Altcoin ETFs, stake houses, and tail risk in the crypto-circular economy

The big news in crypto this week is altcoin ETFs. But while the SEC fiddles with its rules to accommodate such things, Europe has been careening ahead.

Here’s a press release:

The Deutsche Börse welcomes Cardano Staking ETP by Liqwid (CASL) a disruptive crypto product

Frankfurt, 21 May 2024 – Liqwid Finance (“Liqwid”), an open source, algorithmic and non-custodial interest rate protocol built for lenders, borrowers and developers, is collaborating with issuance.swiss AG (the issuer of ETP) to introduce CASL, a groundbreaking financial listed vehicle in the digital asset realm. CASL not only tracks the performance of its underlying Cardano token ADA, recognised for its extensive academic peer-reviewed research, but also generates staking rewards. Admitted to the exchange as an Exchange Traded Product (ETP), the product is already available to investors on the Swiss SIX exchange and as of 22 May on the regulated segment of Deutsche Börse XETRA (WKN A4AFBK, German ticker CSLE, ISIN code CH1327686056).

Those sure are a lot of words. Let’s take it piece by piece in reverse order of difficulty.

Deutsche Börse is a big stock exchange based in Frankfurt. It is not the issuer of the press release, so “welcomes” is a bit of a stretch.

ETPs are pooled debt instruments that are traded on stock exchanges. An ETF is an ETP, but not all ETPs are ETFs. There are also ETPs that track the prices of debtor notes and commodities, either by holding underlying assets in custody or by using derivatives to replicate their performance. Some financial regulators allow ETPs to track the market prices of non-security commodities, such as standalone entries in a computer database.

Cardano is a public blockchain built in 2015 by a team led by Charles Hoskinson, an Ethereum co-founder who fell out with fellow co-founder Vitalik Buterin. Hoskinson wanted to convert Ethereum into a VC-funded company and Buterkin wanted to keep it non-profit. Cardiano’s the tenth biggest crypto token issuer, with a market cap at pixel time of $17.5bn.

Ada is what Cardano calls its native token. Cardano advertises Ada as a medium of exchange that’s more efficient than bitcoin and more secure than ethereum but, as usual with crypto, it’s rarely used to purchase things. Instead, Ada is Cardano’s in-game currency. Rewards for maintaining Cardano’s blockchain are paid in Ada and anyone running a project that uses Cardano’s blockchain has to pay transaction fees in Ada. Self-sustaining circularity is acknowledged in the name of its ledger audit mechanism: Ouroboros.

Ada is also a wager on Cardano’s adoption, which was most obvious during the late 2021 NFT bubble. According to IO Global data, NFT collections accounted for approximately half the projects being built on the Cardano blockchain. That nonsense squeezed Ada’s market cap to more than $90bn, from which it has fallen 80 per cent.

Cardano has raised external money between 2015 and 2017 by issuing what it calls “Ada vouchers”. Selling tokens to investors makes Ada a security, the SEC says. Cardano’s Hoskinson strongly disagrees.

Issuance.swiss AG says it offers issuers “a turn-key solution” for creating digital ETPs. It is not authorised by Finma or any other regulator. A marquee banner on the website warns that all information therein “IS MEANT AS TECHNICAL SUPPORT FOR REGULARTORY PURPOSES ONLY”.

According to the website, Issuance.swiss is a corporation wholly owned by a foundation called Stakeholder.swiss Stiftung. Swiss foundations are tax-exempt if their activities are in the public interest. Stakeholder.swiss describes itself as promoting “administrative framework conditions and governance rules in the Swiss financial centre that have a positive impact on society and the environment, with a particular focus on the area of digital assets.”

A Swiss subsidiary of Apex Group founded Stakeholder.swiss.

Apex Group is a Bermuda-headquartered fund administrator. In April 2023, the SIX Swiss exchange approved a base prospectus filed by Apex that gave Issuance.swiss approval to sell shares in crypto ETPs that would be administrated by Apex.

Liqwid Finance is a token lending and borrowing protocol that runs on the Cardano blockchain. Users swap Ada tokens (plus a few others on the same chain) for Liqwid’s native token, known as qAda (etc). Each qAda token is created on deposit and destroyed on redemption, so it’s a bit like an algorithmic stablecoin for an unstablecoin whose price isn’t necessarily one-for-one.

Like Ethereum, Cardano is a proof-of-stake blockchain. Rewards for maintaining the ledger are distributed among good operators, as defined by a consensus vote. Tokens are a cross between ballot papers and premium bonds. The more Ada locked up by an operator, the more they get in rewards. The reward, paid in Ada, is a cut of network transaction fees.

In other words:

Stake pools let passive token holders earn interest by delegating their holdings to a network maintainer. Nearly all Cardano wallets let depositors stake their tokens. Staking is by design fundamental to the Cardano network, which critics say is more centralised than alternatives.

Loans are what Liqwid offers over the inbuilt staking protocols. A user can deposit a token and use the collateral to borrow another token (in its qToken form). Liqwid makes a market between the borrowing and lending interest rates. It also puts depositors’ tokens in stake pools, even though it says it doesn’t take custody of those tokens, which is a neat trick discussed below.

Reasons for why a person might want to borrow one token using another token are somewhat murky.

Ada trades on all the main crypto exchanges, so is a route to turn crypto into fiat money, but only in very specific circumstances. Just a handful of other Cardano tokens are active, and moving tokens from other chains on Liqwid is very costly faff.

It might be instead that loans are a way to short tokens, and some Ada holders prefer gambling to yield farming.

A third reason that often comes up in Reddit discussions is to use borrowed tokens to buy more tokens. For example, a person might deposit Ada tokens to borrow DJED, Cardano’s sort-of stablecoin, and use the borrowed DJED to buy Ada. The person can then use the Ada they bought with the borrowed DJED as collateral to borrow more DJED and buy more Ada.

That’s a simplification, because there’s conversion required in and out of the Liqwid-native tokens, qAda and qDJED, but anyway. Buying Ada might help its price go up, but the price of DJED is fixed, so it can seem like perpetual motion. And we all know how that ends:

Non-custodial probably doesn’t mean what you think. Cardano allows smart contracts that let token holders set immutable rules, such as to give another user certain rights over a token, like the right to claim the attached network maintenance fees. Smart contracts promise a solution of sorts to the “not your keys, not your crypto” problem inherent in centralised exchanges, though how much custody the user really retains will depend on each contract’s code.

Liqwid says users “have complete control over their assets” and we have found no reason to doubt that, though there’s a knotty question here around whether the assets referred to are tokens or qTokens.

Non-custodial lending has allowed Cardano to pioneer Initial Stake Pool Offerings, or ISPOs. Projects use them to raise money in a way that might annoy regulators less than Initial Coin Offerings did.

ICOs were big in 2017, were mostly frauds or rug pulls, and were mostly investment contracts by the Howey definition so under US law were unregistered securities.

The ISPO changes the model by letting users keep custody of their Ada tokens while giving away the interest they might earn. A project wanting cash sets up a staking pool to collect network maintenance fees on its backers’ tokens. In exchange, it gives the backers who are donating their yield a new token that’s linked to the project. So long as these new tokens are useful to the project’s functioning, and are not just a share of its future value, they should pass the Howey Test. Maybe.

Backing an ISPO offers another plausible reason why a user might want to borrow tokens with tokens.

The Cardano Staking ETP has barely traded since going live in March on the SIX Swiss exchange, the unofficial home of the crypto ETP. It was the 161st crypto ETP to launch, and one of several that claim to offer investors staking yields without needing a digital wallet.

Staking ETPs say they are one-for-one backed by tokens — though because the ultimate owner of the tokens depends on the code by which they are being staked, the exact meaning of “backed” is never clear. Tokens held by the ETP go into staking pools to earn network maintenance rewards. The rewards earned go back into the ETP, per this illustration: