe than a meme coin.

Stablecoin Regulation Battle – The "Stable Act" and "Digital Asset Market Structure and Investor Protection Act" clash in Washington, but who will come out on top?

The Possibility of Stablecoins as Narrow Banks – The rise of cryptocurrency may force the Federal Reserve to accept a financial concept they have resisted for 20 years.

The Future Bet of HLP Deposits – The host makes a real-money bet on whether the deposit volume of Hyperliquid will recover or continue to decline after the Hyperliquid collapse.

Memecoin and Olympus's New Trends – Are the former "raiders" quietly earning profits from the broken vaults?

Tarun's Failure Leaderboard – Why is JELLYJELLY's failure worse than MobileCoin's, but at least it fits Hyperliquid's branding?

Hyperliquid Event Unfolding

Haseeb:

One of the biggest stories this week is the drama unfolding on Hyperliquid. For those unfamiliar, Hyperliquid is a new popular DEX, now the top DEX by overall trading volume. They conducted a large-scale airdrop, loved by crypto retail investors for the scale of the airdrop and fair launch.

In recent days, Hyperliquid has faced a large-scale attack centered around a memecoin—JellyJelly, a low-liquidity memecoin past its prime but listed by Hyperliquid as a trading pair. A trader opened an $8 million short position on JellyJelly, equivalent to 50% of Jelly's circulating market cap at the time, a massive short position. The trader then manipulated the spot price of Jelly, forcing their own liquidation.

So, why would a trader do this? Why force their own liquidation?

On Hyperliquid, when a position cannot be liquidated in the normal fashion, the HLP (Hyperliquid's crowdfunded market maker) takes over the position and tries to liquidate it in an orderly manner. HLP's presence is crucial to Hyperliquid's liquidity, always providing liquidity to traders. However, due to the massive size of this position, HLP was forced to short Jelly, but there were no takers in the market for this short position, ultimately leading to what's known as a "short squeeze."

This short squeeze is not just a prank by retail investors. In fact, the two major exchanges, OKX and Binance, were indirectly involved as well. When the market realized that Hyperliquid or its HLP was heavily shorting Jelly, OKX and Binance announced that they would list JellyJelly's futures trading within 24 hours.

Almost everyone believed this was a "war between exchanges." CZ and the CEO of OKX had already set their sights on Hyperliquid, seeing this as an opportunity to strike back.

Hyperliquid's validators voted to delist JellyJelly and, through manual adjustment of the oracle price, forcibly liquidated the position at a price below the market rate.

Haseeb:

This decision by Hyperliquid sparked widespread controversy. They argued that rather than making the platform or HLP holders bear the losses, it was better to artificially lock the price at a false low to safeguard the interests of HLP users. However, this action led to a significant drop in Hyperliquid's token price, plummeting from around $21 to $15, a nearly 25% decline in a single day.

This event raised two core questions:

· Firstly, was Hyperliquid's response in this situation reasonable? Does their mechanism design have fundamental flaws?

· Secondly, has this exposed that Hyperliquid's level of decentralization is not as high as it claims?

These questions have sparked intense discussions in the industry, with some centralized exchanges (such as Bitget) openly criticizing Hyperliquid's unfair practices. The competition among decentralized exchanges has also intensified, and the DeFi space seems to be at a critical turning point.

So, what are your thoughts on this HLP event?

Tarun:

I believe this event indeed exposed some flaws in the protocol design. Just like Automated Market Makers (AMMs), AMM mechanisms do not allow for order rejection. For example, both the initial Unicorn v2 and v3 lacked flexibility in this regard, where you couldn't choose to accept or reject specific orders. This issue also exists within Hyperliquid's liquidity pools.

The HLP mechanism of Hyperliquid differs from other platforms (such as GMX's GOP and Jupiter's JLP). The operation logic of HLP is that users deposit Ether (ETH), and the platform allocates these ETH to multiple assets for liquidity provision. For example, 1% of the ETH might be used to provide liquidity for JellyJelly, 90% for Ethereum, and the remaining portion for Bitcoin. This asset allocation is determined by an off-chain algorithm, and users need to trust Hyperliquid team's asset allocation ability.

Evidently, they made some mistakes in the mechanism design, such as not setting position limits and unclosed contract limits. If these limits were in place, the issue could have been mitigated without the need for emergency interventions. Hyperliquid has indicated that they will address these mechanisms, including increasing unclosed contract limits and concentration limits.

This is why I mentioned when describing this issue that liquidity pools that do not differentiate between order types have certain limitations. Under the current mechanism, HLP cannot selectively process orders, meaning it cannot reject certain orders and only accept specific types of orders. If HLP could differentiate positions subject to third-party forced liquidation, the market could price based on the actual value of these positions, and HLP would not have to incur unnecessary losses. However, the current design has HLP automatically trading with these positions, similar to how the Unicorn pool operates. Therefore, they lack sufficient restrictions in strategy design. These strategies are actually run off-chain by the Hyperliquid team and are not executed on-chain publicly transparently.

I am not sure what their code implementation looks like, as most of the code is not open source. Although I can run a node, I can only obtain binary files and cannot view the source code. Furthermore, many system settings are also not sufficiently transparent. This incident clearly demonstrates a significant flaw in their strategy limitations. I believe this is an issue they acknowledge needs to be prioritized for fixing. However, from a market perspective, it also highlights the value of having a more open strategy rather than being completely closed as it is now. Because as it stands, there is almost no transparency to the external operation of the HLP mechanism.

As a depositor in HLP, you actually do not know whether HLP has clear risk limits, such as automatically bearing the entire liquidity pool's position risk. You also cannot determine if they will intervene in the market by artificially adjusting oracle prices as they did in this incident. Although some related content is mentioned in the documentation, due to the unavailability of open-source code, users cannot verify the actual operation of these mechanisms. Even with closed-source code, there is a lack of other verifiable proof to confirm its behavior.

I believe that the mechanism provided by Hyperliquid ensures a difference in transparency compared to what users would expect in other protocols. In other protocols, users can clearly understand the operational logic of the strategy, although this transparency may require some trade-offs in efficiency and flexibility. The strategy of Hyperliquid, however, is not public, which indeed increases capital efficiency but also diminishes user trust. This trade-off is not entirely wrong, but evidently, in certain decisions, they have made less than ideal choices. However, these issues are understandable and can be rectified.

Controversy Over Market Rescue Decisions

Haseeb:

Is rescuing HLP depositors reasonable? Clearly, HLP may face significant losses in this event. Do you think this was a wrong decision?

Robert:

I believe it was a mistake, to be frank. Dealing with market issues after the platform's risk parameters spiral out of control is one thing, but liquidating in a way that benefits the HLP pool through intervention seems inappropriate. In the world of derivative markets, one party's profit usually signifies another party's loss. In this circumstance, the Hyperliquid team and validators seemed to have erroneously picked winners and losers.

HLP liquidity providers should bear the risk. If the liquidation is successful, they profit; if it fails, they accept the loss. However, this liquidation operation resulted in gains for HLP, meaning other market participants suffered losses. I consider this a violation of market fairness. If they insisted on intervening in the price, they should not have chosen a price that benefited themselves. What's even more perplexing is that the price they chose was even below the market price at the beginning of the event, clearly aiming to position themselves as winners.

Tom:

I agree. This behavior has also made the relationship between HLP as a product and the entire Hyperliquid platform delicate. HLP is just one of the liquidity pools; users can choose other pools and operate different off-chain strategies. HLP is positioned as the "official liquidity pool" of Hyperliquid, but theoretically, anyone can create a liquidity pool. Therefore, most people would not assume that HLP would receive any special treatment. However, this event made it feel like HLP was given some form of preferential treatment.

Some people have compared this event to the "loss socialization" or "automatic deleveraging" mechanism of traditional derivative trading platforms, but the two are not the same. In traditional mechanisms, when the market overall falls below the margin level, the trading platform will freeze positions and spread the losses to the insurance fund. However, in this event, HLP's loss state was only remedied through manual intervention, and Hyperliquid itself did not face default risk. This raises questions, why was HLP able to act as a trading platform's primary liquidity provider? If HLP's operation failed, why was it rescued?

Robert:

And it was rescued in a profitable way, which is just insane.

Tarun:

Indeed. What's even more ironic is that HLP's holders decided on the rescue price through a governance vote, indirectly bringing themselves profits.

Robert:

Can you elaborate on that? How did HLP holders participate in the Hyperliquid validation process?

Tom:

HLP holders can delegate their voting rights to a validator, but some validators require KYC, so the mechanism is a bit complex.

Tarun:

Validators control the oracle's price, thus determining the oracle's price adjustment through governance voting. In other words, HLP holders actually indirectly participated in voting through governance.

Haseeb:

Yes, this has received a lot of criticism. Because the Hyperliquid Foundation holds an absolute majority of the HYPE token's voting power, in this case, HYPE holders rapidly voted through delegation. However, this whole process took only two minutes, from the start of voting to the end, and the so-called voters had almost no real say.

Robert:

On whether the launch of contracts on other trading platforms will affect Hyperliquid, I am still somewhat confused. The contract market and the spot market are relatively independent trading venues. Even if there is increased demand for the JellyJelly contract on Binance, it may not directly change the Hyperliquid or spot market price because the spot price is controlled by an index, which also determines Hyperliquid's funding rate. So, what is the specific mechanism of this impact?

Haseeb:

First, if Binance wants to launch a spot market, they need to acquire actual spot inventory, which takes longer to accomplish. However, launching a futures market is faster than a spot market because a futures market doesn't require actual spot inventory. As long as there is sufficient demand, users can start trading futures without immediately impacting spot prices.

Robert:

For every long position, there is a corresponding short position, and every long has a short.

Haseeb:

Exactly. But structurally, launching a futures market is simpler. If you say, "Hey, I want to take these guys down as quickly as possible, and time is of the essence," then the fastest way is evidently through futures, not spot.

The purpose of launching the futures market is to get more people involved in the short squeeze. If Hyperliquid is experiencing a short squeeze, opening the futures market will exacerbate this trend.

Tarun:

This mainly depends on the dynamic change in the funding rate. In this event, the funding rate skyrocketed by 300% in a short period, causing the market to be extremely unstable.

OKX and Binance Joining

Haseeb:

The funding rate spiked by several hundred percentage points. This was a very intense short squeeze, so the market expects this matter to settle quickly. I speculate that Binance and OKX may delist the JellyJelly contract in one to two weeks because evidently, the market doesn't really have a demand for this product.

Tarun:

No one really needs JellyJelly.

Haseeb:

However, I find it interesting that the mechanism of this event may be hard to grasp, especially if you are not familiar with how the futures market, liquidity providers, and HLP operate. Let's simplify things first. The essence of the matter is that Hyperliquid found itself in a high-risk position, and Binance and OKX are attempting to further weaken Hyperliquid's position through market operations. More specifically, their goal is to force HLP, not Hyperliquid itself, into insolvency.

This behavior is very aggressive, isn't it? Some have compared this event to CZ's previous actions against FTX, but I don't think the two are similar. Because at that time, CZ had no reason to believe that selling FTT would directly lead to FTX's bankruptcy. If we look back at the Bitcoin hack incident, Binance and Bitget actually lent out Ether to help Bybit cover the shortfall and maintain its operations. Therefore, their behavior in that incident was completely different from how they are treating Hyperliquid now. I currently don't have a good theory to explain why Binance and OKX would take such a strategy.

Hyperliquid's behavior implicitly conveys a signal, that is, HLP has some kind of protection mechanism. If HLP incurs significant losses, Hyperliquid will proactively intervene to protect it. From the market's response, Hyperliquid's price is very sensitive to changes in HLP's situation, which has left me puzzled. I am curious about the connection between HLP and Hyperliquid's value. Perhaps I am missing some key points about the HLP economic model.

Tarun:

Indeed, HLP does not have a clear economic model. It is more like a pure liquidity provider, not closely related to Hyperliquid's core mechanism. But what I find strange is that I tend to view the HLP pool as a kind of debt instrument since it operates by raising funds from depositors.

Haseeb:

I think this is more like equity rather than debt.

Tarun:

No, HYPE is the equity. That's the confusing part.

Haseeb:

What I mean is, from a market operation perspective, HLP investors actually receive all the profits. So it's more like equity rather than debt.

Robert:

To some extent, that's true. Liquidity providers use the USDC deposited by users to trade in different markets.

Haseeb:

Moreover, the user ultimately receives all the benefits, so this is not like traditional debt.

Tom:

I believe the main reason for the HYPE token price drop is that this event has created uncertainty about the future of the trading platform. After all, if a trading platform has privileged liquidity providers who will never incur losses, why would anyone else trade on this platform? This is actually a problem that all trading platforms with internal market makers will face: how significant are these privileges?

Tarun:

There is a somewhat pessimistic view that most of HLP's liquidity actually comes from the Hyperliquid team itself. So they are not willing to incur this loss.

Another reason to see HLP as a debt instrument is that it receives funds from depositors and uses these funds for market-making activities across various markets. In a sense, it plays the role of a "local lender." Similarly, protocols like Jupiter and GLP are explicit lending protocols that charge fees in this manner. HLP, on the other hand, profits from fees and spreads. If HLP defaults, as in this case, depositors would have priority claims.

So I believe HLP is more like a debt holder, while HYPE is the true equity instrument. Because HYPE is the core asset that can control key mechanisms like the oracle, and this control is the essence of equity.

FTX Moment?

Haseeb:

Hyperliquid is more like a trading platform, and HLP is a tool the trading platform uses for market operations. HLP can be seen as equity in market operations, while HYPE is the equity of the trading platform itself.

Robert:

In fact, I think we should learn from the FTX event. Trading platforms and entities similar to hedge funds (such as teams conducting proprietary market-making within the trading platform) should be completely separated. This is the only way to avoid conflicts of interest, right?

Tarun:

It is worth mentioning that Hyperliquid's mechanism is quite different from FTX. On Hyperliquid, I can view every transaction of HYPE and HLP at any time and withdraw funds whenever I want. This transparency makes it easier to supervise. I agree with this point, and I do not think Hyperliquid's approach is fundamentally wrong.

Haseeb:

If a trading platform provides protection to a liquidity provider, explicitly stating that this provider will not face losses, then the trading platform and the liquidity provider are essentially tied together. It's as if the trading platform team itself is operating this liquidity provider. If you do not trust that team to operate the liquidity provider well, then do not invest in that liquidity provider's equity.

Tom:

But the question is, how did this situation come about? For example, "We have a fund pool that can be launched, and here is another liquidity provider to invest." At first glance, this seems like an open choice, but in reality, this is just a unique liquidity provider.

Tarun:

Indeed, this is a unique situation. If you look at other liquidity providers, such as Seafood, they are always losing money. I don't understand why people are still willing to fund them. His past record shows very severe losses.

His fund pool is indeed interesting. But my point is that there is already a problem of adverse selection in these fund pools. It wasn't until this event happened that people really realized the close connection between HLP and Hyperliquid, and now this connection has become even more evident.

Robert:

I think even before this event, they were not separate. The Hyperliquid team is operating a major liquidity provider, which is the platform's core liquidity provider. Although the economic benefits belong to the users, the owners of the trading platform effectively operate this main liquidity provider and also control the liquidation mechanism.

Haseeb:

True, the connection between Hyperliquid and the liquidation mechanism does indeed put them in a somewhat privileged position. However, on the other hand, this also forces them to take on high-risk positions that other liquidity providers may be unwilling to take.

Robert:

Similar to the Alameda situation, whether they like it or not, they had to take on all the bad positions on FTX, including some high-risk assets. This ultimately led to the collapse of the trading platform. While they were forced to take on these risks, it is also a form of responsibility to some extent.

Haseeb:

In theory, the rationale behind this arrangement is that even if the HLP's funds get liquidated to zero, Hyperliquid can still operate. That's the ideal design. If all mechanisms are mixed together, the overall system design becomes unreasonable.

Tarun:

Sensory-wise, I feel being taken down by MobileCoin is better than being taken down by JellyJelly. MobileCoin at least tried to be a real project, while JellyJelly seems more like a venture capitalist joke.

Haseeb:

Following this event, people might think that HLP and Hyperliquid are closely linked. This may lead to third-party market makers or liquidity providers reducing their activity on Hyperliquid because they realize they are not on the same competitive level as HLP.

Tarun:

To be fair, I've observed many market makers participating in reducing their involvement. This phenomenon is not new, but now they have more explicit reasons to reduce activity.

Haseeb:

On the other hand, you might see more capital flowing into HLP because people now realize the protocol may protect their investment.

Tarun:

We can use the DeFi AMA as a benchmark.

Haseeb:

Will it rise or fall? As of now, it has already dropped.

Tarun:

Yesterday's deposit amount was $1.85 million, three days ago it was $2.96 million, and on March 24th, it was $3 million. I think this is a good baseline time. It has now dropped to $1.85 million. I see two possibilities. One is as Haseeb mentioned, because it is seen as a product similar to insurance, funds will flow in; the other is that due to a decrease in confidence, transaction platform fees may decrease. I am not sure which one will prevail.

Robert:

I think the risk has increased. If the event is serious enough, the platform may intervene and close the market, setting a resolution price so that HLP does not suffer losses. We just saw this in the JellyJelly incident. This is indeed a protective measure, but it also exposes the vulnerability of Hyperliquid's mechanism to small assets. The possibility of such an attack recurring has increased by at least an order of magnitude.

Haseeb:

I totally disagree. But no one will try this again now.

Tom:

Of course, HLP's strategy on the trading platform is clearly evolving to reduce risk. So, this does not mean that these events are completely independent.

Robert:

But this is not an isolated incident either. Two weeks ago, there was a similar attack in the Bitcoin market, which was a very large asset. The exact attack parameters occurred two weeks ago.

The Future of 23andMe and SEI

Haseeb:

Let's talk about DeSci. Recently, there has been a major news in the DeSci field, the SEI protocol, which is a high-performance Layer 1 EVM chain, announced that they are making their boldest DeFi investment to date.

The SEI Foundation plans to acquire 23andMe, a recently bankrupt gene company. They have pledged to protect the genetic privacy of 15 million Americans and ensure the security of this data for future generations. They plan to migrate 23andMe's data to the SEI chain, return data ownership to users through blockchain encryption technology, allow users to decide how to monetize their data, and share the proceeds. This is not just about saving a company, but about building a future where users still have control over their most private data.

Tarun:

Does anyone on the SEI team truly understand privacy-preserving technology? I highly doubt it. If you were to tell me that there is an expert in privacy protection within this team, then I would find it more meaningful. But as it stands, this seems to be a team looking to spend a significant amount of blockchain funding, their approach even worse than those companies merely seeking acquisition.

Haseeb:

If they were to successfully achieve this goal, would you support it? Perhaps you could advise them and provide some professional insights.

Tarun:

If this were to happen, most other bidders at present are mostly computational biology companies, such as AI drug discovery firms. Their aim is to utilize 23andMe data for training AI models. This has sparked controversy because many users are concerned about the misuse of their data. For instance, I purchased 23andMe's service eight years ago when their privacy policy promised not to share data with third parties, but now that the company has gone bankrupt, this data could be used for drug development without my consent for such use. This concern is understandable. So, the core issues here are twofold: privacy protection and data monetization methods.

What people are mainly concerned about are the terms of service or privacy aspects, as well as the monetization aspect. One of the main goals of everyone attempting to acquire the company is purely monetization, such as these computational biology drug discovery companies. Then there are some trying to bid like nonprofit organizations, of course, along with participants from the DeFi world.

If blockchain can indeed bring about a breakthrough in data monetization, it might trigger a wave similar to the 2017 ICO craze, but I doubt it will fail again. If they can genuinely find a way that both protects privacy and enables data monetization, then that would be something to look forward to. However, from what I can see now, merely claiming to "let users own their data" is not enough because so far, I have not seen any successful examples. This reminds me of Tom's previous complaint, where people were lamenting that studios were not monetizing content through blockchain, but that's not the crux of the issue at all.

Tom:

Indeed. And I am curious how they will go about the acquisition, as far as I know, 23andMe still has $200 million in debt. Unless they have devised a very complex financing structure or attract investors with SEI tokens.

Tarun:

The issue is that most other bidders are large companies, and SEI's chances of winning seem low. However, emotionally, many people hope that the company can have a better outcome rather than being acquired by a bidder looking to monetize the data. If SEI could propose a plan that preserves the original terms of service and protects privacy, then I think they should give it a try. However, this also means they would need to rely on validator support, as they are essentially borrowing from the future earnings of validators.

Robert:

From a macro perspective, currently, this data is all stored in a bankrupt company's database. Generally speaking, migrating data to a blockchain may not be any more secure than the current way. In fact, it may increase the risk of data leaks. Of course, this depends on the security measures adopted, such as encryption technology, Zero-Knowledge Proof (ZK), etc. But overall, I don't think this will significantly improve privacy or security.

Haseeb:

Assuming, as Tarun said, the current situation is that a company has acquired this database and is handling the data arbitrarily. This is clearly not what we want to see, but theoretically, such risks do exist. I have always been skeptical of the concept of "data ownership." For example, some propose encrypting data and putting it on the blockchain, authorizing others to use the data through decryption keys. But I have never seen this approach truly solve the problem.

Tarun:

This is also my concern. If blockchain practitioners lack an understanding of privacy protection technology and try to address such issues, they often end up doing more harm than good. For example, they might exhaust all funds but inadvertently leak data due to operational mistakes. What's worse, this data may be used by certain countries to develop bioweapons.

I prefer teams that focus on fundamental encryption technologies to handle this, such as teams researching Zero-Knowledge Proof or Homomorphic Encryption. But even with these teams, they may not be adept at scaling the technology for commercial purposes.

Haseeb:

It's been three months since you declared war on DeSci, how's the progress?

Tarun:

To be honest, I've already given up. For example, projects like Bio Protocol have now almost disappeared without a trace. I think everyone has realized that most of these projects were scams.

My point of view is that the DeFi craze is essentially a better-packaged meme coin. It rebranded itself to attract those who are disgusted by traditional meme coins. These people are actually still trend-chasing speculators. The operation of DeFi is more like donating to a non-profit organization, but it lacks a mechanism to verify its charitable nature.

Stablecoin Legislation: Genius Act vs. Stable Act

Haseeb:

Now, Congress is pushing forward a new stablecoin bill. Previously, we mentioned the Genius Act proposed by Kirsten Gillibrand, and now there is a bill introduced in the House called the Stable Act by French Hill.

Robert:

These two names sound like a combination of 'stable' and 'genius,' a bit like 'stable genius,' don't you think? Perhaps that's where they drew inspiration from, as if referencing Trump's 'stable genius' remarks.

Haseeb:

The new bill is called the Stable Act. To more clearly contrast the Genius Act and the Stable Act, the main difference between them is as follows: The Genius Act is more industry-friendly. It allows banks and non-bank entities to issue stablecoins, with state regulatory agencies also being able to participate in regulation, not just federal agencies. It also supports interoperability and allows for interest payments in certain cases, overall encouraging stablecoin innovation and growth.

In contrast, the Stable Act is more stringent. It stipulates that only banks or approved bank subsidiaries can issue stablecoins, and they must be subject to direct oversight by the Federal Reserve. Additionally, it imposes more restrictions on the types of reserve assets, does not allow interest payments, and enforces a two-year moratorium on algorithmic stablecoins, although existing stablecoins will have a transition period.

Robert, you recently participated in lobbying activities in Washington DC regarding stablecoin legislation. How do you feel about the reception of this bill?

Robert:

I happened to be in Washington DC on Tuesday and Wednesday, where I met with about 15 members of Congress. Apparently, the most discussed topic was stablecoin legislation.

Robert:

I feel that both sides have shown great interest in enacting legislation favorable to the cryptocurrency industry, and there hasn't been much controversy. Stablecoin legislation is currently the most pressing issue because both sides recognize the need to establish a legal framework for stablecoin operations. This legislation is relatively straightforward, so it may become the first major cryptocurrency legislation. Although there are still some disagreements to be resolved between the House and the Senate, overall, I believe these differences will not be obstacles. After stablecoin legislation, there may be more discussions about market structure, but the current focus is primarily on stablecoins themselves.

At the same time, there have also been many discussions about the market changes that stablecoin legislation could trigger. Overall, the industry generally believes that this legislation will lay the foundation for the future market structure. While this goal may take some time to achieve, the current discussions and focus are almost entirely on stablecoin legislation itself.

It is worth noting that in my conversations with some crypto-friendly lawmakers, I sensed their strong support for stablecoin legislation. While this may carry some bias, overall, the reconciliation of differences between the House and the Senate is expected to proceed smoothly, and the prospects for legislative progress are very optimistic.

Will Stablecoins Become the "Trojan Horse" of the Crypto World?

Tarun:

I first heard about the concept of a "Narrow Bank" in 2009. At that time, many were discussing narrow bank legislation. Although this made me seem a bit old-fashioned, at that time, everyone was discussing this model: should there be a strictly limited bank that can only provide very basic types of returns.

Haseeb:

Could you explain what a Narrow Bank is?

Tarun:

The definition of a Narrow Bank has evolved over time, but the core idea is to simplify banks. Especially after the financial crisis, some proposed whether banks should be subject to stricter regulations, such as restricting their involvement in trading or other complex activities? Or, could a bank be created that only provides basic services, such as deposits and loans, without engaging in other complex business? Interestingly, many early fintech applications were somewhat like "pseudo narrow banks." They allowed users to deposit funds, but offered minimal return products. Users might indirectly purchase government bonds through these platforms or, like Square, provide bitcoin services, but these platforms themselves do not engage in complex investment activities, such as proprietary trading or bond portfolio investment.

In a sense, many of the stablecoin-related bills remind me of the concept of narrow banking. Stablecoins themselves do not yield interest, and the use of a banking license behind them makes it very interesting to me. The idea of narrow banking has been around for almost 20 years, and now it is finally being realized through blockchain technology. I feel like history is repeating itself, just at a very slow pace. After all, there was a period of nearly a decade in the U.S. where no new banks were established, and no new bank charters were issued.

Robert:

My understanding is that the core of narrow banking lies in depositing all funds at the Fed's discount window, maintaining 100% liquidity. This way, the bank does not need investment analysts or loan officers; all deposits are given to the Fed to earn interest, and then paid back to depositors after deducting a certain fee. In a sense, this is basically a branch of the Fed.

This model is a full-reserve bank, with 100% liquidity, eliminating liquidity risk. In theory, only a dozen or so employees would be needed to manage a large-scale banking system. But the reason people are against narrow banking is that it competes with existing commercial banks. Commercial banks expand the money supply through loans, while narrow banks only deposit funds at the Fed, reducing the liquidity of high-quality assets like mortgage loans.

Haseeb:

I believe the Fed rejects narrow banking because it weakens its direct ability to intervene in the money supply. Although mortgage loans can still be provided by private lenders, once the market fully shifts to private lending, the Fed will lose direct control over monetary supply expansion.

Robert:

From another perspective, the Fed may actually gain more intervention ability because the adjustment of overnight rates affects all market participants.

Haseeb:

If there still exists a reserve requirement, indeed. The reserve requirement is the second lever, a very powerful lever that can instantly change the money supply. Raising or lowering rates clearly has a lower bound, although technically you can go negative, the U.S. will not enter negative rates. But this is just a slower mechanism; getting into the market, now as a bank, you can use everything in reserve to invest, which is a faster change.

Robert:

This reminds me of the Genius Act. Tarun mentioned stablecoins being like narrow banks, but I don't think they are exactly the same.

Haseeb:

I believe he was referring to the Stable Act, especially because it does not allow for yield. Why is yield not allowed in the Stable Act? Probably because they don't want it to compete with commercial banks.

Robert:

Tarun's point may be that this restriction makes stablecoins more like narrow banks. However, the core of a narrow bank is that it allows for full interest-bearing deposits.

Haseeb:

So, if yield is not prohibited, you could create a narrow bank with a stablecoin. Therefore, under the Stable Act, you can't truly create a narrow bank that competes with commercial banks. But under the Genius Act, you could essentially have a stablecoin holding only treasury bonds and returning all treasury bond yields minus 20 basis points or other returns, which would ultimately be a very straightforward business model.

You could say this is the model of Tether; obviously, they do not pay out yield, but if they did, it would be an incredibly lucrative business model. It's very operationally efficient; they have around 90 employees managing over $100 billion in assets. So, it's a pretty nice business.

Haseeb:

I think this perspective makes a lot of sense. Stablecoins might be reintroducing the narrow bank concept in a more palatable way while also bringing geopolitical advantages. In contrast, narrow banks would only impact commercial banks without aiding in the internationalization of the dollar. The advantage of stablecoins is that, even if they compete with commercial banks, they can expand the overall market size of the dollar through internationalization. Narrow banks cannot do this because they are in a zero-sum game between commercial and narrow banks.

From a policy perspective, this is why stablecoins might be more favored. But I also agree with your point, Tarun, that when central bankers or bank executives look at this issue, they may lean towards allowing bank license holders to monopolize stablecoin issuance. This is actually a manifestation of "regulatory capture," restricting market participants to protect existing interests.

Robert:

What is your view on the final bill? Do you think it will be more like the Genius Act or more like the Stable Act, with fewer restrictions or stricter ones?

Robert:

I think that aside from the yield aspect, it will be less strict. I believe that the current commercial banking sector does not want to see yield on stablecoins.

Haseeb:

This reminds me of some strange phenomena in the banking industry. For example, in my Chase bank account, why can't my cash automatically move into a money market account to earn yield, and instead, I have to rely on my proactive actions? It would be great if the bank could do these operations automatically. However, the reality is that many people do not take proactive steps, leading to cash sitting idle. This phenomenon is actually quite common; although users can transfer funds to a money market account with the press of a button, many just don't do it. As a result, brokerages have made a good amount of money from this laziness.

Robert:

One of the main sources of income for brokerages is the interest spread.

Tom:

I heard that the FTC once investigated Citibank because they offered two almost identical savings products, but one had a lower interest rate. This demonstrates how banks profit from information asymmetry, while stablecoins, in some aspects, mitigate this issue.

Robert:

You can't easily lower the rate for new customers, but you can introduce a second product, with all existing customers still sitting on the unchanged rate.

Haseeb:

Ironically, if you consider this as a cash account, stablecoins, even if you don't earn a yield, such as with Tether or USDC, simply lending in the market can bring you quite a high return.

Tom:

The current market lending rate is between 5% to 6%. The advantage of a narrow bank is that users can freely choose their risk allocation, rather than the bank making decisions for you. For example, you can choose to invest in private lending or tokenized government bonds, rather than being bundled by the bank. If users are willing, they can operate by themselves.

Haseeb:

This does make sense indeed. If a stablecoin is truly siphoning deposits from the banking system, I suppose it might be because it allows users' cash to earn yield no matter how lazy it is.

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