Crypto Assets as Financial Innovation, Not Just Fintech The author, Dr. Nicholas Adams Judge, is a political economist and cofounder of RootProject. The other cofounder is Chris Place, a Y Combinator Fellow. The nonprofit’s pre-ICO recently passed 203% of its funding goal and is open until July 28th, 2017. The cofounders are taking zero tokens and no compensation beyond a reasonable salary.Most coverage of cryptocurrencies focus on either the underlying tech or recent market developments. Cryptocurrencies’ most important features — the economic ones — get left to the side or dismissed as ‘magic’ by crypto purists who think ICOs are just a trend.If you want to think seriously about crypto assets you have to think about them in terms of the new institutional capacities they create. If you think well-planned institutional arrangements designed in conjunction with a new asset class is ‘making something up out of thin air’ or ‘magic’ then pick up a history book.Cryptocurrencies allow for an asset to be designed that investors can put value into even in the absence of underlying market activity. If you don’t think that’s a big deal then I really don’t know if you’re awake while reading this.I’ve talked elsewhere about the topic. Here I’m going to lay out the development of crypto assets in the context of financial innovation. Derivatives and Financial Innovation Financial innovation has been going on, by historical standards, at a breakneck pace. Since large financial institutions have gamed the system and bought off regulators, it has literally broken many necks, as lives were ruined in multiple completely unnecessary recessions.But financial innovation is different from the political subterfuge of wannabe oligarchs. One is positive, the other is negative.Derivatives get a bad rap because of their role in the financial crisis. However they are such a broad array of asset types that blaming them for anything is borderline financially illiterate. It’s like blaming molecules for murder. OK, yes, they sure did help that one guy kill the other, but I’m not sure your causal narrative is all that useful. Derivatives are contracts that are, well, derived from traditional financial products such as a commodity, debt or equity. A future, for example is a contract to buy something at a future date.Derivatives have become so flexible that almost anything can be accomplished with them. But their nature as a contract creates a few important shortcomings. Scale, Liquidity The first is a question of scale. Derivatives are expensive to create. For instance, a bank won’t bother to securitize a bunch of mortgages into a mortgage backed security unless you’ve got at least $100 million worth lying around, usually more like $200 million.Once you’re talking about that kind of financial scale, you’re way beyond anything directly useful to start-ups or small businesses.You could easily design contracts that become standard, like Y Combinator did for SAFEs (Simple Agreement for Future Equity). But they remain illiquid, which greatly reduces their value — to both entrepeneurs and investors. I’ve written about that here.The illiquidity of SAFEs and start-up equity generally is a massive screaching break on the pace of innovation. It creates massive risk in an already risky endeavour, and keeps a lot of good ideas from becoming reality. Complexity and Derivation The next limitation of derivatives is that they are, by definition, derived from underlying, already-existing financial structures. They can be redesigned in clever ways (like a SAFE), but that linkage makes them complex, and complexity makes people less likely to trade them.Complexity in their inherent nature makes it harder to include other complex features that both the buyer and seller may want. Make the underlying asset class big enough, and massive institutions will invest enough $800/hr lawyers into the project to understand a complex instrument. But the more you have to do that, the more you limit who participates and directly benefits. Crypto to the Rescue Cryptocurrencies — crypto assets is a more accurate term — fix the disadvantages of derivatives. First, they are liquid. You can trade them on any number of exchanges.This combines nicely with their low start up cost — zero-ish dollars instead of tens or hundreds of thousands of dollars spent on contract-writing — to make them more democratic and open.They are also more transparent, which makes them more accessible to individuals and small firms that can’t spend lavishly on lawyer’s bills.Second, they can be designed without any attachment to some other financial instrument. This creates incredible advantages. It allows for a simple connection of an underlying asset to an institution’s activity. An asset can be designed that investors can put value into even in the absence of market activity.Crypto assets are not without their risks. Most importantly, if they became large enough, those risks could become systemic. For investors, they introduce the risk that the institution that created the asset may mismanage supply and demand. Investors will accept that risk in order to enjoy greater liquidity, but it’s still an important variable.This is also the first time that a few twenty year olds can easily launch a company and be interacting with liquid markets right away. The learning curve won’t be pretty. Even the most sophisticated crypto institutions still have a long way to go just in learning basic market best practices, never mind maximizing the efficacy of communicating to a live market.Vast literatures on these topics exist, however, and eventually the norms in the space will get sophisticated enough that companies will have to hire people that have read them.The institution-asset feedback loop that crypto assets allow for should lead to a big bang of innovation in how institutions are designed. It will take a while to prove out the model, but once that happens, get ready.