The idea of lending to regulated intermediaries such as banks and delivering much higher returns by lending digital assets was a key attraction of distributed finance, or DeFi. But that was before the bloodshed began, due to the collapse of the Terra-Luna cryptocurrency last month. The appeal of converting money into TerraUSD, a stablecoin that promised 1: 1 convertibility into dollars, consisted of an almost 20% yield on TerraUSD deposits. Withdrawal of funds from Anchor Protocol, the main DeFi loan application on the blockchain, crushed the currency, as did Luna, its sister property.
Shortly afterwards, lenders froze Celsius Network and Babel deposits. BlockFi Inc., a lending platform backed by Peter Thiel, said it had “fully settled or secured all related collateral” of a large client believed to be Three Arrows Capital, based in Singapore, a cryptocurrency hedge fund in trouble. BlockFi is reducing its workforce by 20%, just as Coinbase Global Inc., the largest US digital asset exchange company, is laying off 18% of its workforce. It sees no end to the cryptic winter. Of the $ 252 billion in investor capital tied up in the DeFi protocol last December, less than $ 75 billion remains.
Blockchain technology promised the Impossible Burger version of finance: lending without trust, the most important ingredient. DeFi market participants are anonymous. “It is not possible to assess the risk of borrowers using time-tested methods – from bank screening to relying on reputable online networks -” researchers at the Bank for International Settlements said recently. Thus, loans need to be mortgaged to make up for the lack of trust. But as recent events have shown, Bitcoin loans with Ethereum collateral can be just as flammable as a portfolio of subprime mortgages that support the CDO.
Compare the vulnerabilities Defi and the strength of “hawala”, a very efficient system for transferring funds in the Middle East and the Indian subcontinent to the media. If DeFi relies on software code to replace the courts in enforcing contracts, hawala seeks to fill a legal vacuum with trust. As Matthias Schramm and Markus Taube described the institutional structure in their 2003 article:
“(Hawala) is able to transfer large sums of money without resorting to a formal banking system and even without keeping accounting notes. Instead, it is based on the trust of the participants and the social and religious commitment within the Islamic community.
Modern regulators hate hawala because users of multinational, club-like networks can easily circumvent anti-money laundering and terrorist financing laws. Yet, the way the system works, it is almost impossible to eradicate it, or even discover it. Hawala intermediaries often maintain regular banking transactions that cannot be reported on legitimate accounts in small businesses.
Good or bad, hawala is a very real money transfer – and has been for centuries. On the other hand, a lot of DeFi is just a devolution of kabuki. Crypto smiles talk a lot about challenging the tyranny of governments and large custodians, although in reality DeFi can not even equate to the success, in this regard, of a formodern option. Hawala rose up to circumvent the lawlessness that pervaded medieval merchants who traveled long distances; it then learned to live outside – but alongside – the law.
That’s not all. To be a DeFi borrower, you need more cryptocurrency than the loan you are looking for. This restricts “access to credit for borrowers who are already rich in assets,” the BIS report said. For DeFi lending to be a serious tool for financial participation, two things need to happen. First, people need to be able to borrow under their own name in order to establish trustworthy behavior. Second, more real assets such as buildings and equipment must have a digital representation of the blockchain so that even the more affluent have initial insurance.
In terms of all the worries about large technology platforms benefiting from consumer data, fintech is doing much better than DeFi in participating. Online shopping platform MercadoLibre Inc. A mechanical learning-based scoring model is demonstrably better than what credit institutions can tell traditional banks about Argentina’s creditworthiness. Same for Alipay payment network Ant Group Co. in China. Fintech has added more diverse information – about a wider group of potential borrowers – to what traditional lenders might find out about the narrow group of people within the current banking relationship. This has had a major impact on emerging markets. A Nutella jar sold by a mom-and-pop store in India now tells a potential lender something valuable about their owner’s creditworthiness.
It does not end well to ignore information at the borrower level – or lose it in the mazes of financial engineering. Think of senior CDO mortgages where the underlying mortgage was a subprime mortgage. DeFi needs to give up on its tech-anarchist utopia and become more real and centralized. Otherwise, DeFi lending will go down in the financial annals as a mistake where hawala has succeeded: 21st century untrustworthy technology that loses out to 14th century innovation that thrived by maintaining trust supreme.
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