Forbes Interview with Coin Metrics Founder: We Have Not Yet Truly Fallen into Crisis

Interviewee: Nic Carter, Co-founder of Castle Island Ventures and Founder & CEO of data analytics company Coin Metrics

Written by: Steven Ehrlich

Compiled by: Katie, Odaily Planet Daily
In a conversation with Forbes, Nic Carter, co-founder of early crypto venture firm Castle Island Ventures and founder & CEO of data analytics company Coin Metrics, discussed how the crypto market crash aligns with broader macro trends, how venture capital should adapt to new market conditions, what the future of DeFi will look like, and how regulators are responding to these leveraged and high-risk trades.

Forbes: How do you evaluate the current sluggish market?

Carter: This massacre is not just about crypto; it's about all asset classes. Some people think this is just a crypto sell-off or a sell-off alongside risk assets, but that's not the case. Sovereign debt and U.S. Treasuries are selling off alongside stocks, which shouldn't happen; they should be negatively correlated. Therefore, we are not only heading towards a very severe recession, but if liquidity continues to be drained from the financial system, we may experience a round of economic depression and a sovereign debt crisis.

Forbes: Many Wall Street bankers and analysts are downplaying the likelihood and duration of a recession. Why do you feel so strongly about this?

Carter: The Federal Reserve is wrong, and Congress passed this massive economic stimulus plan and other unnecessary stimulus plans back in 2020. This is a collective failure of this administration and its predecessors, and it is the basis for deflation.

The Fed's solution to the problem is to raise interest rates, essentially restricting private enterprise activity. We are in an extremely fragile, highly indebted system. Further damage to the supply chain will crowd out private investment and make it harder for the government to pay off its own debts. Any economic indicator, whether it's the mortgage-backed securities market or its two-year yield, shows rapid changes indicating a lack of confidence in the U.S. government, many of which are the worst on record.

We are entering stagflation. The inflation problem is much more deep-rooted than short-term trends and factors; it is indeed related to the de-globalization caused by the pandemic and fundamental energy shortages, which will not be resolved anytime soon.

It will be like 1969/1970, when inflation rose, and the Fed raised interest rates during a short-term recession, successfully bringing inflation down, only to soar to new highs in the late 1970s because the energy crisis did not ease. I think that's what is going to happen. But a recession won't solve the fundamental issues; the actual resources our dollars can buy are becoming scarcer, and the products our dollars can buy are becoming fewer because they are harder to obtain. I believe this will be a decade of stagflation, and I don't think a recession will defeat inflation.

Forbes: Aside from the downturn, do you see any growth trends in the crypto space?

Carter: Right now, every crypto institution that was once a "local player" is being plundered or destroyed. The backbone of the industry has been drained. Terra was the fourth-largest project, and both it and its algorithmic stablecoin have been destroyed. Three Arrows Capital was the largest private fund in the entire crypto industry, but Voyager Digital has indicated that if the fund cannot repay its loans, it may issue a default notice. The largest or second-largest retail bank in crypto, Celsius, may go bankrupt. So basically, the entire structure of leverage and loans, as well as the connection between DeFi and CeFi yields, has been severely questioned by the market. You could say that the new banking structure built in the crypto space over the past two to three years is being completely dismantled.

The foundation of future DeFi (including yields) will not be based on this false Ponzi scheme of re-staking and securitization, but must be grounded in actual economic returns.

Forbes: Surveys show that 70% to 80% of DeFi activity is purely speculative. Why is the bubble so large?

Carter: I think there should be high standards for DeFi because the goals it pursues are very important. I believe in DeFi; it should be a transparent financial system without intermediaries. However, it has done a terrible job in execution. There is a lot of building, but without thought. For example, placing customer deposits into high-risk DeFi protocols, as happened with UST and Anchor. I want to tell industry practitioners that a lack of thought is equivalent to laying hidden dangers in the early stages.

Forbes: Is a bear market a good time to create wealth? Where should large investors put their money now?

Carter: We will continue to execute our established strategy—early-stage venture capital. Many primary and secondary market funds will halt their crypto strategies. Many crypto funds will not trade for the rest of this year because they are too concerned about market conditions.

Regarding the liquidity crisis, we haven't really fallen into a crisis yet, but we may be heading in that direction. In a liquidity crisis, you have no liquidity, so you cannot decouple yourself from the market environment. Unless you are truly prepared, it is easy to be wiped out. Some crypto funds and hedge funds are facing redemptions, and next up are venture funds, which have to face LPs and tell them not to call for capital. Venture funds do not get all their funds on day one.

LPs may feel frustrated; they may not want to allocate more funds to cryptocurrencies or early-stage venture capital, even if they signed limited partnership agreements, as they have legal obligations. All the backup funds you see in the over-the-counter market may not have actually been put to use; similar things happened in the venture capital space in 2008 and 2001. Especially in the context of declining valuations, I think market activity will decrease, and this buying the dip may be constrained by institutions.

Forbes: What advice do you have for retail investors?

Carter: Actually, the best position right now is cash.

Consider the entire asset space, not just cryptocurrencies; consider the relative value between fixed income and stocks and real estate commodities. The traditional market has not yet seen a massive shrinkage of funds, so I would consider buying listed stocks. All cryptocurrencies below a market cap of $1 trillion seem quite cheap, but there is no fundamental valuation method. Bitcoin's total value is $400 billion, which is less than 1/20 of gold's total value. In the long run, I believe Bitcoin's importance as a social savings tool may surpass that of gold.

These prices are very attractive, especially compared to Bitcoin and the current L1. All Ethereum competitors had a significant year last year. These narratives will face real challenges this year. They became popular because of the high demand for Ethereum block space, which has spread to other chains, especially EVM-compatible chains, but other smart contract chains similar to Ethereum will not have this block space demand in the future, which is cyclical.

Ethereum is moving towards the merge, transitioning to PoS and inserting staking protocols, which will indeed put a lot of pressure on all competitors. I would invest cautiously in the list or focus on last year's very popular L1s.

In the current situation, liquidity continues to deteriorate, and there are no signs of the Fed's interest rate hikes ending. The situation in the crypto market may worsen. The defaults of lenders and large funds are spreading.

Your best position tactic is to hold cash and wait; you don't have to be active all the time; I would also focus on the companies with the strongest liquidity and the highest quality, as well as those with the lowest internal leverage.

Forbes: What do you mean by "internal leverage"?

Carter: A lot of things are built on a set of defined protocols that use L1 base assets as collateral. The total value locked in these protocols is growing. This leads to supply locking, where the units of tokens are locked, and then market floating contracts push the price of tokens. When the market deleverages, the total value locked decreases, and the collateral is thrown out back into the public market. At the same time, many of these protocols are venture-backed, which means there is ownership, so there is a large supply locked up. A lot of liquidity appears on the network because the venture funds that invested in the protocol must liquidate their positions, especially now.

Another huge source of selling pressure is that the liquidity of these institutional supporters of the protocols is locked in these grants, and this liquidity will be returned to the market. No one wants to hold because we are in a period of significant sell-offs. Almost every investor in L1 is investing in these different tokens, which is the behavior of institutional allocators who will immediately liquidate these tokens after investing. Any less mature company trying to build its own company through institutional support and establishing a DeFi ecosystem is likely to perform the worst in this downturn.

Forbes: How will the "contagion" of crypto institutions spread, and in what direction?

Carter: I was shocked by the Three Arrows incident. I was not surprised by the collapses of Celsius and Terra. It was clear that Terra was not robust and would eventually collapse. Celsius has been on red flags for years; Celsius is an active participant in DeFi, so they would allocate customer funds in DeFi. What I completely did not expect was Three Arrows Capital.

These centralized lending institutions and participants injected a lot of liquidity into DeFi, and many of these DeFi structures are Ponzi schemes destined to fail, but that did not stop many entities from participating in this system. In fact, there are many interconnections, and even centralized lenders like Celsius have been affected. However, other central banks that provided loans to these private companies may now lack liquidity or be insolvent and are also affected.

Now there is a hole in their balance sheets. In my view, the largest institutions in this industry have balance sheets to absorb these funds, so ultimately they will be fine. Celsius has an ICO-reviewed token overseas, and they put customer funds in DeFi. They do not all follow the same risk management standards, which is dangerous. Some are onshore and support regulation. I believe there will be more capitalized institutions that can weather this storm.

Forbes: What is the best way for those who still want to earn passive income by holding crypto assets?

Carter: In the U.S., basically all retail lending channels have been blocked by the SEC, which is a regulatory issue. Other countries still have many options. Right now, you have to be very careful about yields. Some people like to call the proceeds from options trading yields. I don't consider that yield; it just increases the risk position. There are many providers that will let you do structured products, which are highly risky, especially for retail investors. So in my view, this does not actually yield returns. You are just significantly changing the risk level of your investment. Don't just focus on yields.

Additionally, staking is like anti-dilution yields. Actual yields are based on real economic activity. You lend someone money, and they are engaging in some kind of risk investment. There is a risk of failure, but you will be compensated. If the economic activity is productive, they will return your investment.

Forbes: Aside from trading, what "real economic activities" in DeFi are you paying attention to?

Carter: More and more protocols are now putting cryptocurrency funds into real-world lending. Goldfinch, which does microfinance, is one example. Different lending institutions are starting to look at external markets, not just lending to other DeFi market participants, such as Maple. It is launching a pool focused on Bitcoin miners, and I think they will expand their business to make mining more complex.

Miners want to hedge their risk exposure and may just want to lock in a rate of return of 20% over the next year, rather than being exposed to the fluctuations of Bitcoin prices, which is an interesting model. I hope to see more protocols like this in DeFi. They do indeed envision real economic activities and create structures that are useful for producers and consumers.

Forbes: Can decentralized governance in DeFi really work? We are seeing liquidity crises in many protocols, and the Curve pool between stETH and ETH is drying up.

Carter: I think decentralized governance is a contradictory term. If your governance means centralization, in the case of equity, shareholders are the owners of the company. They should implement governance—it's their responsibility and right. Under the protocol, if there are stakers and token holders governing, it necessarily means it is not decentralized. Because crypto players know nothing about corporate governance. For a large group of small token holders or shareholders, there is no motivation to execute governance because governance requires gathering important information to work effectively.

That's why we need venture capital. There need to be large shareholders to manage corporate governance. Therefore, having a highly distributed token holder base means no governance, no oversight. In a corporate environment, the directors are the ones operating the protocol. Decentralized governance essentially means governance does not work. In centralized governance, one or two entities are responsible for information gathering and oversight, ensuring that the system's protocol managers do not expropriate the system, which is an important reason for corporate governance, and this requires centralized agency. In fact, the large venture capital funds that hold a lot of tokens in DeFi are the ones hiding their investment footprints because they do not want regulators to know their investment directions.

If you want to truly implement governance and keep it dynamic and changing, then it will be centralized. If your protocol is static and does not change, then there is no need for so much governance. In my view, that is when you can have true decentralization. Bitcoin does not change often, so there are not many decisions to be made, which is decentralized. But apart from Bitcoin, there are not many protocols that can truly achieve this and minimize governance.

Forbes: What will the crypto industry face next?

Carter: I believe that future industry regulation will be severe, and crypto participants would do well to welcome the policies that will come out next. If you suffered losses in Celsius, Terra, or the hacking incidents, regulation is not a bad thing for you. After a financial crisis, there is always more regulation. That's how the market operates.