Is DeFi a Mirage?

Walking across the desert without water can either lead to a blissful hallucination of an oasis or to death. Similarly, attempting to build a new concept, product, or service without the required capital can lead to either of these extremes. This may explain why several entrepreneurs, in need of capital to survive, have no shortage of creativity when it comes to making noise around buzz words. Over the past few years, successive fund-raising narratives have formed around blockchain, tokenization, smart contracts and ICOs. DeFi is an additional iteration of this creativity.

DeFi sounds cool. It sounds like defiance, which means open resistance and bold disobedience. This can sound very appealing to those disgruntled with traditional financial services. DeFi stands for Decentralized Finance and it aims to deliver an open-source, permissionless, peer-to-peer financial system. In others words, it is reinventing banking and capital markets in a disintermediated fashion.

Before diving deeper, let’s review some banking basics. Put simply, a bank attracts deposits from savers by offering a flat interest rate. Following that, the bank lends a portion of these savings to borrowers in exchange of a greater interest rate. The interest rate is determined by weighing the credit profile of the borrower with whether or not there is collateral to back up the loan. Credit history, income level, net worth, and repayment capacity are also constituents of the credit profile. Assessing both the value and the liquidity of the collateral is part of the lender’s task.

If the bank is good at lending, then the bank owners (i.e. the shareholders) will do well. The interest spread minus the operating expenses will either be paid out in dividends or put on the balance sheet in retained earnings.  If the bank lends poorly, it loses money. And if the bank loses money systematically, not only is the capital of the shareholders at risk, the deposits of the savers are as well. To simplify the text, notions of deposit insurance and bail outs by the Federal Reserve are purposely left aside.

Now, let’s view savings and loans from DeFi’s point of view. Savers are replaced by stakers. Stakers are both shareholders (reap benefits) and managers (vote on credit policies). Imagine the bank is run as a democracy with all the flaws it entails.

Leaving Bitcoin aside for now, how do you assess the collateral value of tokens that are literally minted out of thin air? How do you assess the liquidity of what you hold as a guarantee in both normal and abnormal market environments? Who do you trust as the custodian of the collateral backing the loan?

Then, if you think the token is worthless, decline to use it as collateral, and rely solely on the profile of the borrower to extend the loan, how do you assess the credit profile worthiness? How do you reconcile that one can borrow in ABC while having income in USD? How do you price that basis risk, and how does it impact the credit assessment?

Since you are in a democratic-like business model, how do you assess the intellectual capacity, involvement, and adequacy of the other stakers you are in business with? What is the mechanism for dispute resolution? Perhaps, it would be worthy to review ECAF’s (EOS Core Arbitration Forum) failure.

 While it may seem more attractive to earn yield on token, rather than earn a near zero interest rate from the banks, one cannot forget the impact of a permanent loss of capital. Buyer, beware of these dividend yields and this ratio presented ex-ante by creative marketing people, and expect to be surprised on the downside.

 Lastly, if you are to participate in the creation of decentralized finance, other than for a quick and easy cash grab, why build or invest in an unsound protocol such as Ethereum? Ignoring the numerous problems with this protocol, it still does not offer a sound monetary basis to start from. In many ways, it looks worse than what it is attempting to replace. Why build on that?

 On the other side, Bitcoin is tangible and systemically stable. Its collateral value and liquidity are also continuously being tested. There is a growing number of businesses with revenues and expenses priced in BTC, which will reduce the basis risk in BTC borrowing and lending. This seems like a stronger foundation to build tomorrow’s capital markets and reach actual water.

Disclosure:

The author, Elisabeth Préfontaine is a seasoned finance professional with over 25 years of experience. She is a Chartered Financial Analyst (CFA) and a Chartered Alternative Investment Analyst (CAIA).