Why DeFi Might Be Safer Than Traditional Finance

Why DeFi Might Be Safer Than Traditional Finance

There are two questions of acute relevance I want to try to answer in the wake of the latest crypto market retreat. First, is decentralized finance more trustworthy and robust than conventional financial services? And second, are some DeFi systems more stable than others?

Those questions became newly weighty as a wave of loan defaults and insolvencies in recent weeks hit centralized “lending platforms” like Celsius Network and Voyager Digital. Those entities sometimes leveraged DeFi rhetoric and, in Celsius’ case, deployed customer funds to DeFi systems with extremely mixed results . Three Arrows Capital, arguably the Typhoid Mary of this year’s crypto contagion, had major exposure to the luna (LUNA) token and terraUSD (UST) algorithmic stablecoin, a fatally flawed system based on some DeFi principles. (For a thorough description of these relationships, see my recent account of the Great Crypto Unwind .)

At the same time, more reputable DeFi systems have held up better than centralized lenders in the downturn. While their volumes and yields have declined sharply, systems like the Uniswap exchange, Aave lending system and DAI stablecoin have continued to function smoothly . Most importantly, the systems haven’t been destabilized by huge losses from loan defaults or declining asset prices, which proved fatal for the centralized lenders.

So why did centralized and human-monitored players like Celsius and Voyager prove so fragile compared to largely automated systems? And what separates DeFi systems that did fail, particularly LUNA, from those that held up?

The answers are complex, but essentially boil down to specific financial and technical design decisions. Some of these, such as systemic transparency, overcollateralized lending and automated liquidation of borrowers, are inherent to DeFi. Other features, including “tokenomics” and governance, can vary dramatically between systems – and go a long way to explaining why not all DeFi is created equal.

First, a quick refresher. In theory, DeFi systems are to trading, lending and other financial services what bitcoin (BTC) is to currency. Because they’re run on distributed blockchains, these systems are meant to be uncensorable and transparent. They are built largely around “smart contracts,” on-chain functions that can be used by anyone with an internet connection and crypto in their wallet and which automatically execute without human supervision.

Smart contract-based DeFi services include digital asset trading and lending. Some stablecoins, such as MakerDAO’s DAI, are also based on DeFi technology. A core concept for trading and lending services is “yield farming” or “liquidity mining,” which rewards users for “staking” funds to liquidity pools. Standing pools of staked assets eliminate the need to directly match buyers with sellers or lenders with borrowers.

A further declared goal of DeFi is to dispense with centralized leadership and enable users to manage the systems, though that goal has been pursued inconsistently. For a deeper exploration, see CoinDesk’s full DeFi explainer .

Arguably the defining characteristic of decentralized finance systems, the feature from which all others flow, is their almost complete transparency. Much as you can track bitcoin transactions by looking directly at blockchain records , DeFi systems allow near-complete visibility into loans and order books. This notably includes visibility into “liquidation points,” or asset prices at which the collateral for certain loans would be market-sold to cover losses. More on those in a moment.

This transparency is a sharp contrast to services like Celsius, which take depositor funds and deploy them in a wide variety of ways to generate yield. Depositors have almost no visibility into, much less oversight of, how those funds are deployed. Those deployments can include over-the-counter trades which are nearly impossible to spot on-chain, or intentional obfuscation of DeFi activities.

While that opacity can be a valid strategic choice for investment funds trying to outmaneuver competitors, it also means depositors in centralized systems are accepting a simply unknown amount of risk. The most dramatic illustration of this came with the revelation that a DeFi account known as 0Xb1 had been trading on behalf of Celsius , but did not disclose that connection – while apparently losing hundreds of millions of dollars .

“That is definitely one of the biggest issues when it comes to these [centralized lending] providers,” says Eric Chen, founder of the DeFi protocol Injective. “They say they’re going to deploy DeFi strategies for you, and they can undertake a lot more or a lot less risk than what the consumer prefers.”

An even more important bit of transparency in DeFi comes from strict policies on loan collateral. One reason Three Arrows Capital blew up is that it was taking out an array of huge loans from […]

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