Monday, March 4, 2024
HomeBusinessFinanceThese claims that DeFi is unresolved or structurally flawed are false

These claims that DeFi is unresolved or structurally flawed are false

This observation is ill-informed and misguided. We are seeing problems as a result of a sharp, sudden and widespread market decline in all cryptocurrency. This caused problems in “algorithmic”, Stablecoins such as Terra Luna +0.9% (and no fully fiat-backed Stablecoins such USDC USDC ) and deleveraging at major CeFi companies, which led to many prime brokers and trading firms going bankrupt. These problems are not indicative of CeFi companies. They do not reflect the solidity of DeFi platforms’ foundations. Despite being under severe market pressures, the DeFi infrastructure has performed just as expected. This Viewpoint clarifies the misconception that DeFi is in trouble or that its core foundations are failing. It also explains how the market turmoil caused the problems. Partly, the notion that DeFi is responsible for Crypto’s current problems stems from a lack in fundamental understanding of DeFi and traditional finance.

Getting the Nomenclature Correct: TradFi and CeFi

TradFi, or Traditional Finance, is built on an “intermediated” model. Retail and institutional customers are connected through intermediaries (banks., insurers. asset managers. brokers. exchanges. custodians. etc.). To execute the four core financial activities of payments, borrowing/lending and investing, as well as insurance. Centralized Finance, or CeFi, operates in a similar centralized finance model to traditional finance but with cryptocurrencies and digital tokens. The CeFi model is similar to TradFi in that it relies on an individual’s identity for underwriting and managing risks through intermediation. This is what causes most of the problems in CeFi models.

Decentralized Finance, or DeFi, is a completely decentralized, blockchain-based financial system with smart contracts, programmable code, and replacing intermediaries’ roles in underwriting, execution, and managing risk for financial transactions. DeFi’s Smart contracts are immutable, and can be controlled by on-chain governance. The Community can set the parameters of DeFi agreements (what is considered acceptable collateral or the actual interest rate and yield paid), but not core risk parameters which are programmatically embedded within the protocol. To be considered pure DeFi, the settlement layer must not be centrally managed. True DeFi models need to have three fundamental characteristics. Each change must be approved and reflected on Blockchain.

True DeFi models are those that work (exampled by companies such as Aave AAVE +1.8%, Compound and DyDx), Synthetix and Uniswap. They are performing well and working as expected. These platforms are subject to stress due to declining value-locked stats and volumes. This is not different from the market cap losses at equity exchanges like NYSE and Nasdaq. While this may affect the venue’s revenue-generating capacity, it does not mean that the underlying market infrastructure has failed. Most of the problems that we see in CeFi businesses today stem from traditional finance issues. These can be avoided by core DeFi principles.

Looking back at the last few months of crypto events

In April 2022, the crisis hit a high pitch as Bitcoin +0.5% dropped 50% from 46,000 in April and 20,000 in June. Its all-time high was 68.789 on November 18,2021. Similar price drops in other cryptocurrencies caused a cascading effect throughout the crypto market. A large order for Luna, a crypto token backed by the algorithmic Stablecoin Terra, was placed in May 2022. This prompted other Luna holders to look for liquidity immediately. The Terra foundation, which was backing Luna using UST, was forced to place gates on customer withdrawals to stabilize the token. The Terra foundation was unable to keep up with withdrawals, leading to a Luna wipeout. This temporarily put pressure on other fully-fiat-backed stablecoins such as Tether’s USDT -1.1% USDT, and Circle’s USDC.

Best Travel Insurance Companies

Best Covid-19 Travel Insurance Plans

The contagion spread quickly to all market participants, causing widespread loss of trust. Three Arrows Capital (3AC) was one of the most exposed firms to the Terra-Luna crisis. It had acquired leverage from top crypto prime brokers such as Voyager, Celsius, and BlockFi, and had built up massive exposure. These prime-broker lenders declined to make margin calls to the 3AC founders.

Crypto lenders installed gates restricting customer withdrawals to protect customers and avoid a “run-on the bank”. This created panic and forced sellers on other sites that were still open, further decimating confidence in the market.

CeFi companies have been known to take Crypto deposits from customers and promise above-market yields. They then deposit this Crypto into DeFi and use massive leverage. As Crypto prices continued to rise during 2019-2021, this strategy was successful. VC/PE investors continued financing these CeFi businesses at higher valuations. However, crypto prices plummeted and forced Stablecoins de-peg. This exposed the weaknesses in business models and excessive leverage, which led to CeFi companies going bankrupt.

It is important to note that almost all crypto-related businesses in crisis are CeFi companies, and not DeFi. CeFi companies are the main cause of Crypto’s ongoing turmoil. They have weak business models, high transparency, low regulatory oversight, supervision, misrepresentation and fraud. DeFi infrastructure, on the other hand, has performed admirably due to its decentralized programmatic structure that requires almost no human intervention or judgment. This is why no major DeFi company is insolvent or facing undue financial stress.

CeFi companies (e.g. Celsius, Voyager Capital), despite their dire financial position, have been repaying their loans fully to DeFi protocols because that is how they can release the collateral. This is usually set at 150% of loan value and will ultimately be used to recover a portion for their customers. This is a testament to the power of DeFi platforms, which command the highest priority in liquidation and generate total payback for their members. This was possible because the rules of engagement were programmatically coded and no individual risk officer could alter these risk parameters. This is a testament to the power of DeFi platforms in managing risk and collecting dues, without ever having to step into a courtroom.

Similarities to 2008 : The Crypto Crisis and

The current Crypto crisis is similar to the 2008 global financial crisis. The current Crypto crisis is similar to the 2008 global financial crisis. This was due to large bets made in real estate and high-leverage. Although the assets were different (real estate in 2008 and cryptocurrency in 2022), the market conditions were similar, with high risk taking, poor risk management and weak business models. The entire market collapsed when crypto and real estate declined in 2008 and 2022 respectively. This caused significant collateral damage to other market segments and sectors. Lehman Brothers was the poster child of the GFC in 2008. Celsius and Voyager are now the epitome of the Crypto crisis 2022. Market stress in 2008 caused some money market funds break the buck and depeg, which severely damaged investor confidence. De-pegging created basis risk which then turned into liquidity risk and, in turn, credit risk. This led to widespread contagion, systemic instability and steep declines and a loss of confidence. Similar to the drastic fall in crypto in Spring 2022, Stablecoins such as Terra Luna were forced to de-peg Tether and USDC. The entire crypto market was affected by this, with counterparty issues, forced liquidations and market unrest. The spark that ignited the entire crypto market was Luna’s fall. Three Arrows Capital received the bulk of the damage due to its high leverage. Lehman had placed large bets on real estate derivatives. 3AC made high-leveraged bets on crypto using LUNA. All of these bets collapsed. It is very similar to the Archegos hedge fund saga. The banks didn’t know of the systemic risk Archegos had accumulated through loans from their prime-broking unit.

Ironically, Satoshi Nakamoto’s efforts to create cryptocurrencies and the core concept of cryptocurrency were motivated by the desire to solve or at least partially eliminate the problems associated with the traditional, central financial system that caused so much destruction in 2008. However, a decade later, CeFi firms have used crypto to leverage up, aggressively market and misrepresent its advantages to millions of naive investor. This was in a highly-regulated environment.

Six Observations about the Current Crisis and DeFi

These are some important observations regarding the current crypto crisis, especially DeFi.

  • DeFi has failed, CeFi has not: If you look at the chaos in the wider crypto market, the problems center around centralized financial models, but not DeFi. BlockFi, Celsius and Three Arrows Capital are the classic CeFi companies that are under stress and facing liquidation or insolvency. These CeFi companies have been hard hit by severe declines in crypto markets and the demise of algorithmic Stablecoins such as Terra Luna (and de-pegging Tether). Uniswap and Aave, Compound and DYDX (+3.6%) are classic DeFi companies that have maintained their business models, continue to operate as normal, and show strength. Although their revenue is declining or the value of tokens may be decreasing, they remain in business and are able to withstand extreme market disruptions with resilience. Aave and Polygon +0.9% announced major product launches and are continuing to build their infrastructure.
  • DeFi models are often misrepresented as DeFi models. They are centrally driven, can take on excessive risk, and often have been poorly managed traditional finance platforms. They can mistakenly be considered DeFi because they use the Blockchain to do some of their activities, deal with crypto, as well as loan funds to DeFi protocols. They are not. This explains why media outlets such as the Wall Street Journal or the Financial Times mistakenly referred to DeFi companies as failing and in decline when they are CeFi companies.
  • The classic TradFi issues that are currently surfacing in CeFi are Many of the problems surfacing today in CeFi are problems familiar from traditional finance. These include a lack transparency, high leverage and centralization. Market disruptions in crypto involving CeFi businesses are revealing weaknesses that we have seen in traditional financial services: high leverage, poor human judgement, lack of transparency, greed, and very high levels of leverage. In 2008, mortgage-related derivatives were hidden in the balance sheets. This caused liquidity problems, which quickly turned into credit problems, and then became systemic problems and contagion throughout the market. There are strong parallels in CeFi today. A broad decline in cryptocurrency has exposed opaque balances, weak business models and led to the insolvency or insolvency of companies like Celsius and Three Arrows Capital.
  • Loans to DeFi were created as senior secured loans: DeFi’s models are programmatic and driven by smart contracts. These smart contracts auto-execute when certain conditions are met and can be over-collateralized. As a result, funds lent to DeFi are becoming senior secured debt. This is a step ahead of preferred and common stock. Contrast this with traditional finance and CeFi, where deposits are loaned with high leverage and human judgment and willingness-to-pay often decide who gets paid. DeFi protocol loans are paid automatically when certain conditions are met. It is programmatically driven, automatic, and without human subjectivity. CeFi companies have returned funds lent DeFi protocols despite problems. They also did not return client deposits or repay other lenders. Celsius has paid $800 million in loans to Aave and Compound. However, its 1.8million customers still have to pay $4.2 billion in deposits. DeFi protocols funds are now more secure than those in TradFi/CeFi. They are essentially senior secured debt and much higher up the capital structure that regular debt.
  • Market declines should not be confused with structural problems: It’s important to distinguish between a cyclical fall in asset prices from structural problems in a market. Cryptocurrencies have been contracting just like other assets and equities. Market disruptions can affect all assets. They expose weaknesses in business models, poor management, and sub-par balance sheet. Asset price drops don’t necessarily mean the market is in trouble or that an asset class has structural issues. The current bear market in Equities does not raise concerns about the soundness and structure of the equity market. However, Crypto’s downturn doesn’t necessarily mean that there are structural problems with DeFi.
  • Market downturn will drive regulatory action: Political pressure often drives regulators to take action after investors are hurt and sentiment is low. The poor performance of Crypto and subsequent bankruptcies will force politicians to act. This will in turn push regulators to take appropriate action. This will give the sector a boost. Three areas can be expected of regulators: 1) clarify whether Crypto and derived instrument are securities and under which regulatory jurisdiction they fall; 2) require much more transparency, investor education and disclosure requirements on CeFi and DeFi providers (although DeFi has a lot more transparency with all data on-chain and publicly accessible); and 3) substantially increase supervision of CeFi exchanges (e.g. Binance, Coinbase and Kraken), DeFi Exchanges, as well as other market participants to rein in market manipulation and other infractions.

DeFi Future Course: Where do we go from here

What does the current crypto market turmoil mean for DeFi? The majority of problems in today’s Crypto market are caused by CeFi companies, not DeFi. They don’t have any impact on the core DeFi infrastructure. However, the collateral damage will engulf the whole sector and stop DeFi from growing. DeFi’s Total Value Locked is falling by 70%, as crypto prices fall and customers lose confidence in the space. It was at its highest in December 2021. This could lead to a decline in customer confidence, which can delay institution acceptance, participation, and adoption. This could also delay or prevent the necessary investment in DeFi infrastructure’s continued growth.

But, DeFi has great potential and there’s more growth in the long-term. It’s built on solid technology and infrastructure. It addresses the key drawbacks of TradFi/CeFi such as opacity and decentralization and human folly/greed. It will, undoubtedly, have to address regulatory concerns regarding AML/KYC as well as other risks. Innovations like Zero Knowledge Proofs and Subnet-based fully verified DeFi are promising solutions to these problems. This technology is being applied in every major financial function by institutions. We are seeing continued interest. The DeFi momentum will continue to be driven by the triumvirate: smart capital, institutional interest and the best programming talent. DeFi isn’t a replacement for TradFi, and I don’t believe DeFi will necessarily be disruptive to TradFi. Both models will continue to exist side-by-side, and DeFi will have many bridges between them. The DeFi model will help to overcome some of the limitations in TradFi’s areas, such as cross-border payments and P2P lending/borrowing, insurance, and the creation and use of synthetic Derivatives.

Conclusion

Major market corrections can be confusing and cause extreme emotions. It is hard to predict when they will end, and people often interpret them incorrectly. Some people mistakenly believe that the current crypto downturn is due to a DeFi structural problem. This Viewpoint has proven this is not true. The classic CeFi companies are the ones that have been impacted by all the problems. Just as we expected, the DeFi model has performed remarkably well. The core elements of DeFi – decentralization, transparency, replacement of human involvement with programmable code, and over-collateralization have proved resilient to crisis, and had they been followed, We are now in a situation where Crypto is losing a third its value and billions of customers have lost their deposits. This has caused significant collateral damage to DeFi (TVL dropped from $240 billion in December 2021 to $77billion today). Good news is that previous downturns in crypto actually helped to improve the ecosystem and have helped it move towards a better future. The market downturn was a huge stress test for DeFi models, their infrastructure, but they have done very well. Let’s hope that, despite the market contraction, liquidations, bankruptcy, and a boost to confidence, we emerge stronger and more confident than ever before.

RELATED ARTICLES

LEAVE A REPLY

Please enter your comment!
Please enter your name here

Most Popular

Recent Comments