DeFi is a term used to describe the part of the crypto universe that aims to build a new
financial system that is internet-native and uses blockchains and smart contracts to replace
the traditional intermediaries and trust mechanisms that are used in traditional finance.
The term DeFi is short for decentralized finance.
In today’s financial system if you want to move money, borrow or lend, buy or sell
securities or insurance like products you use an intermediary, like a bank, a broker
an insurance company or an exchange.
And that whole system relies on all parties trusting that the intermediaries will act
with fairness, honestly and within the law.
In DeFi, the idea is to do all of the same things, but in a peer-to-peer manner where
blockchain-based “smart contracts” replace the middlemen but still ensure that the entire
process is fair and trustworthy.
Defi can be thought of as a blanket term for how, crypto people are trying to build a new
version of Wall Street, where central counterparties are replaced with decentralized software that
deals exclusively in crypto assets, with crypto versions of many of the products offered by
traditional financial firms.
They aim to do this without a lot of the red tape and regulations that govern the existing
financial system.
Decentralizing finance, they argue might fix the problems in our current financial system,
in part by erasing the power that big Wall Street banks have over our economy, markets
and the general financial system.
While DeFi has been generating a lot of press, it is not necessarily that big, it’s total
value locked is around 40 billion dollars or so, which would make the entire DeFi industry
combined the 52nd largest bank in the United States by deposits, if it was a bank.
Now I should note that the size of the DeFi industry is quite volatile, and its total
value locked six months ago was over 100 billion dollars.
DeFi optimists argue that their approach will eventually be cheaper, more efficient, and
more transparent than the traditional financial system is, and obviously that is a very attractive
proposition for most of us.
They pitch the idea of a utopian financial future with no centralized intermediaries
because those layers just add costs and inefficiency.
On the other hand, a lot of people argue that this lack of regulation, consumer protections
and other safeguards make DeFi unworkable.
If you make a mistake and transfer the wrong amount of money in DeFi, there is no helpdesk
to call to undo the transaction.
– you are simply out of luck – it was your mistake, and you should have been more
careful.
Additionally, they argue that there are lots of costs associated with using defi protocols,
and these systems are by no means as cheap and efficient as they claim to be.
For these reasons, and a few more that we will look into shortly, DeFi has gained a
reputation for being the wildest part of Cryptos “Wild West”, with regular thefts of tokens
worth hundreds of millions of dollars as people exploit these poorly designed systems.
In today’s video we will look at a few examples from last week where the teams running various
DeFi protocols had to step in and take control, showing that at least right now DeFi – and
Crypto in general is much more centralized than you might expect.
We’ll also discuss whether these new financial systems are likely to ever become truly decentralized
and mainstream.
But, before I get to all of that, let me quickly tell you about today's video sponsor, Private
Internet Access.
Ok, so last weekend, users of Solend, a lending platform on the Solana blockchain, proposed
taking control of the wallet of its largest user – this was an unprecedented move in
the DeFi world.
The reason given was that the protocol operators worried that this whale account had a large
margin position that was putting Solana – the blockchain protocol and its other users at
risk.”
The big user – or whale - had borrowed a huge amount of stablecoins from Solend to
fund a position in Solana’s native SOL token.
If the price of that token fell much more – in the broader crypto sell off, the smart
contract would automatically start liquidating this huge position in a way that could overwhelm
market liquidity and cause huge losses for the other market participants who had lent
to the whale.
According to the operators, the ripples through the market meant that “Solend could end
up with bad debt.”
To avoid this, they decided to amend the smart contract to let Solend’s team take over
the whale’s position and start liquidating it in over-the-counter transactions before
the market hit the margin trigger and the automated selling began.
In order to be allowed to do this, the team put the proposal to a hastily organized vote
of its decentralized autonomous organization requesting emergency powers.
The proposal passed, but it looked like it had been forced through which led to a backlash
on Twitter.
The worst kind of backlash…
The team then withdrew the plan following this criticism, but said they were “committed
to protecting user funds, transparency, and doing what’s right” and then a third proposal
to create new position limits to mitigate the risk in a more mechanical way was passed.
I guess the takeaway from that situation is that - most of the time code is law, except
when you don’t like the outcome, and then you make something else up quickly – which
is not as catchy a phrase at all…
It might need some work…
OK, so next up… here is a great phrase for you.
“Due to hostile market conditions, Bancor’s Impermanent Loss Protection is temporarily
paused.”
OK, so, that’s confusing, what could it mean?
Impermanent Loss Protection…
temporarily paused…
I guess something impermanent might be temporarily paused… and there is losses – but luckily
they are impermanent…
OK, so I worked it out…
Bancor is a decentralized crypto exchange that allows users to trade cryptocurrency
tokens.
It basically works as an automated market making system where you can deposit your crypto
which will then be used to make markets.
When things go well, you get a share of the profits, but… when there are “impermanent
losses,” – which are just losses in the real world.
Bancor then prints some of its own BNT tokens and gives them to you to make you whole.
Thus, I guess the losses are impermanent because you get these loser tokens, which are valuable…
because crypto.
I’m not sure that there is anywhere else where if you lose money someone would offer
you a piece of paper saying that you had lost money, and you – and other people- would
gladly accept that piece of paper as being valuable – in fact maybe even more valuable
than the money you had lost.
But anyhow – that is how things work in this day and age.
This is what happens when the participation medal generation gets to design financial
systems.
Anyhow – this turned out to be a great system when crypto in general was going up: Bancor
could keep printing these tokens – which represent their core business operations losing
money, and these would keep getting more valuable…
OK, it doesn’t actually make much sense…
But most importantly – this week we learned that when the Loser token goes down, everything
falls apart.
Which is bad…
The Bancor team explained it on their blog, but the takeaway is that if the price of BNT
goes down, they could print more BNT to make holders whole for the loss.
But doing this of course makes the price go down even more…
This isn’t precisely the same as the Terra Luna situation from a few weeks ago, but it’s
close enough that the differences barely matter.
Anyhow, last week, citing “hostile market conditions” Bancor decided to temporarily
pause this mechanism.
I guess when losses are rare, these rare loser tokens possibly have a “rarity value”,
but in “hostile market conditions” – loser tokens become plentiful…
Anyhow, they said they would ask those that hold the voting power to ratify the temporary
pause.
So that is that…
I’ll be nice and I won’t call it a Ponzi scheme, as, who knows, maybe these guys aren’t
actually Ponzi schemers, maybe they’re just not very smart.
Do let me know your thoughts in the comments section below…
And, finally, Maker DAO, a collective that runs the Dai stablecoin — which is designed
to be pegged to the dollar — voted to freeze a link to AAVE – a lending platform, because
of the latter’s exposure to another struggling lending platform, Celsius.
Now, some of the DeFi ideas like Bancor for example, are a bit silly, and easy to make
fun of- and of course that is my job here… but obviously not everything in the space
is.
There are many ways that over time something quite good could come from DeFi where there
are fewer middlemen, greater inclusion and lower transaction costs for everyone.
It can be argued that crypto in many ways has been speedrunning all of financial history,
and re-learning all of the lessons, of traditional finance.
"I used to hate history, didn't you?
It's all just a load of stuff that's already happened.
What are they doing over there?
They're filming something!
They're filming midges!
This isn’t necessarily a bad thing, as Speedrunning all of financial history from scratch means
that you might make different, interesting and sometimes better choices about what to
do about the lessons learned.
But often this approach has just shown that there are good reasons for the ways things
are done and that most people have simply forgotten what those reasons were.
For example, sometimes, the slower pace and high transaction costs that you see in markets
are a function of government regulations, and on top of that, many market participants
specifically accept higher costs in exchange for better service and more customer protections.
Now, to a certain extent, the emergency plans that these DeFi protocols had to enact over
the last few weeks were a vindication for global regulators, who warned that some DeFi
projects were much more centralized than their marketing indicated.
The worry that users are left with - is that governance in DeFi might be highly concentrated
amongst a few big players that could possibly co-ordinate and change the rules when it suits
them, at the expense of other small users.
A recent report from the Bank for International Settlements, questioned whether DeFi projects
could ever expand into an adequate monetary system because developers can’t predict
every potential market move.
They argue that in the real world, it’s impossible to write hard coded contracts that
spell out what actions should be taken in every contingency and that centralization
allows firms to deal with this “contract incompleteness”.
If you can’t reasonably devise contracts that cover all possible eventualities, then
central entities are just needed to resolve disputes.
They additionally argue that more efficient methods to speed up and handle greater volumes
of payments tend to lead to a greater concentration of computing power.
While regulators warn about the pitfalls of DeFi, the market is making its own judgments.
For some DeFi believers, the unplanned moves by Maker DAO, Bancor and Solend this week
are good as they just wash out the people who never fully committed to the DeFi ethos.
But for others, this is simply reality reasserting itself in the marketplace.
A new analysis from DARPA this week analyzed whether blockchain technology, which serves
as the underlying transaction ledger for Bitcoin DeFi and numerous other cryptocurrencies,
is as decentralized as its biggest proponents suggest.
They found that four mining pools make up 51 percent of the total Bitcoin mining activity,
with two mining pools doing the same for Ethereum.
They found that 60 percent of Bitcoin traffic is confined to just three internet service
providers and that around four and a half percent of bitcoin owners control 85 percent
of the entire bitcoin pool.
So this decentralized industry is a lot more centralized than many people think.
Is this a problem?
Well, concentration can allow for possible collusion and could limit blockchain viability.
It raises the risk that a small number of large validators could gain enough power to
alter the blockchain for financial gain.
Additionally, large validators could deliberately congest the blockchain with artificial “wash”
trades between their own wallets in order to push up the fees that other traders have
to pay them to validate transactions.
Another big issue highlighted is that validators are able to front-run big orders for higher
trading profits.
Now, front-running does also occur in traditional finance, but it is illegal and is punished
by regulators, who are on the lookout for it.
Rent-seeking behaviors like this are just bad for market participants and could erode
interest in DeFi going forward.
The DeFi industry is of course aware of this and discussions about changes to governance
protocols, in particular to rein in collusion, have gained momentum.
But adopting these changes would not alter the basic fact that some centralization appears
to be unavoidable.
History shows that new and innovative technologies often cause bubbles or come from bubbles.
It is quite possible that new ideas that come from the crypto space will be of broader use
in the future.
DeFi might eventually play an important role in our mainstream financial system.
On the topic of regulation, since the main products in DeFi and almost all of their challenges
resemble those in traditional finance, a lot of the established regulatory principles could
reasonably serve as a compass for future regulation.
The basic tenet “same risks, same rules” should possibly apply, if for no other reason
to prevent regulatory arbitrage.
Let me know your thoughts in the comments section below.
If you enjoyed this video, you should watch my video on when pubs replaced banks during
the banking strikes in Ireland in the 1970’s.
Don’t forget to check out today’s video sponsor Private Internet Access by clicking
on the link in the video description.
See you next week, bye.