A fair number of The Otonomist readers are non-crypto natives with curious minds who want to know more about blockchains and their applications.
Many will be reading headlines about crypto markets’ cardiac arrest and wonder if the technology has any future.
In this post, we urge those readers to look behind the headlines and see the key difference between CeFI and DeFi, and why the latter represents the future of finance.
Debt will undo us all
Crypto is not in crisis. CeFi is. CeFi is when you have centralized players such as market makers and trading desks use digital assets to do what Wall Street has been doing for decades, but in a space that is largely unregulated and with technology that removes a lot of the analog friction.
It allows for players to lever themselves by using digital assets as collateral for loans. The proceeds of such loans are then used to borrow more digital assets which are again used as collateral.
It is not dissimilar to adding to your overall mortgage debt by taking out equity from your home when its price goes up and using that equity as a downpayment towards another mortgage.
Such schemes work as long as prices keep going up. When the price of the assets used as collateral goes down (house prices in the case of TradFin, or digital assets in the case of CeFi), the loans are no longer covered by sufficient collateral and will be called (the dreaded “margin calls”).
Assets need to be sold to raise funds to pay back the loans, resulting in a death-spiral of downward prices triggering more liquidations, forcing more asset sales, and leading to a meltdown in prices of the type of we have seen over the last weeks in crypto.
DeFi standing tall
Amidst this pandemonium, it seems it is lost on many - even the specialized financial press - that DeFi has actually proven why the future of finance can only be genuinely decentralized.
In this context, and in layman terms, “decentralization” means that financial transactions happen on distributed, public ledgers such as the Ethereum blockchain, on terms hardcoded in smart contracts for everybody to see and inspect and which nobody can manipulate or unilaterally control.
Think of the Ethereum blockchain as the execution layer - the operating system if you will - on which automated scripts (smart contracts) can run without the risk anybody can tamper with them.
One such script is a lending contract. In DeFi lending, all transactions are auditable by simply looking up the smart contract address of the lending protocol. For instance, the MakerDAO contract will show at any point in time how much collateral is held in the contract and how much in loans is outstanding against the collateral locked up in the contract.
Crucially, because DeFi does not judge creditworthiness, loans have to be over-collateralized, meaning you need to post assets generally worth at least 150% more than the value of the loan you take out. If the ratio of collateral over loans falls below this 150% for any given loan, the script will automatically trigger liquidation: the collateral gets sold, the proceeds of the sale cover the loan plus a penalty, and whatever is left is retuned to the borrower.
This is very different from the opaqueness of centralized dealing rooms and trading desks who bilaterally negotiate terms nobody can access nor audit, leading to the sort of recklessness we have seen from players in the crypto space such as Three Arrows Capital (now under liquidation in Singapore after a spectacular meltdown), but also in the traditional hedge fund space, for instance with New York-based Archegos.
The Monsters Lurking Beneath the Sea
DeFi-type auditability of onchain contracts will not prevent price meltdowns, however it will prevent the sort of systemic dangers building up beneath the surface of the world’s financial system that lead to monster crises with the potential to bring the whole system down, à la 2008.
Paradoxically, regulators’ response to the recent events in CeFi will likely lead to more regulation of crypto generally, including DeFi, forcing it into more centralized setups and controls.
Proposed regs such as Europe’s MiCA rules are likely to include authors of decentralized code within their definition of Crypto Asset Service Providers (CASPs), forcing them to i.a. incorporate in the E.U. and hence adopt a more centralized governance structure.
In doing so, regulators risk taking away the radical transparency as one of the key benefits of DeFi.
Wall Street Mutants
Despite the fawning over Sam Bankman-Fried or CZ by a large part of the crypto crowd, centralized exchanges such as FTX or Binance and related proprietary trading outfits and market makers such as Alemeda Research or Genesis are not champions of DeFi but rather mutants of the worst viruses of Wall Street.
The very fact that an owner of a centralized crypto exchange - which in TradFin are low margin businesses that trade at low multiples when publicly listed - can become a billionaire within a couple of years indicates the level of rent-extraction centralized crypto exchanges currently enjoy.
It can only leave us guessing about the amount of front-running, wash-trading and insider dealing CeFi feasts on.
It is a grotesque caricature of finance by Wall Street sorcerer-apprentices whose greed can roam freely in a largely unregulated space.
But let’s not call this the revolution. DeFi is where the hope lies and we predict that when it matures from metaverse techno-experiment into realverse operating system, the revolution will be upon us.