DeFi: Stop and Think. Part 1

The ongoing cryptocurrency crisis, which coincided with a large outflow of funds from DeFi protocols, is a good reason to momentarily step back from the endless race for profitability and rationally assess the prospects of the decentralized finance industry. Having done so, we will immediately see what we need to change in DeFi to make it more resilient to such shocks.

As early as March 28, long before the dramatic fall of Terra USD, it became clear that disaster was rapidly approaching decentralized finance. Back then, all DeFi tokens sank 75% from the highs of May 2021, as the crypto community shifted attention to GameFi, NFT, and DAOs.

The industry still took noticeable strides, partially due to the emergence of new blockchains increasing the number of users and the size of the market. Other reasons include introduction of decentralized options and the DeFi 2.0 wave bringing forth several exciting projects. But overall, they have not lived up to the height of expectations set by the success of the first generation of DeFi protocols. The latest innovations are hardly comparable to the launch of Uniswap and Synthetix (January 2019), MakerDAO and Dai (November 2019), Curve (January 2020), or YFI (July 2020).

And now, the DeFi crisis is a fait accompli. So let’s examine what the industry has done wrong and where it should go next.

It only took humanity a few years to realize that cryptocurrency could replace fiat money entirely and another year or two to see how decentralized finance can substitute the banking system. However, few then drew a parallel with American history and the remarkable fact that the Federal Reserve System (the US central bank) was only created in 1913 – 140 years after America had gained independence. Until then, the country’s economic growth had been financed by independent banks, each issuing its own dollars.

To be fair, at first, there was a kind of central bank: the First Bank of the United States created by Alexander Hamilton in 1791. 1816 saw the formation of the Second Bank of the United States, but its charter was not renewed in 1836. As a result, from 1837 to 1862, there was no formal central bank in the US – a period called the Free Banking Era. From 1862 to 1913, the country used appropriate legislation to operate a system of national banks.

That means that the economic rise of the United States, the conquest of the “Wild West”, the construction of cities and railways – all were funded by private banks, each issuing its own dollars.

This would be hard to even imagine in the modern world, but it is very similar to the decentralized system we would like to see, with DeFi projects in place of private banks. Of course, 19th century America experienced its share of turmoil similar to the current crisis in crypto and DeFi – the banking panics of 1873, 1893, and 1907 that eventually led to the creation of the centralized FRS.

We expected blockchain-based decentralized finance with smart contracts to be able to replace conventional centralized finance (CeFi) entirely. Unfortunately, for now, the industry is clearly skewed towards what I would describe as usury and derivatives.

The main feature of decentralized finance is that any investor can become a liquidity provider. In conventional finance or the stock market, you buy and hold assets expecting their value to rise, but mostly not using them in any way.

In contrast, acquiring an asset in DeFi is just the first step. Any investor can then embed these assets in a smart contract that will find a way to apply them and bring additional income. Yet, a distortion soon arose: DeFi projects began to think more about capital efficiency and product complexity and less about the needs and concerns of a regular holder. It was very evident, for example, in Uniswap, whose creators raised capital efficiency to the maximum, leading the market in trading volume. As a consequence, it became attractive primarily to expert market makers, in turn losing almost all passive capital from non-professional investors. (In fairness, I will note that this is not always the case, but the trend is quite apparent.)

We want DeFi projects to work like banks but forget that the banking sector does not grow without substantial deposits. An efficient network bank cannot be built with leveraged capital aiming for ultra-high returns. In other words, until TVL in DeFi protocols reaches at least a couple of trillion dollars, speculation will dominate the sector.

Another issue is stablecoins. Everyone talks about them, but not everyone understands that stable cryptocurrencies are only really in demand in countries outside the OECD (the Organization for Economic Co-operation and Development, an international economic organization uniting 38 of the world’s most developed nations). The OECD states enjoy a stable financial policy and strong currencies. Meanwhile, the rest of the world frequently sees savings denominated in local currency decline due to political blunders and unsuccessful attempts at reducing the budget deficit and the current account.

The countries then often use inflation as a coordinated strategy to depreciate savings and lower borrowing costs – with the largest borrower in any country being the government itself. That is what causes significant dollarization in emerging markets – businesses and citizens are preserving their savings. The ability to store money in US dollars is essential if you live somewhere in Kazakhstan, Bolivia, or Egypt. Investing in dollars ensures you against inflation and bankruptcy of local banks.

But access to dollars is often made costly or difficult by local financial policies, as authorities manipulate official US dollar exchange rates. Such conditions make stablecoins bought through online exchangers a convenient means of both saving money and making transactions that bypass corrupt government agencies and unreliable banks.

The next step for individuals and businesses in developing countries is to start using DeFi as a global savings account that can exist outside the infrastructure of well-known banks, making it a savings technology for non-OECD nations. On the other hand, developed countries – where most of the world’s money is concentrated – have no particular need for DeFi services. And unfortunately, until they do, one cannot count on the industry to experience any leaps in growth.

As we have mentioned, DeFi has become the primary beneficiary of the huge liquidity injections that central banks have resorted to amid the coronavirus crisis in the past two years. But today, as governments are fighting inflation and reducing liquidity, it’s all bear markets everywhere. Businesses need to pay for sharply increased commodity and energy prices, so funds are leaving risky assets in favor of the real sector. As the value of money (bank interest rates) rises and liquidity shrinks, investment flows out of cryptocurrency and decentralized finance markets – just as it does the stock market and the precious metals market.

To be continued…