CeFi Models have stumbled exposing flaws, while DeFi has worked, as expected
Amidst the severe contraction in cryptocurrencies and the near or actual insolvency of prominent crypto-infrastructure companies (BlockFi, Celsius, Voyager), there is talk that DeFi is in decline and its foundational structure is weak. This observation is 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’ foundational principles. 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., brokers., exchanges. custodians., etc.). To execute the four core financial activities of payments, 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 (e.g., what is considered acceptable collateral or the actual yield or interest rate paid), but not core risk parameters which are programmatically embedded in 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 +1.7%, Compound +1.3%DAO), 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 with core DeFi principles.
Looking back at the last few months of crypto events
In April 2022, the crisis hit a high pitch as Bitcoin +0.7% dropped 50% from 46,000 in April and 20,000 in June. 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 restrictions 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 0.0% USDT, and Circle’s USDC.
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The contagion spread quickly to all market 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 depressing market confidence.
The common problem and excessive leverage of CeFi companies got exposed, thrusting them into insolvency.
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, poor 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.